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Inversion Springs Eternal - The Week Ahead

FICC Podcasts April 21, 2022
FICC Podcasts April 21, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of April 25th, 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 168, Inversion Springs Eternal. 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 April 25th. And as we dust off our Treasuries 101 textbook to help explain why five-year-yields would be higher than 30-year-yields, we realized the plastic seal has never been broken. And now, it all makes so much more sense.

Speaker 2:

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 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 had remarkably little in terms of fundamental information, with which to derive a trading direction of any relevance. We did see housing starts and permits, as well as existing home sales. A softer tone across all of the housing data did end up being the unifying theme. We also saw a disappointing Philly Fed Print, although frankly, it's been a long time since the manufacturing series has been a significant market mover.

Ian Lyngen:

The initial jobless claims print, which was for non-farm payroll survey week was strong, albeit slightly above consensus. But, given that the jobless claims numbers are trending as low as they are, it followed intuitively that was a limited pricing response in that regard. What was useful information in the week just passed, was the three basis points stop through for the 20-year auction. Now, this is been the highest yielding point on the yield curve for some time, yielding more than 30 years as that curve has been inverted for the bulk of the cycle. So with that context, it's not completely surprising that the $16 billion offering was underwritten with relative ease. It's also worth noting that the auction was an important departure point, for pressing the curve even flatter. Now some of the flattening was already underway, but we really didn't make it to break out momentum, until the 20-year auction.

Ian Lyngen:

Now, from a technical perspective, we've noted in the past that stochastics have been extended for some time in favor of higher yields, but also more recently in the last several weeks, in favor of a steeper curve. So with both past and slow stochastics above 90, the market was primed for at least an extended period of consolidation at best, as was realized. A meaningful correction toward a flatter curve. The re-inversion of the 5s/30s curve speaks to the strong fundamentals behind wanting to own longer dated duration as the Fed, and increasingly other major central banks, push forward with the process of monetary policy rate normalization. Now we've heard recently from the ECB, we know the Bank of Canada's on the move, as well as the Bank of England, to say nothing of the Reserve Bank of Australia, or New Zealand. So, upward pressure on policy rates has been thematic, and we don't expect that will change anytime soon.

Ian Lyngen:

What will be more fascinating is, the extent to which the full cycle that has already been priced into the treasury market remains as such, or if it's all ultimately extended. It's easy to envision a situation where we head into the May 4th FOMC meeting, expecting a 50 basis point rate hike and confirmation of the runoff of the balance sheet. And upon delivery, the market simply looks at the 50 basis points and says, "Okay." Comfortable with that cadence, not only for the June meeting, but also further out. And that would be a clear trigger for additional weakness in 2s, and it would accelerate the flattening and the depths of inversion that one might anticipate.

Ian Lyngen:

Our take on the shape of the curve, particularly 2s/10s, as well as 5s/30s, is that we'll drift flatter from here. And the market will ultimately find itself in a situation where the zero level functions as a focal point, and the curve oscillates on either side of that as a function of the perceived pace of rate hikes, and any increasing risk that the Fed has prematurely brought the recovery to an end.

Ben Jeffery:

So Ian, where should we begin? 3% or the curve?

Ian Lyngen:

Well, Ben, frankly, it's part and parcel of the same conversation. We saw 10 year yields back up to effectively, 3%. Technically, a little bit below there during the early parts of the week. That elicited a reasonable amount of dip buying interest. We then saw a very strong 20-year auction take down, which added to the curve flattening pressure. The 5s/30s curve re-inverted, 2s/10s off dramatically from the steepening peaks. And now, we find ourselves in a situation where we continue to ponder whether or not we actually will see a three handle in 10-year yields in any sustainable fashion. Now, the two technical levels that we had been watching were obviously the handle change at 3%, but then that 326 level, which represented the yield peaks from the last cycle. Now, that would clearly be a strong buying opportunity in the event that we got there.

Ian Lyngen:

But, given that there appears to be something of a stabilizing bid, it will be very informative to see how the next two weeks play out, in terms of trading in the treasury market. My focus at the moment is on Wednesday, the fourth, and Wednesday, the 11th. On the fourth, we will get the FOMC decision in which we're anticipating a 50 basis point rate hike and a balance sheet runoff announcement, but we'll also see the refunding announcement for the May series of three, 10 and 30-year auctions. The following Wednesday, the 11th, is CPI Wednesday. And within the April data, we'll get the first look at how relevant the base effects are going to be, and the extent to which they can bring the year-over-year prints in, headline in core inflation, off what I suspect will be the cycle peaks established in March.

Ben Jeffery:

And, I want to circle back briefly to what you touched on, Ian, which is last cycles' peak in 10-year yields at 326. The fact that we are even having a discussion about how much further 10s can sell off beyond 3%, after we've seen just a single 25 basis point rate hike this cycle, really gets back to this idea that we're in the midst of a very condensed economic, business, and monetary policy cycle.

Ben Jeffery:

Remember, the last time around, the Fed delivered lift off in December 2015, kept rates on hold for a full year, before ultimately delivering on that quarterly tightening cadence that concluded in December 2018. So, three full calendar years to see the same degree of bearishness play out that we've experienced in effectively a single quarter. And given what we saw in terms of how the last tightening cycle ended, the upper bound of the target range to 250, a sharp correction in equities at the end of 2018. And then, the very quick pivot to an on-hold stance from the Fed, has already led to incoming questions on just how long this equilibrium between tenure treasuries near 3%, and domestic equities that are holding in quite well, can persist.

Ian Lyngen:

And, I think that part of that comes down to the way that Powell and the Fed have framed the relevance of inflation to this cycle. Now typically, containing inflation with tighter monetary policy was presumably done at the expense of the employment landscape. This cycle, however, Powell has emphasized the importance of price stability for hiring plans, and hints identified inflation as the public enemy number one, as it were, for the real economy. I think that, that is to a large extent why risk assets continue to perform. Although, we are reminded that at the end of the day, tightening is tightening. And there will be ramifications, especially as 10-year real yields have recently drifted above 0% into positive territory.

Ian Lyngen:

Now, whether or not that ultimately ends up being sustainable is a different question. But from a market's perspective, the Fed has been effective in signaling their willingness to tighten at the risk of slowing the recovery. And the market has taken up the mantle, and effectively tightened even further for the Fed, as evidenced by how much is priced in the Fed Funds Futures Market, as well as the positive skew to real yields.

Ben Jeffery:

And along with the outright level of 10-year real yields, that as you point out, Ian, moved from decidedly negative territory into positive territory for the first time since 2013, it's also worth discussing the speed with which that's occurred. If you look at the price action in 10-year reals on a month-over-month basis, the size of the pickup we've seen in such a short amount of time has only occurred a handful of times over the last three cycles. And unsurprisingly, the tightening in financial conditions has also been very fast. But given the easy extremes that financial conditions started out at and outright level terms in the FCI, financial conditions are still much easier than they had been at any point before the pandemic. And, I would argue that it's this dynamic that helps account for the fact that the S&P 500 is still within and 10% of its all time high.

Ian Lyngen:

Another aspect of the recent price action that I have found fascinating, is the commentary around the steepening of the yield curve. Now, throughout the beginning part of April, there was a decidedly bear steepening in place, as the narrative shifted from normalizing policy rates to normalizing the balance sheet, and the ramifications around that, insofar as what that would suggest for the Treasury Department's borrowing needs and the way in which Yellen chooses to fill the funding gap.

Ian Lyngen:

Now, we're certainly cognizant that the Fed has made the argument, the reason that there's little term premium in the market and the curve is as flat as it is, has to do with the fact that the Fed has been actively engaged in buying treasuries directly in the market. And, therefore, the logic follows that once the Fed steps away and the balance sheet runs off, that some of that term premium will be in reinstated. My interpretation, and then I'll be interested in your thoughts on this, is that does hold true, insofar as all else being equal, you remove the Fed as a buyer. You let the balance sheet run off. You need to find other funding sources, that you should have a steeper curve. But the reality during this cycle is, the aggressiveness on the rate normalization front will overshadow any steepening impulse, and lead the curve back to this flattening bias with a potential for re-inversion, sooner rather than later.

Ben Jeffery:

Ian, I would completely agree. And would actually add the point that, maybe this steepening we saw in the early part of April was the market reflecting exactly that dynamic that you just highlighted. There's some debate whether the process itself will begin in May or start in June. In practical terms, the macro difference there is negligible. But it's the issuance implications and what was broadly expected to be a steeper curve resulting from QT, that I would argue pulled 2s/10s and 5s/30s back from inversion. And now, that the market has had an opportunity to trade that impulse, attention is shifting to the tightening part of quantitative tightening, in an environment when we're already starting to hear rising chatter about recession risks, how growth is going to fare, given what appears to be mounting headwinds in a world where there's far less monetary policy accommodation and fiscal support. Considering the gridlocked situation in Washington, that we'll be heading into midterms in November, where I would argue it's expected that Republicans are going to gain control of at least one of the chambers of Congress.

Ben Jeffery:

And, this matter is not just for growth, but inflation as well. And is another contributing factor, to the artist formerly known as transitory. We saw used auto prices fall, month-over-month in March's inflation data. And on the 11th, as you touched on Ian, the degree to which that continues or becomes more widespread in April's inflation data is going to be especially topical, now that the stimulus live effects of the unprecedented amount of fiscal spending we've seen have started to work themselves out in a more material way. That certainly doesn't mean we're on the precipice of a swift return to sub 2% year-over-year inflation, but it does on the margin hint that, maybe the peak acceleration of consumer prices is behind us.

Ian Lyngen:

Well, I think in practical terms, just looking at the math behind the base effects, most people are expecting that core year-over-year inflation will be sub-5% by the end of the summer. I think that, that's a reasonable assumption to bring into the next several months of trading. And it also puts into context, some of the responses seen by other major central banks. Obviously, the Bank of Canada recently moved, and we're hearing more and more chatter from the ECB and monetary policy makers in Europe, that positive rates should be a foregone conclusion by the end of the year. And July will probably represent the end of their asset purchase program.

Ian Lyngen:

What this does, is it not only and intuitively, puts upward pressure on front end rates throughout a variety of global fixed income markets, but to some extent, it also lessens the burden put on the Fed to be the only central bank out there, normalizing rates to offset inflation. Now, to be fair, Powell wasn't the first one out of the gate. As we know, the Bank of England started hiking rates, the Reserve Bank of Australia, as well as New Zealand have been on the move. So while this might optically appear to be a coordinated move in terms of global monetary policy makers, I would argue that it's more akin to major central banks pushing back against the same underlying set of fundamentals, I.e. inflation expectations risking no longer being well-anchored.

Ben Jeffery:

And on the topic of inflation expectations, I also just want to flag that after looking at the latest leg of the sell off that brought 3% 10s within range, unlike earlier this year, that was not a derivative of higher inflation expectations. And in fact, it was real yield driven, kind of getting back to that discussion we had earlier about 10-year reals moving briefly positive. And from the Fed's perspective, I would argue it's precisely that variety of an increase in rates that the Fed is pursuing. Higher real yields that weigh on economic activity and come at the expense of inflation expectations. Now, 10-year break evens are still unquestionably high, well north of 280, but they have pulled back from their all-time peaks set just a few weeks ago. And, Powell is surely taking solace in that.

Ian Lyngen:

And further to the point, Ben, I think that one of the underlying dynamics in the market is that this is a Fed credibility moment. So by that, I simply mean the market and a broad variety of investors need to be convinced that the Fed is not only able, but willing to follow through on the hawkish rhetoric and what that implies for higher policy rates. And as that occurs, what we'll see, is we'll see break-evens begin to sustainably drift lower. Now that will probably occur over the course of the next several months, unless we find ourselves in a situation where there is another external shock, in either the energy sector or in the global food and commodities markets elsewhere. So, obviously, the war in Ukraine has contributed to upward pressure on headline inflation, that is bound to persist for several months, if not quarters. However, there's going to be an increasing divergence between headline and core inflation, and as core inflation drifts lower, I suspect that five year forward break-evens will be the first gauge of market based inflation expectations to come back within the range, that the Fed would feel more comfortable.

Ian Lyngen:

And from my perspective, at least, I think that will be the first indication that the Fed has succeeded, insofar as they've received a vote of confidence from the market.

Ben Jeffery:

And, as we watch the reaction function, both in terms of Fed rhetoric and action over the summer months at the June, July, and September meetings, one of my key areas of focus is going to be, how much Powell chooses to de-emphasize the pickup in headline prices, in favor of focusing on core. If the committee is looking for a quote, "Dovish excuse," to walk back some of their extreme hawkishness, any spread widening between headline and core prices could certainly provide them a ready opportunity to shift to a 25 basis point per meeting, or slower rate hike cadence.

Ian Lyngen:

So are you implying something about summer doving?

Ben Jeffery:

It's never too soon for that joke.

Ian Lyngen:

No such thing as too soon.

Ian Lyngen:

In the week ahead, the treasury market will have a wide array of economic data and flows to deal with. It will be a defining moment, we suspect, for forward growth expectations. If for no other reason, then we get the first look at real GDP for the first quarter. The consensus as it currently stands, is that real growth increased 1%. Now, in nominal terms, this is going to be a much more impressive read, simply because the price deflator will be so high as a result of upward pressure on energy prices, as well as service prices more broadly.

Ian Lyngen:

Keep in mind that in the month of March, we actually saw a net decline in goods prices, which reflects what we expect will be a developing trend over the course of the next several months, where the rotation from goods consumption to service consumption continues, and that stabilizes prices on the service side at the expense of goods. More to come on that obviously as the inflation data gets closer and we get a better sense for how used auto prices are shaping up, as well as airfare, apparel, and some of the major movers within the inflation series.

Ian Lyngen:

Let us not forget, we also see durable goods on Tuesday, as well as consumer confidence. Now the conference board consumer confidence survey has been trending lower, albeit outperforming the University of Michigan. Now, the University of Michigan tends to be more heavily weighted toward equities and energy costs, in terms of what drives the shift in confidence. Whereas, the confidence board has a heavier employment component. So it follows intuitively that the conference board measure has held up better. Nonetheless, higher prices are going to continue to undermine confidence, with the caveat that as long as domestic equities can hold a reasonable range without a sharp correction, we suspect that the degree to which confidence undermines consumption will be limited. Let us not forget that, there's also a reasonable amount of excess savings that was accumulated during the pandemic. When while higher prices will erode savings more quickly, we're still early enough in the process that consumption patterns are unlikely to be curtailed, with the exception of the bottom quartile of wage earners. For whom, we've already seen higher energy and food prices lead to more meaningful substitutions and trade offs in the basket of consumption.

Ian Lyngen:

The week ahead also sees three treasury auctions, 48 billion, two-years on Tuesday, followed by Wednesday's five-year at 49 billion, and capped with the seven-year at 44 billion. We're generally apprehensive about front-end auctions in this environment, particularly the two year sector. While outright yield levels might be attractive, the influence of the Fed and the potential to price in more rate hikes will keep investors somewhat cautious, we suspect. Further out the curve we go, the stronger the case becomes to add at least incremental duration exposure. And so, that leaves us optimistic on sevens, with the nod to the fact that the five-year is simply going to be a function of terminal rate expectations at this point. So, we're operating under the assumption, and we'll argue that most in the market are, that the more aggressive the Fed is at the beginning of the cycle, the less they will need to hike later. And the lower the terminal rate will ultimately be.

Ian Lyngen:

Also embedded in the five-year sector is this idea that when one looks historically, we see that the Fed very rarely is able to keep policy rates at the terminal rate for more than nine months, before needing to either deliver a fine tuning adjustment or respond to a more material slow down in the real economy. So, that could also be an underlying factor as investors prepare to underwrite the five-year issuance.

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, both in terms of this specific episode, as well as 168 episodes. We would've taken the under on that one and lost, again. Hence, a career in strategy.

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 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. This show and resources are supported by our team here at BMO, including the Thick Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

Speaker 2:

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.

Speaker 2:

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.

Speaker 2:

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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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