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Inflation Conflation - The Week Ahead

FICC Podcasts July 08, 2022
FICC Podcasts July 08, 2022


Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of July 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 179, Inflation Conflation, 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 July 11. On the topic of payrolls, and our endeavors to remain on them, we're once again requesting support in the institutional investor survey this year. If you need more information, please reach out.

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 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 put in a very choppy performance. This is consistent with the time of the year, as liquidity starts to decrease. We have seen some modest stress in certain sectors, although Treasuries are comparatively an extremely liquid market. Nonetheless, the volatile price action is also consistent with the fact that the macro narrative is at an important inflection point. Recessionary concerns have increased. That has led to a bid for Treasuries. Some of that was subsequently reversed following the stronger than expected ISM Services print, as well as the better than expected payrolls data.

Ian Lyngen:

The upside from the BLS report was, in addition to the headline payrolls and private payrolls figures, were also contained in the higher than expected year-over-year average hourly earnings. This contributed to the perception that not only is a 75 basis point rate hike from the Fed on July 27 the path of least resistance. But the market is now pricing in a non-zero probability that the Fed will choose to move a hundred basis points, at the end of the month. Our base-case scenario remains for a 75-basis-point move, which will bring policy rates to the highs that were seen during the last cycle. We also heard from a variety of Fed speakers, as well as received the FOMC minutes.

Ian Lyngen:

The key takeaway from this series of events was that, while there is some evidence that the real economy might be cooling a bit, the Fed is committed to pushing forward with the process of rate normalization and with a acknowledgement that the Fed might actually hike us into a recession. On that topic, the Atlanta Fed's GDPNow tracker slipped convincingly below zero, suggesting that the first half of 2022 might actually have been a period in which the U.S. economy might have been in a mild recession. As we ponder the relevance of this for the Fed, given that any downturn in the real economy will be a function of higher consumer prices, by and large, we wouldn't anticipate that the Fed would slow the hiking process. In fact, if anything, it would only galvanize their commitment to normalizing rates. After all, once we see the GDP deflator start to drift lower, i.e., inflation come off the highs, that should be a net positive for real growth.

Ian Lyngen:

We've also seen the yield curve invert a bit further. 2s/10s, in particular, dropped below zero for the third time this cycle, and pushed convincingly toward the extreme of negative 9.5 basis points. 5s/10s also inverted. And that's the spread that we've been focused on, given that it represents the trade-off between a higher terminal funds rate assumption and a lower overall global growth outlook. And, therefore, we're expecting that a deeper inversion in fives tens will also prove to be the path of least resistance as the month of July unfolds.

Ben Jeffery:

So I guess the recession has been canceled?

Ian Lyngen:

One might be excused for thinking that, given the strength in the payrolls data. Headline payrolls gained an impressive 372,000 versus the consensus for roughly 275,000. In addition, we saw a stronger than expected year-over-year average hourly earnings print, up 5.1% versus the forecast of just five percent. Overall, it was a strong reading on the U.S. labor market that triggered a pretty significant selloff in the Treasury market, especially in the front end. In terms of the Fed, this all but cements a 75 basis point rate hike when the FOMC meets on the 27th of July. And, while we don't think it should be on the table, we're already starting to see a non-zero probability of a 100 basis point rate hike reflected in Fed Funds futures.

Ben Jeffery:

And, Ian, there was never really the risk that June's payrolls data was going to call into question the Fed's intent to deliver another 75 basis points at the end of this month. Sure, maybe a negative payrolls read would've skewed the odds more toward 50. But, at this stage, given what we've heard from monetary policymakers, and seen in the data itself, another 75 basis point hike is all but certain. There is the final fundamental update, and I would argue the one that really matters, in the form of Wednesday's CPI release. And, on your point of the market's willingness to price in more than 75 basis points and that tail risk of a hundred bp move, I certainly think an upside surprise in inflation would add to that market pricing dynamic, even if it is ultimately unlikely that the Fed would move by a full percentage point.

Ian Lyngen:

Now, obviously within the details of the CPI release, we'll be looking at the breakdown between headline and core. Given the relevance of higher energy prices and food prices to real spending power, the divergence between headline and core is becoming increasingly apparent. I'll also note that the front month RBOB future is trading off roughly 20% from the peaks. Now, while that's unlikely to be reflected in June CPI data, it does become more relevant for the current month which, of course, won't be released until mid-August.

Ben Jeffery:

And along with the payrolls report, we also did get the minutes of the June FOMC meeting this past week which, again, reinforced the Fed's hawkishness and served as a flattening impulse to the yield curve. The primary risk in the Fed's eyes, at this point, is that inflation becomes quote/unquote "entrenched." And, related to the point you made about gas prices, Ian, the role that gas prices play in consumers' expectations of inflation means that, even if we start to see core inflation moderate, so long as headline inflation remains high, it's that risk of higher inflation expectations driving higher realized inflation. That is exactly why the growth outlook is dimming, and why the Fed is still so hawkish, hence, an inverted curve.

Ian Lyngen:

And I think that the inverted yield curve is a key component of the Treasury market, at this point. One that we anticipate will ultimately define the second half. Now it is important to keep in mind the history of curve inversion. So, for context, we tend not to see 2s/10s dip materially below negative 10 basis points. In 2006, we got the spread down to negative 20 basis points. And, as we think about the rest of 2022, and the balance of risks facing the real economy versus the Fed's commitment to normalized rates, we can't help but assume that that lower bound is going to be vulnerable. Specifically, negative 20 basis points will serve as an initial target for us. But we do think that this cycle will see a breach of that key level.

Ben Jeffery:

And, related to that discussion, Ian, was what we saw in terms of the outright performance of yields over this past week. We got 10-year yields down to 2.75, more or less, which closed an opening gap we had been watching. And, once we challenged that threshold, heading into NFP, 10-year yields moved back to effectively three percent into the numbers themselves. And this was driven, at least partially, by both what we saw from the minutes, but also the ISM Services gauge that came in stronger than expected, as some evidence that service-providing firms are not suffering from the same degree of recessionary worries that the bond market was earlier this week, that 3.25, 3.26 level in 10s is still going to matter, both psychologically, and as 2018’s yield peaks.

Ben Jeffery:

With, obviously, that 3.497 level we saw, set in early June, a clear line in the sand in evaluating whether or not we're going to see enough bearish conviction over the second half of this year to get rates higher than that level.

Ian Lyngen:

Returning quickly to the FOMC minutes release, another aspect contained within the official communique was the notion that the Fed is worried, and rightfully so, about maintaining credibility. Now, part of that is so that, as you pointed out, Ben, higher inflation expectations don't become entrenched in the economy. And in keeping with that theme, I think the framing of credibility is important. It's a double-edged sword. On the one hand, the Fed needs to be aggressive enough during this cycle to maintain what I'll characterize as decades of hard-won credibility as an inflation fighter. That much goes without saying. If the Fed is comfortable risking a modest recession, and hopes that we don't see one, that seems reasonable given the trade-offs.

Ian Lyngen:

But the flip side of credibility comes in the form of the Fed hiking too far, and triggering a significant recession, one that is characterized by materially higher unemployment which brings us back to the misery index, i.e., the combination of the unemployment rate and headline CPI. At present, it's currently tracking CPI, given that the unemployment rate has been steady at 3.6%. But, if the Fed's normalization is effective and we start to see the unemployment rate come off the lows, then, it would follow intuitively that, if we don't see year-over-year CPI start to edge lower throughout the course of this year, then the fallout for the consumer, particularly in real spending terms, could be rather dramatic.

Ben Jeffery:

And shifting gears slightly, but still in the realm of Fed credibility, front-end investors that we speak to continue to ponder just how rich the bill market is, how low funding market rates are relative to the Fed's target band, and the sheer amount of cash that continues to sit at the RRP overnight. Well over $2 Trillion, on a daily basis, serves as a reminder of the massive amount of liquidity that Powell injected into the system during QE. And, unlike the speed with which QE was rolled out, undoing that is clearly going to be a much more drawn-out process.

Ben Jeffery:

We've heard the criticism levied against the Fed that they need to drop the RRP rate back to being in line with the lower bound, in order to start dis-incentivizing use and getting some of those funds back into the market. However, what we saw in the minutes release was the exact opposite line of thinking. In fact, the Fed is considering increasing counterparty limits to introduce even more upside to the RRP in order to take some of the pressure off short rates that we've been seeing. Now, Fed Funds' effective is still eight basis points off the bottom of the target band, which historically the Committee has been comfortable with. And it's not until we start to see that drift higher, to 10, 12 basis points off the bottom of the band, that I would really expect a downward revision to RRP would become topical.

Ben Jeffery:

Another point made in the minutes, in a notion that we are certainly on board with, is that will need to be a function of the gradual rundown of the Fed's balance sheet that's still running at $30 Billion a month in Treasuries. We're not going to see that pace increase until September. And, frankly, with over-tightening concerns already making their way into the market, to me, at this point, it seems unlikely the Fed will want to ramp up the balance sheet rundown, at least through the end of this year, if not, frankly, the early part of next year.

Ben Jeffery:

And, on the issue of next year, and related to the balance sheet, was something that was worth highlighting from our pre-NFP survey this month, in that nearly half of the respondents expect the first rate cut of this cycle will be coming at some point in the second half of next year. Right around 20% expected, either a third quarter '23 or, fourth quarter '23, rate cut with another 20% looking for that to take place in the first quarter of 2024. But, in any case, it's become clear that the market's expectation is that Powell is not going to be able to keep rates at terminal for long.

Ian Lyngen:

And this obviously feeds into our rate forecast. We came into this year thinking that we could see 10-year yields ending 2022, and a range of 2.25 to 2.50. Clearly, we're biasing that toward the 2.50 level, or the upper end of the range, at this point. But, implied in that is, as we mentioned earlier, a relatively deep inversion of the curve. However, as history suggests, it's not out of the realm of possibilities to see two-year yields trade below effective Fed Funds or, more importantly, in this particular cycle, below the expected terminal rate of Fed Funds.

Ian Lyngen:

So that means that we could have two-year yields at the end of this year with a two handle, while effective Fed Funds is at, let's call it, 3.25, which is what the market is currently pricing. A typical yes, but certainly not off the table. Said differently, while the Fed has historically had control over the front end of the curve, over the last 10 or 15 years, what we have seen, and was characterized as a conundrum, is that longer-dated yields, 10s, 20s, and 30s, are responding to a different set of influences, notably the global growth and inflation outlook.

Ian Lyngen:

Fast forward to the end of this year. To a large extent, two-year yields have functioned as a floor to how low 10-year yields can be in a given cycle. Again, as we highlighted earlier, inversions tend to only go as deep as negative 20 basis points. One of the risks for this particular cycle is that, that dynamic breaks. And our logic behind that dynamic breaking is relatively straightforward. This is the first time that the Fed has said that they're going to keep hiking monetary policy rates, regardless of what happens to the real economy. Even if there is a recession, the Fed needs above all else, to make sure that forward inflation expectations are contained. And that is going to be expensive.

Ben Jeffery:

And at least, as measured by the TIPS market, we're starting to see some signs of collective faith in the Fed's ability to keep inflation contained. Five-year, five-year forward, and outright 10-year break-evens, have both continued to decline sharply back to levels that are some version of acceptable from the Fed's two percent inflation target. Now that certainly doesn't preclude more periods of widening, especially around CPI releases, like the one we're going to get this week. But, generally speaking, the more time break-evens spend closer to two percent than three percent is going to be interpreted by the Fed as a positive development and an endorsement of the effectiveness of their hawkishness.

Ian Lyngen:

Speaking of endorsements, Ben, where are all those podcast sponsors?

Ben Jeffery:

I agree. I like to think of us as the Dumb and Dumber of the bond market.

Ian Lyngen:

Don't have to think very hard to get there. In the week ahead, the Treasury market has a variety of meaningful events from which we expect a convincing trend to be derived. First, we have a series of three coupon auctions of note. We have, Monday, the $43 billion three-year, Tuesday, the $33 billion 10-year and, Wednesday, the $19 billion 30-year. The Fed moved the schedule forward by a day to allow for a buffer day between the last auction on Wednesday and the actual settlement of the auctions on Friday, May 15.

Ian Lyngen:

The calendar also contains what is arguably the most important data point at the moment, i.e., June's CPI release. The consensus call is for a 1.1% monthly gain, a lot of that attributed to higher energy costs as well as higher food prices. Core CPI is seen increasing just 6/10 of a percent month over month. And, within there, we’ll be focused on OER, new and used auto prices, as well as airfare. Recall that the pass-through of higher fuel costs to air travelers has been thematic over the course of the second quarter. And we don't anticipate that will change anytime soon.

Ian Lyngen:

All else being equal, the divergence between headline and core remains an interesting facet of the market at the moment, but not one that is going to lead to any changes in monetary policy direction. In practical terms, we don't anticipate the difference being of any relevance, at least from Fed speakers and the official policy stance, until after the midterm elections have passed. Let us not forget that the week ahead also shows the retail sales numbers for the month of June. Given the spending trend in the first quarter was revised lower, via the final Q1 GDP numbers. And personal spending, at least in real terms, has been trending lower throughout the second quarter. All eyes will quickly shift from CPI to retail sales, once the inflation numbers are in hand. So at a 9/10 of a percent headline forecast for Friday's retail sales figures, if in fact, CPI prints at 1.1%, that means, in real terms, spending during the final month of the second quarter, we'll be trending into negative territory.

Ian Lyngen:

As this feeds back into the recession argument, negative real spending figures will be a drag on the outlook for second-quarter growth. And the final data point of the week will be the consumer sentiment figures in the University of Michigan survey. This is for the month of July. And the consensus is looking for another record low print. More importantly, in terms of forward expectations for inflation, we'll be watching the medium term inflation numbers. Recall that, recently, the June figures were revised from 3.3%, in terms of the five to 10-year inflation expectations, to 3.1%. And, at 3.1%, that still represented the upper bound for this cycle. But the fact that it was revised down by 2/10 of a percent did lead to a rally in the Treasury market that was led by the front end of the curve.

Ian Lyngen:

So the inflation numbers will be of particular relevance as the market continues, the process of recalibration, to reflect the Feds' increasing degree of hawkishness as well as the risk of a slowing economy as 2022 unfolds. 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 in the wake of the July 4th holiday, we're reminded that the next long weekend isn't until September. SIFMA, that's just unsporting of you. Thankfully, July is National Self-Regulator Awareness Month.

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 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.

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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