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Inflate, Hike, Repeat - The Week Ahead

FICC Podcasts April 07, 2022
FICC Podcasts April 07, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of April 11th, 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 166. Inflate, Hike, Repeat, 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 April 11th.

Ian Lyngen:

Friday's market holiday and Thursday's early close will offer a much appreciated shortened trading week. Thanks, SIGMA, you finally got one right.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's 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 I-A-N, dot, 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. That being said, let's get started.

Ian Lyngen:

In the week just past the Treasury market received a great deal of new information in the form of the March FOMC meeting minutes. Now typically the meeting minutes don't carry a great deal of informational value when it comes to trading and Treasuries. However, because of the timing of this cycle and the Fed's objective of normalizing the balance sheet, this particular release contained a great deal of insight. Specifically, the Fed has signaled that they intend to hike 50 basis points in May, as opposed to the 25 that we saw in March.

Ian Lyngen:

In addition, we learned that the Fed will run off the balance sheet at a pace of 60 billion per month, achieved in a ramp up that will only be three months. And mortgages will be runoff at $35 billion a month, also reaching maximum runoff in three months. In addition, the Fed has left open the possibility of selling mortgages directly out of SOMA, but didn't mention such an action for the Treasury market. So on net, the Fed has given us their blueprint for normalizing the balance sheet.

Ian Lyngen:

Now what I find fascinating about this is the price action that subsequently followed in the market. The Treasury market has been in a very bearish mode over the course of the first quarter. And as a second quarter has gotten underway, our stance has been to go with a trade to the point where we see a durable period of consolidation and buyers emerge. Now while that hasn't happened yet, what we have seen is we have seen the yield curve invert and subsequently uninvert. It's the re-steepening of the curve that is particularly telling.

Ian Lyngen:

Now the logic here is that the Fed has effectively laid out what they plan to do with all key aspects of monetary policy between now and the end of the year and therefore it is less of a tradeable event, if that resonates. Said differently, no one will be surprised at the May meeting to see a 50 basis point rate hike and the official announcement of balance sheet unwind hit the tapes. The surprise could come if they end up delaying the process, and a delay would clearly be a function of geopolitical uncertainties and have far less to do with the fundamentals of the US economy. That said, we're not anticipating a delay, although we will concede there's still roughly a month until the Fed meets.

Ian Lyngen:

What remains to be seen is how long the transition to the next phase of trading in the Treasury market occurs and what the focus will be. All else being equal, we anticipate that the next phase will be one focused on evaluating the impact of a tighter monetary policy stance on the real economy. Are increasing mortgage rates going to undermine the gains in the housing market to the point that consumers might adjust their behavior? Will higher food and energy prices continue to crowd out purchases of non-necessities, and therefore weigh on real spending in the US? And will all of the uncertainties facing the US and global economy ultimately lead to a downshift in the pace of domestic hiring?

Ian Lyngen:

All of these are clearly risks over the next several quarters, even as the Chair has reiterated that he believes that the economy is on strong enough footing to withstand rate normalization, as well as a runoff of the balance sheet.

Ben Jeffery:

So we got the minutes release and we did learn some fairly important information, most not around the Fed's balance sheet and how they're going to endeavor to start winding down their holdings in May.

Ian Lyngen:

I think the punchline from the FOMC minutes was that they have effectively used the official communication as a form for managing market expectations as it relates to the normalization of the balance sheet. We learned that the Fed will cap Treasury runoff at 60 billion and cap mortgage runoff at 35 billion. And rather than take several quarters to ramp up to these levels, the Fed expects it will take just three months.

Ian Lyngen:

Assuming that we get a May announcement that takes effect mid month, that means that by the end of the summer the runoff will be at the maximum levels. The Fed minutes also did an effective job of laying the groundwork for a 50 basis point rate hike when the fed meets again in early May.

Ben Jeffery:

And the market reaction to the minutes release itself was very telling. And what I mean by that is, it frankly was not all that dramatic following what we heard from Governor, still not yet confirmed Vice Chair, Brainard on Tuesday. And that she wants to get policy to neutral by the end of this year, and that the balance sheet runoff can be much more aggressive than it was last time around.

Ben Jeffery:

She has long been the most dovish board member and one of the most dovish on the entire committee. So the fact that we heard this relative hawkishness from her the day before the minutes, I would argue, gave the market a bit of an excuse to press the bearishness and ultimately get rates across the curve to their new highs. In the case of the front end, back to levels not seen since the height of the last tightening cycle when Fed funds was 225 to 250.

Ian Lyngen:

And in the longer end of the curve, we saw 10-year yields as high as 265, so the selloff managed to get 10-year yields back within striking distance of that 270 level. Which brings us to the obvious question, has the selloff run its course, and is this the point in which one might expect dip buying to become more relevant?

Ian Lyngen:

As we look for any indication that it might be the time to anticipate dip buying to become the norm, it's notable that the most recent Ministry of Finance data from Japan shows that Japanese investors have been net sellers of a total of 50 billion in overseas notes and bonds during the last 10 weeks. This is consistent with the run up into their fiscal year-end. And while the turn doesn't necessitate buying out of this region, it remains on the radar as a potential source of demand.

Ben Jeffery:

And outside of foreign flows in the Japanese fiscal calendar, we're also starting to hear increasing anecdotal evidence that domestic money that has been sitting on the sidelines for some time in anticipation of this great pickup in yields, is now beginning to take interest in duration now that we have seen this great pickup in yields so far in 2022.

Ben Jeffery:

10s beyond 265, 30s to a comparable yield level, now represents enough of an increase in yield that investors are starting to consider just how much more the selloff can extend, and if it's worth waiting to try and pick up that incremental discount. Or if now is the time to simply get into duration and take advantage of yields at levels that we haven't seen since 2019.

Ian Lyngen:

And that is the fundamental question. And I think it's also notable that the run up in rates has led to a crowding out of other products. For example, on the structured side we're increasingly hearing from clients that why would they venture into a non Treasury product when in fact, Treasury rates this high are attractive on an outright level. It's that dynamic that I expect will ultimately result in the needed flows sufficient to stop the selloff.

Ben Jeffery:

And, Ian, I'm glad you touched on that crowding out effect, because there's another aspect of what we learned from the minutes and the balance sheet rundown that's worth highlighting from an issuance perspective. And that is, when the Fed's monthly reinvestment is diminished by $60 billion a month in July, that's going to represent money that the Treasury department is going to need to make up via increases in auction sizes.

Ben Jeffery:

Now the timing of the May refunding announcement on the morning of the FOMC meeting means that Yellen won't yet have the necessary information to adjust coupon auction sizes to reflect balance sheet normalization. But as we get towards the August and November refunding announcements, the precise way in which the Treasury department will continue to fund the deficit and by how much they will start increasing coupon auction sizes, is going to be especially topical. And could add some marginal steepening pressure to the curve as we get through the third and toward the fourth quarter.

Ian Lyngen:

And this dynamic has also informed our general outlook for the Treasury market. We continue to anticipate that the market is actively in the process of establishing the upper bound for 10 and 30-year yields that will hold throughout the bulk of the summer. Historically, the period between the May refunding and the middle of September has tended to be net bullish for Treasuries, as yields decline and investors get a better sense of how the real economy is performing.

Ian Lyngen:

But now, fast forward to the end of the year, we anticipate a revisiting of the upward pressure that we've seen early in the year will become the path of least resistance. And expect that the path to higher rates in the first quarter of next year will resume yet again.

Ben Jeffery:

But early in the days of balance shoot rundown, the bill market still has room to grow to a size that is more in line with the Treasury department's longer run aspirations of getting bills to 15 to 20% of total Treasuries outstanding. As it currently stands, after the issuance of the last several years, we're below that other target band. So moving forward into May, June and July, it's certainly reasonable to expect that bill issuance will start to tick up.

Ben Jeffery:

There was also another very important detail within the minutes that framed how the Fed is thinking of winding down the bills that they still hold from those reserve management purchases that took place. After the repo volatility that took place in late 2019, the Fed still holds $326 billion worth of bill. And what we saw in the minutes was that they're going to use those holdings to make up for any shortfall in maturing coupons, versus the $60 billion cap.

Ben Jeffery:

For example, in any given month, if we have 50 billion of maturing coupons with a runoff cap of 60 billion, the Fed would then allow the net difference of 10 billion to be runoff in bills. This was definitely an area of focus ahead of Wednesday, and the fact that the Fed decided to offer some guidance on the topic was definitely well received by the market.

Ian Lyngen:

We also had an astute client ask a really good question as it relates to the Fed's bill portfolio. The question was, "Will the Fed choose to stagger the maturities of what they reinvest in the bill market to better match the months of the largest shortfall in coupon runoff?" In effect, slightly altering the buckets of maturities within the bill holdings to maximize the runoff potential.

Ian Lyngen:

Suffice it to say, there's no obvious answer to this yet, but it is a clear opportunity for the Fed to capitalize on the runoff momentum that the market seems content to price in and move on from.

Ben Jeffery:

And it's very much in keeping with their longer term goals of the balance sheet to consist of solely Treasuries. And the final important detail was that that will probably, at some point in the future, include the sale of some of their MBS holdings.

Ben Jeffery:

Mechanically that process probably won't be all that dissimilar to what they'll be doing with treasury coups and bills, in that as prepayments decline and in months when maturing MBS does not meet the $35 billion cap, any spread between maturity and cap will be made up for by sales into the secondary market. Not something that's going to be an issue in the very near term, but is something to keep in mind in the mortgage space as the process ramps up.

Ian Lyngen:

The mortgage market is particularly notable in this cycle, especially given the disproportionate increase in mortgage borrowing costs that have occurred over the course of the last several months. Now on one hand, the Fed has to be looking at the affordability index for the housing market and saying, "Well, there's a clear bubble." And an aspect of living costs that have contributed to the steady rise of core inflation, we've seen that in the OER and the rent figures. We don't expect that to shift anytime soon, even as this increase in mortgage rates will presumably take some of the wind out of the sales of the real estate market, at least in the near term.

Ian Lyngen:

Nonetheless, it does present an interesting quandary for the Fed. Given how much of the household wealth effect in the US is driven by home price appreciation, the process of normalizing borrowing costs could have a disproportionate impact on consumers' willingness to spend at a moment where prices on necessities, gasoline and food in particular, continue to rise because of supply constraints.

Ben Jeffery:

But OER represents 24% of CPI.

Ian Lyngen:

And 33% of PCE.

Ben Jeffery:

So in their mission to contain inflation, almost by definition, the Fed is going to want to take some of the upside out of the real estate market. And as has been the themes throughout 2022, this represents yet another tight rope that Powell is attempting to walk between weighing on consumption and weighing on inflation.

Ian Lyngen:

And to be fair, we don't need to see an outright reversal of home prices, just a slowing of the trajectory of the gains. I think that is very consistent, Ben, as you point out, with the idea that the Fed is in a somewhat precarious situation as they attempt to orchestrate a soft landing for the real economy, while ensuring that inflation expectations remain well anchored.

Ben Jeffery:

And it's with this backdrop that we saw 2s/10s on invert. We got as, quote unquote, steep as 15 basis points, which naturally led to the sarcastic question, has the recession been canceled? And the more serious one in that, is the path from here toward a steeper curve, or will we still see more flattening realized?

Ian Lyngen:

I didn't think that was sarcastic.

Ben Jeffery:

Wait, are you serious?

Ian Lyngen:

No. No, I'm not. But I do think it's a good question. And what we expect will play out over the course of the next several months is that we'll have an oscillation of the shape of the yield curve around zero. So in 2s/10s we could see the curb inverting as far as 20 basis points. But on the flip side, we could see positive 20 to 25 basis points as an opportunity used by investors to reestablish core flattening positions. Because as long as the Fed is actively hiking, the fundamentals behind a flatter curve in this environment will continue to resonate.

Ian Lyngen:

In the holiday shortened week ahead, the Treasury market will have a variety of incoming fundamental inputs with which to contend, not least of which will be a series of auctions. We have 46 billion in three years auctioned on Monday afternoon, followed by Tuesday's auction of 34 billion in 10s. Now this is a reopening. As well as the reopening of the long bond 20 billion on Wednesday. All else being equal, we expect some degree of a curve concession to take down supply, and that should keep a steeper bias in place, particularly in 2s/10s and 2s/30s, until the supply is dutifully absorbed.

Ian Lyngen:

Let us not forget, we see the March CPI data, where the consensus is for a 1.2% month-over-month gain on the headline basis. Now core is seen repeating February's gained by increasing 0.5% during a month. And that divergence between core inflation and headline inflation is growing, and clearly this is a function of the fact that energy prices are higher. And given the war in Ukraine, expectations are for not only energy but also food prices to continue to move higher.

Ian Lyngen:

When we dive into the details of the core CPI series, we'll be focused on the shelter category, particularly OER, or owners' equivalent rent, to see if we continue to see those consistent four 10s of a percent gains in the series. We'll also be particularly attuned to the new and used auto price series. That had been such a key contributor to the upside realized in April, May and June of last year, that it warrants attention at this stage, especially as we are approaching the base effects that will become relevant during the data for the second quarter. So Tuesday's print will be the last numbers where we would expect the year-over-year pace to increase, before having to contend with the base effects.

Ian Lyngen:

In addition, on Thursday morning, we'll also see the retail sales figures for the month of March. Expectations there are for 0.5% increase. Keeping in mind that this series is not presented in real terms, so in a month where headline inflation is seen increasing 1.2%, a 0.5% gain in retail sales represents a decline in real terms. Some of the detail offered within the retail sales spending figures will be notable, particularly the rotation between necessities and non-necessity spending. As we know, elevated prices do not have the same impact on each segment of the consumer base. And it follows intuitively that the lower quartile of wage earners will see a greater erosion of real purchasing power, given the run up in consumer prices that have occurred during the most recent stage of the recovery.

Ian Lyngen:

Now this is a fact that is not wasted on the FOMC, nor policy-makers in Washington more broadly. And this has surely contributed to the Biden administration's decision to release oil from the strategic petroleum reserve. What remains to be seen is the degree to which that will ultimately offset higher gasoline prices over the course of the next six months.

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 all eyes will be on Augusta this weekend and golf season gets underway, we're reminded that we're not out of the woods yet.

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 this show in some 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 2:

This podcast has been prepaired 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.

Speaker 2:

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. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients.

Speaker 2:

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Speaker 2:

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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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