Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

Hut Hut Hike - Monthly Roundtable

FICC Podcasts November 03, 2021
FICC Podcasts November 03, 2021

 

Margaret Kerins along with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton and Ben Jeffery from our FICC Macro Strategy bring you their reactions to the November FOMC meeting and other main narratives that are dominating market pricing and what these themes imply for US rates, high quality spreads and foreign exchange.


Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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.

Podcast Disclaimer

Read more

Margaret Kerins:

This is Macro Horizons, monthly episode 34, Hut Hut Hike, presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton and Ben Jeffery from our FICC macro strategy team to bring you our reaction to today's FOMC meeting and the other main narratives that are dominating market pricing and what these themes apply for US rates, high quality spreads and foreign exchange. Each month members from BMO's FICC macro strategy team, join me for a round table, focusing on relevant and timely topics that impact our markets. Please feel free to reach out on Bloomberg or email me at Margaret.kerins@bmo.com. With questions, comments, or topics you would like to hear more about on future episodes. We value your input and appreciate your ideas and suggestions. Thanks for joining us.

Speaker 2:

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

Margaret Kerins:

So in line with expectations, the FOMC announced a taper of 15 billion per month, consisting of 10 billion in Treasuries and 5 billion in agency MBS to begin later this month with purchases likely ending mid-2022. Of course, the pace is not on a preset course and will be adjusted if needed. Also in line with expectations at today's refunding, Treasury announced nominal coupon cuts that will trim net issuance by a trillion dollars over the next nine months. If they continue to cut at the current pace. And as a result, Treasury coupon cuts basically offset the reduction in Fed purchases. For example, through mid-2022, Treasury is set to issue about 400 billion less in nominal coupons while the Fed is set to purchase about 360 billion less in Treasuries. So even though taper and coupon cuts were just announced today, it seems like old news, the market had already moved the next play in the sequence of accommodation removal.

Margaret Kerins:

The timing of the first rate hike. Currently, the market is pricing a probability of 2.25 basis point hikes by the end of 2022 and the possibility of an earlier Midsummer liftoff. There are four Fed meetings in the second half of 2022. So basically the market is pricing a chance of a 25 basis point hike at every other meeting, which is similar to the hiking pace from [inaudible 00:02:30] D 2016 to D 2018. During that period one-year OIS generally underpriced the pace of tightening by about one hike at the onset of the cycle.

Margaret Kerins:

Then market expectations fell in line with the eventual realized rate and as the actual pace unfolded, however, one-year OIS still slightly underpriced the actual moves likely due to recency bias because a full year passed between the first hike in 2015 and the second hike in 2016. So we continue to expect the fight to keep a few months between the end of taper and liftoff as they have consistently attempted to divorce the two actions and Powell reinforced a patient stance today, while this falls within our base case for inflation to be transitory, it's also a matter of credibility for the Fed.

 

 

Margaret Kerins:

So let's kick it off with Ian. Ian, the market is a tiered cheaper and steeper on the back of the FOMC. Powell reinforced the FOMC's commitment to full employment and being patient regarding liftoff while also acknowledging that they want to be in a position to act, to ward off inflation, if needed, which is completing tapering. So, Ian, how are you interpreting this FOMC meeting and the market's reaction?

Ian Lyngen:

Well Margret? I think that one of the most fascinating aspects of this particular FOMC meeting was we came in as a market to the event expecting that the Fed would follow what we had seen from other global central banks, specifically the Bank of England as, as the Bank of Canada and the RBA, which all had decidedly more hawkish leanings. In fact, what we got was a very typical Fed transition into the next phase of monetary policy, which as you pointed out is a steady tapering effort, a bit of flexibility around the $15 billion a month tapering. But to a large extent, the assumption at this stage is that it is largely on autopilot.

Ian Lyngen:

What I thought was fascinating in the press conference was when Powell was asked about the trajectory of inflation, he reiterated the idea that the Fed expects inflation to begin to moderate in the second quarter or third quarter of 2022. So my takeaway from that was not only did the Fed double down on the transitory characterization and the out performance of inflation, but they also made it clear that they can hold onto that definition well through the first half of next year.

Ben Jeffery:

And Ian, another critical facet of Powell's tone at the press conference was his level of concern on what we're seeing in the labor market. And specifically on the participation rate, remember that while yes, we've seen a very impressive recovery in jobs since the depth of the pandemic, we're still missing 5 million jobs versus pre pandemic levels. Now, clearly a complete recovery was not the needed threshold to begin tapering, but Powell's focus on those still absent jobs and especially among the subsets of the population hardest hit by the pandemic. I think reinforced that more patient stance. In addition to an acknowledgement of some of those inflation considerations that you touched on.

Ian Lyngen:

Powell also made it very clear that the depressed labor market participation rate was a surprise to the Fed of this cycle. And I think that, that's important when we think about the Phillips curve and what it implies for future inflation gains. The chair made it abundantly clear that the Fed is not viewing the run up in wages simultaneous with the supply driven inflation spike as a traditional Phillips curve dynamic, which has implications insofar as how long the Fed might be willing to wait to allow the bottlenecks and the supply chain disruptions to work their way through the system

Margaret Kerins:

So, Ian, I really liked your point about Powell doubling down on the FOMC's characterization of inflation as transitory. They really reinforce the idea that they want to wait and see how the labor market evolves and develops once the Delta variant spike is over. Basically they will be patient even in the face of inflation in order to get greater clarity on the ground regarding employment. This seems to be a very different message from what we're hearing from some of the other central banks globally,

 

Greg Anderson:

Interesting point Margaret. I'd like to back up to a year ago, roughly. And at that point, the dollar was drifting down what I would call a steady percent and a half a month pace or so, and I had the open question like who's ever going to dare to tighten policy because the way that currencies are arising, nobody will dare to get it in front of the Fed in terms of tightening. Well, what ended up happening is early this year, the dollar touched bottom and started to move the other direction. And we've had a bunch of central banks, I would say, get ahead of the Fed. So, Bank of Canada has completely ended its QE program.

Greg Anderson:

The RBNZ, not only did it end its QE program, they've raised rates, the RBA has taken its first tapering step several months ahead of the Fed. They ended their yield curve control. They ended their funding for lending scheme. You know, all these steps were taken and their currencies did not take off. And that's kind of been a surprise. And I wonder if that's kind of encouraging news for the Fed that maybe they can act and not have to worry so much about foreign exchange implications because the sensitivity of currencies to policy shifts seems to be less than it has been in previous tightening cycles.

Margaret Kerins:

So, Greg, that's an interesting dynamic that's currently playing out in the foreign exchange markets relative to what's going on in monetary policy. Do you think that the currencies will react in a more traditional way eventually?

Greg Anderson:

That's a great follow up question Margaret. My typical rule of thumb has been the first rate hike in a cycle, and particularly if a central bank's acting alone and pretty much the same for a first rate cut in a cycle too, that should be worth something like 5% for the currency. And it just hasn't been. Will we ever have some type of a catch up move, maybe, but I guess if it didn't happen on the first reaction, chances are not that good that you have the catch up move. Maybe we're just in a less interest rate sensitive environment for foreign exchange.

Margaret Kerins:

Well, speaking of divergent central banks, Stephen, what's going on with the ECB.

Stephen Gallo:

Thanks for the question, Margaret. Yeah, I think the European Central Bank is a very interesting topic because in as much as there have been, as Greg pointed out hawkish shifts by central banks, one central bank that has not gone out of its way to be hawkish is the European Central Bank. And here's the question. Does this reflect the fact that the Eurozone typically has low inflation or does this reflect that the ECB has less flexibility to anchor inflation expectations? And I would argue it's a bit of both. And that in addition to having low inflation in the Eurozone, the ECB is constrained by the need for it to soak up a lot of sovereign issuance, particularly of Italy and parts of the periphery. But also I would argue France, because France's borrowing is set to remain high in the run up to the spring of next year.

Stephen Gallo:

And the government just raised its forecast for the 2022 deficit, the fiscal deficit, interestingly for the time being the backup and rates, which has occurred despite the ECB remaining dovish has been viewed positively by investors. So if you look at bank share prices in the Eurozone collectively, they're about 4%, I think, quarter to date. And that's probably indicative of the market viewing the re-pricing of yields as a good thing for net interest margins. But obviously there's a limit to how far rates can back up without raising concerns. So, I think there are two scenarios here, which are crystallizing for 2022 that are worth considering two different scenarios. One is that inflation pressures show signs of dissipating energy prices, dip the Euro zones, energy import tab drops, and that gives the ECB more legal room to keep policy easy for longer, possibly even still growing the balance sheet next year through asset purchases that would cap the Euro.

Stephen Gallo:

The second scenario is that the ECB falls behind the curve on anchoring inflation and has to catch up quickly in which case the backup and yields becomes a problem for credit spreads and I don't think you want to be over exposed to the Euro or the Eurozone in that case. For the time being, I think my money would be on scenario one, the ECB gets more leeway to keep growing the balance sheet, but there is really a palpable risk to that view if inflation pressures prove stickier. And that's why my conviction on this is medium as opposed to high.

Margaret Kerins:

Thanks Stephen. Let's shift gears a bit. I'd like to go back to the Fed and the bottlenecks that were discussed today in the market that we all are aware of and the frictions in the labor market. So, for Dan and Danny, this kind of goes right to your credit markets, which are on the front lines of the supply chain issues and labor market frictions, but credit spreads really haven't reacted and have been trading in quite a narrow range. What is your interpretation of this?

Dan Krieter:

Yeah, Margaret, I think we could start with what you said about credit outperforming. It really has been quite the out performance of credit in just the past couple weeks, given all the volatility and fixed income markets, particularly at the short on the Treasury curve. Credit just hasn't moved at all and is still just four or five basis points off cyclical lows despite all that volatility. And you touched on some of the key things that we're focused on right now, supply chain constraints, cost of labor, that credit market investors are really focused on that could impact earnings going forward. And we've seen throughout the current earning season in Q3 earnings releases, we've seen, sort of one executive after the other, most of them all coming out and saying that supply chain constraints are not something they're too worried about in the long term, but there has been at least some degree of concern displayed over the cost of labor.

Dan Krieter:

Labor costs don't often go down and this could be a more permanent increase in labor. And I think that aligns relatively well with what the Fed was saying today. They're really harping on the notion that this is supply side inflation, even going so far to say that their tools are not equipped to deal with that. I mean, there's multiple examples throughout the press conference where Powell kept saying that. So, it does seem from both those on the frontline and from our central bank, that supply chain constraints look like they're going to be cleared up in the next six to 12 months. And, and that inflation should ultimately come down and for credit, I mean, I think that's a pretty dovish reading. I mean, I think the Fed meeting today was pretty much as dovish as it could be. I mean, Ian talked about it earlier.

Dan Krieter:

Chairman Powell says they expect inflation to moderate in Q2 or Q3 of next year and they acknowledge it should be very, very high in Q1. Well, the market's currently pricing to a June hike. How are you going to hike rates if you're still expecting inflation to come down, even keeping transitory in the statement itself, everything seemed to be dovish all along the way. So I think that'll give a bit of a boost to credit here in the near term, but looking ahead to the medium and longer term, I do think there are still some factors that may lead to credit repricing to at least a slightly wider trading range in 2022.

Dan Belton:

Yeah, Dan, and you mentioned a lot of the reasons that credit liked this announcement from the FOMC. Credit spreads are in about a basis point and a half in IG, and as many as four or five basis points in high yield, at least based on the derivatives market right now. And this is really a continuation of a trend that we've observed for much of the past several months, which is credit outperforming, where fundamentals really dictate they should be trading. So, over the past three months or so our model implied valuation of credit spreads has credit out about 20 basis points, whereas actual credit spread indices have really not budged at all. And this is based on a lot of the factors in our model, just moderating from these very, very bullish levels that we've seen over much of the past year to the levels more in line with historical norms, suggesting that credit should eventually move back to more normal ranges.

Dan Belton:

Of course, we haven't seen that happen and a big reason for that is the monetary and fiscal accommodation we've seen. And even if credit continues to rally on days like today, given this continued Fed support, it's likely that once the mechanical impact of tapering starts to feed through to less accommodated financial conditions, the credit is likely to face a much more challenging environment, particularly in the context of inflation remaining elevated for the next few quarters or so, at least by chair Powell's admission today. So, we think that into year end and early next year credit is likely to migrate to wider trading ranges about 10 to 20 basis points wider than current levels.

Margaret Kerins:

So, Dan and Danny, you raise some really interesting points and one of them is the inconsistency with the market pricing and mid-summer liftoff. While at the same time, the Fed believing that inflation will be transitory and come down, which makes liftoff a little less likely. However, when I think about the Fed in those terms, just the mere fact that they need to be ready to react in the event that they are seeing persistent in high inflation means that the market has to price some risk of that, even though it might be a lower probability. Ian, do you have any thoughts on that?

Ian Lyngen:

Yeah. My counterpoint to that would be the timeline that Powell laid out today, insofar as reiterating expectations for inflation to moderate in the second and third quarter of next year. Pricing in a June rate hike in implies that the Fed will abandon the transitory definition sometime in the first quarter of next year, start accelerating the tapering process and then find itself in a situation that a June liftoff rate hike makes sense. Now I'm not going to suggest that ultimately it might not be the case that inflation isn't transitory, because I think in being intellectually honest, we need to keep that open as a potential risk. What I would say, however, is that such a quick transition would need to be predicated on even stronger core inflation numbers than we saw in the first quarter. And in practical terms would crush the five year sector and flatten the 5s-30s curve rather dramatically as the market then subsequently assumed that the Fed was far enough behind the curve that they would need to ratchet up terminal rate expectations as well.

Margaret Kerins:

Certainly not our base case in the marketplace. That's something to keep an eye on. One other topic that Chair Powell discussed today was the idea of the Fed's definition of transitory, which is something that we've discussed before. This perception in the marketplace that inflation has to come down in order for it to be transitory. When in reality, it just doesn't have to persist and become something that consumers and corporations are embedding into their future daily expectations. I thought that reinforcement of how the Fed is looking at inflation was an effort to try to mitigate maybe that earlier pricing that's going on in the market.

Ian Lyngen:

Yeah. I tend to agree Margaret because effectively what Powell has said is a massive one off repricing in consumer prices as a result of supply chain issues, and bottlenecks is entirely different than organic demand driven inflation that investors and consumers should expect to continue for the foreseeable future.

Dan Krieter:

And I just would jump in there Ian, by saying there is a demand component to it. Powell said that today, but I think when you think about things from a demand perspective that this pent up savings that we all got during the pandemic, either from stimulus payments or from asset price appreciation or just from not being able to do anything. So like for savings, like there is this big deployment of savings now. And so when you combine supply constraints with a onetime disposal of pent up savings, of course you're going to see inflation. But if we look at this as just savings being spent on whatever it is, living costs, so maybe you don't have to go back to work so quickly or that luxury item that you've always wanted to have once that's exhausted, you're going to theoretically have supply constraints being ironed out while demand falls back to more historical levels. If we're not seeing that psychological shift, like you were saying. So, ultimately, inflation likely proving transitory, whatever that definition is.

Margaret Kerins:

Good point, Dan. Along with the Fed, the market also needs to be patient to see how employment and inflation unfolds over the next couple of quarters. So, let's shift gears a bit. Powell did the Hut Hut Punt today on the question regarding the Fed chair. And of course we had news yesterday that president Biden said that he will announce his Fed pick soon, and that he's got a lot of good choices. So, what are we thinking about the probability of Powell being renominated? I'll pass this one to Greg.

Greg Anderson:

Margaret. There is a futures market conducted by predictit.org. Not going to read out the whole URL, but it's pretty easy to find. That has a contract on, will Powell be confirmed by the Senate as Fed chair second term. And he was trading at about 75 cents on a $1 payout. So, call it a 75% implied probability before those remarks by Biden yesterday, he dropped to 64 cents after those remarks. And he was trading at about 68 or 69 an hour or two before this press conference, guess what? He's back up to 75 cents. And I would just say the press conference and the way he handled it, he didn't seem like somebody who was under the gun and worried about renomination. Personally, I think the market odds that are in that price are probably about right.

Dan Krieter:

And to piggyback on that, Greg, I mean, Biden just has other things to worry about right now. He's got a package he's trying to push through Congress that he needs Congress focused on that. Not confirming a potentially more controversial choice. I agree with you. I think it's going to be Powell. And if it is Powell that gets Renominated, I think there's a very high likelihood that governor Brainard will be given the vice chair, a supervision role, which is an important thing to look for with more regulation likely coming in 2022 with a new vice chair. Powell fielded a few questions in the presser today on things like SLR and Treasury market functioning that will likely be coming down the pipe pretty soon once we have a new vice chair.

Margaret Kerins:

All right. Thanks Dan and Greg, for your thoughts on Powell being renominated. So, that's a wrap. Thank you to all of our BMO experts and thank you for listening. This concludes Macro Horizons, monthly episode 33, Hut Hut Hike. As always, please reach out to us with feedback in any ideas and topics you'd like us to tackle.

Margaret Kerins:

Thanks for listening to Macro Horizons, please visit us at bmocm.com\macrohorizons. We'd like to hear what you thought of today's episode. You can send us an email at Margaret.kerins@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. And we'd appreciate it if you could take a moment to leave us a rating and a review. 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 is produced edited by Puddle Creative.

Speaker 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Inc. and BMO Capital Markets Corp. (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. Notwithstanding 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. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. .

Speaker 2:

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 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 U.S. Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you or in your best interests and 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. You should conduct your own independent analysis of the matters referred to herein, together with your qualified independent representative, if applicable. .

Speaker 2:

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. .

Speaker 2:

BMO and its affiliates may have positions (long or short), and effect transactions or make markets, in securities mentioned herein, or provide 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.

 

Margaret Kerins, CFA Head of FICC Macro Strategy
Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy
Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD
Ben Jeffery US Rates Strategist, Fixed Income Strategy

You might also be interested in