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Jay Powell and the Inflation Jitters - Monthly Roundtable

FICC Podcasts October 05, 2021
FICC Podcasts October 05, 2021

 

Margaret Kerins along with with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Ben Reitzes, Dan Belton and Ben Jeffery from our FICC Macro Strategy discuss the new range for US rates and  what to expect in 2022, potential implications of Fed taper on TIPS pricing and what this means for nominal yields, oil prices and the FX market, G10 monetary policy stances, inflation versus growth in Canada, and corporate market supply and spread projections including implications of a new Vice Chair for Supervision at the Fed.


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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.

Podcast Disclaimer

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Margaret Kerins:

This is Macro Horizons, monthly episode 32, Jay Powell and the Inflation Jitters, presented by BMO Capital Markets.

Margaret Kerins:

I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Ben Reitzes, Dan Belton and Ben Jeffrey from our FICC Macro Strategy team to bring you our debate of the main narratives that are dominating market pricing and what these themes imply for US and Canadian rates, high quality spreads and foreign exchange.

Margaret Kerins:

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 are the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Margaret Kerins:

The main themes dominating market pricing include the ongoing frictions and supply chains and the labor market as the US economy continues to reopen and what these frictions imply for economic growth and inflation in the backdrop of debt ceiling, jitters and additional fiscal stimulus. On the COVID-19 front, we've had some positive news of an antiviral pill that some are calling a game changer in the fight against the virus. On the taper front, all eyes will be on Fridays nonfarm payrolls data. The consensus is currently a gain of 450,000 for September, following an increase of 243,000 in August, which was well below expectations. Chair Powell indicated at the last FOMC meeting they would only take a reasonably good employment report for the Fed to announce reduction in asset purchases as soon as November. For us, reasonably good is probably a number that could be as low as 200 or 300,000 as we think that the bar to push tapering back is high considering the upside risks to inflation.

Margaret Kerins:

And of course, inflation is another big theme dominating the market narrative with the discussion surrounding whether inflation will in fact be transitory and the fear that if the consumer starts to worry about broad based inflation, it will become self-perpetuating. Basically the fear that a negative feedback loop will emerge as consumption is brought forward to avoid future higher prices, which of course results in higher prices.

Margaret Kerins:

Let's kick it off with Ian. Ian, since our last podcast, yields have broken out from the previous established range that held for the past several months. What range should we expect in 10s over the next few months? And what are the key risks to this call?

Ian Lyngen:

Well, we came into the month of September looking at the September 22nd FOMC meeting as the potential pivot point for the Treasury market. Now, what we saw was a repricing after the event, although the exact motivations behind the repricing are unclear when we break down some of the details of what has moved versus what hasn't moved but we'll get to that part later. What I think is fascinating is we went right into that 155 to 160 zone. We traded it twice. It was tested on two separate occasions and we have since retraced back into the high 140s, low 150s for 10 year yields. I don't expect the current magnetism of 150 to persist all the way into year end, if for no other reason than we will once again, press the trade in the wake of the nonfarm payrolls report.

Ian Lyngen:

All else being equal, I expect that we will see 10 year yields pushed back into the 155 to 160 zone, if not further, until we see a reasonable amount of buying interest emerge with the backdrops of the debt ceiling and the budget debates. There's plenty in terms of near to medium term headwinds for an improving economic outlook. But as we think about 2022 and the reemergence of the real economy, the case starts to become a lot stronger for a higher rate plateau to ultimately be sustainable. Now, a higher rate plateau next year, we're not thinking three to 4% in 10 year yields but we are thinking that a challenge of that 2% level in 10s is very reasonable. Especially as you point out, Margaret, with the backdrop of building inflation expectations that if not transitory, could ultimately be self-perpetuating to the point where we start to hear an increase about concerns related to stagflation or stagflation light.

Ben Jeffery:

And looking at the breakdown of the price action in the TIPS market, that really begs the question of how the breakdown between the moves and break evens and real yields will inform where it ultimately is that we see 10 year yields reach at the end of this year and in the early part of 2022. We've been talking about how tapering at this stage has been well traded by the market, incorporated in valuations and really a testament to how well Powell was able to lay the groundwork for the start of the Feds winding down of their asset purchases. But when we're looking at what could be argued as some economic optimism being priced into real yields, I do think it is worth emphasizing that given the difference between the TIPS market and the nominal treasuries market, there could be something of a mini tantrum playing out in real yields.

Ben Jeffery:

And what I mean by this is that given Fed holds $362 billion in TIPS, which represents 22% of that market, a pullback in Fed demand in the TIPS market could translate to higher real yields, which while optically looks like economic optimism, could just be a reflection of investors preparing for less Fed demand. Looking at the taper tantrum in 2013, we saw real yields move from negative 80 basis points to positive 76 basis points. That's certainly not going to be the case this time around but expecting a gradual increase in real yields to ultimately offer a bearish underpinning to nominal treasury yields seems to be the path of least resistance at this point.

Margaret Kerins:

We're talking about the path of real yields heading into the next tightening cycle, which the market is currently pricing for late 2022. Ian, what does this imply for the level of real yields and how that may impact nominals?

Ian Lyngen:

Well, at the moment, we're carrying a negative 50 basis point target for 10 year reals in the first quarter of 2022. And this implies again, a fair amount of optimism being priced in but a disproportionate hit from the tapering side. All else being equal, one would assume that that would translate through to even higher nominal rates. The issue that I think that we will run up against in financial markets is the feedback between higher Treasury rates and risk assets. While we will attempt to push nominal rates higher, at the end of the day, we'll actually see a compression in break evens as forward expectations for inflation come under pressure as the Fed gets closer to the first rate hike and the perception will be if in fact inflation isn't transitory, that the tightening curve will be much steeper for the Fed than even the current dot plot implies.

Margaret Kerins:

Basically the Fed will fight inflation if it does become more than transitory. Speaking of real yields and inflation, Greg, why is the price of oil at cycle highs? And what are the risks for the next few months?

Greg Anderson:

Glad that you brought up oil, Margaret. And indeed Brent trading at $83 a barrel today and WTI, we'll call it $79 a barrel. Next I want to point out, it's not just crude oil, natural gas prices in many delivery markets have actually rallied more spectacularly this year than crude oil. And to answer the question why, I guess the first thing that I would tell you is that commodities markets pay an awful lot of attention to inventories and they are down. Last week, if you look at sort of the total crude plus product inventories in the US, they were the lowest that they've been in the last six years for the same season, call it late September. When inventories drop, people chase commodities higher, both out of speculation as well as out of fear.

Greg Anderson:

The thing that's interesting to me fascinating, is that it hasn't transmitted through to currencies as much as I would have expected. If you asked me a few months ago where would Canadian dollar go if Western Canadian select oil was in the mid-sixties, I would have told you probably dollar Canada 1.15. And similarly for big importers like Japan is the classic example, if you'd have told me Brent's going to 83, I probably would have told you dollar yen would go to 1.15 at least as a response to that. And thus far, we have not seen the big reaction in FX markets to what seems like semi-permanently higher energy prices and also the possibility of a spike. And I don't rule out a winter spike in oil to a $100 a barrel or something like that. Just doesn't seem like it's fully priced in yet.

Stephen Gallo:

Greg, if I can just jump in here, I want to extend that coverage of the limited price action in oil exporting and importing currencies you mentioned to the currencies associated with central banks that have either been early or late to the policy normalization process. And to summarize, there have been numerous central banks, excluding the Fed, that have moved forward with policy normalization but their currencies haven't really appreciated as a result. Let me just raise a few examples. The Canadian dollar, as we know, is fundamentally one of the better placed currencies out there but it's backed off it's 2021 highs considerably, even as the BOC has continued to normalize policy. We're probably on the verge of the RBNZ lifting its benchmark rate tomorrow Auckland time. But the Kiwi is down slightly year to date in broad nominal terms. Shifting over to Europe, the Norges Bank has already lifted its benchmark rate once and flagged more to come, but the Norwegian Krone is flat year to date versus the dollar and that's despite the move in oil.

Stephen Gallo:

Just in the last few weeks, the UKOS curve has repriced for, I think at least two to three rate hikes next year. And the ECB announced a slower pace of asset purchases at its September meeting and both currencies are lower now than where they were trading a month ago in broad terms. What's the catch? What's going on here? And why haven't we seen more appreciation of these currencies? And one explanation I can give is just simply broad dollar strength. And that's been off the back of a reduction in risk appetite throughout the FX market. Which raises the question what's driving that?

Stephen Gallo:

Well firstly, there's the debt ceiling impasse in the US, that's not helping risk appetite. But I also think that the prospect of many central banks reducing stimulus simultaneously, given the evolving outlook for inflation, that has got a lot of investors assuming a pretty guarded stance. And with Chinese economic growth expectations being lowered as a result of domestic financial stability risks, we saw our economists trim their forecast for GDP growth next year, last week. With that happening, we've got a backdrop of reduced expectations for growth and higher prices unlike we've seen in recent times. Certainly not in the last few years.

Ben Reitzes:

Stephen, you make a good point. And this is exactly what I want to chime in on the Bank of Canada. They are facing a pretty big dilemma in that they've missed pretty meaningfully on their growth forecast. The second and third quarter GDP growth forecasts were materially too high. And so it does look as if the Bank of Canada's output gap forecast, it's going to close maybe a little bit later than they thought, while at the same time, inflation has stayed relatively elevated. We'll get the next print in a couple weeks. And we're looking for a further acceleration in inflation in September. And there's a pretty decent chance that these elevated rates of inflation persist into next year. It's not as if supply chain issues are going anywhere. Commodity prices continue to move higher and so the pressure is definitely still there. And so the Bank of Canada will be faced with seemingly persistently high inflation on the one hand and a disappointing growth backdrop on the other.

Ben Reitzes:

And so they're going to face a pretty big dilemma on how to deal with that and how aggressive they want to be on rate hikes, while at the same time deciding on how much support they want to provide to the economy. In the near term, I don't think that changes their timeline for tapering. They probably still taper later this month in October but the rate hike timeline is definitely in question. I think this will be a big theme through the early part of 2022. If you take a step back though, really this is an issue faced by I think most global central banks at this point with inflation perking up and potentially staying high, amid consistent supply chain issues. And moving away just from central banks, this has the potential to have an impact on broader markets. Dan Belton, can you give us a little bit of insight onto how the maybe shift away from easy policy from central banks could impact your markets?

Dan Belton:

Yeah. All of the factors just discussed in this podcast up to this point have had a significantly negative impact on our credit outlook but I want to highlight one more factor that we're expecting to shift the narrative in credit to one that's more bearish heading into the medium and longer term and that's technicals and specifically net issue in technicals. Most issuers and investors who follow the corporate bond market to at least some degree are probably aware that gross issuance this year has been exceptionally heavy. It's the second heaviest year on record behind 2020 and supply has come 11% above the previous record pace through this point in the year. But what's not as well understood is that net issuance has actually been pretty light this year.

Dan Belton:

Total corporate debt outstanding grew by just 1.4% in the first half of the year and that's the lightest first half since 2010. If we're looking at IG index eligible debt specifically, that has grown by about 5.7% through the first three quarters of this year, which is down from an average of 7.8% since the financial crisis. This just goes to show that liability management has been very active and a lot of this gross issuance has been done to refinance existing debt. And I think it also helps explain why this issuance has been so readily digested by the market.

Dan Krieter:

I just want to wrap up by putting a few numbers out there. If we look at reserve injections into the financial system as a metric of quote unquote demand, between the Treasury cash account this year and QE, we've had $2.6 trillion of reserves into the financial system. And you look at net Treasury supply of about 1.1 trillion and net corporate supply of a neighborhood of 300 billion, that's 1.4 billion in supply versus 2.6 trillion in quote unquote demand. Looking ahead to next year after the Fed has eliminated asset purchases, we're not going to have growing reserves anymore. We're going to have just what the Fed does through the first half of the year, a couple 100 billion maybe but we're projecting Treasury supply of 800 billion, corporate supply of between three and 500 billion so that's net quote unquote, supply of 1.1 to 1.3 trillion and we're going to find out now for the first time since the pandemic, at what level is that actually going to clear the market when you don't have all of this massive support from central bank?

Dan Krieter:

All the macro factors that you guys have talked about, plus the deteriorated technical picture, I think we're going to have a higher trading range for credit, similar to what you discussed Ian, regarding rates in 2022, I think we're going to see a similar dynamic for credit and that the lows that we've just reached are likely to be the lows for this cycle in credit.

Margaret Kerins:

Let's shift gears a bit. We have some potential changes in the FOMC. Of course, the most important of these are that of the chair and the vice-chair of supervision. Let's turn it back to Dan Krieter and specifically, what might the change in the vice chair for supervision mean for credit spreads?

Dan Krieter:

Yeah, Margaret, the end of vice-chair Quarles term is something we're monitoring very closely, just given the impact of a likely more hawkish vice-chair for supervision on the regulatory front and what it could mean. The Fed has been dropping breadcrumbs around more regulation for a few meetings now, going back to the beginning of 2021, regarding both potential increased regulation for shadow banks and increased money market regulation given the outsized role both of these participants had in the liquidity event of March 2020.

Dan Krieter:

And I won't spend a lot of time here, but if you think about what more money market reform could mean, we could be seeing the end of prime funds as we know it and just a conversion of all short term funds to government owned. We've already seen that shift beginning and it could really culminate with another round of money market reform. Similarly, more shadow banking reform could put leverage limits and things of that nature on less regulated entities right now. That we saw a lot of selling pressure out of during the March 2020 liquidity event and all this would just work to potentially widen credit spreads going forward if we have more regulation on these historically lighter regulated entities.

Margaret Kerins:

Okay, and that's a wrap. Thank you to all of our BMO experts and thank you for listening. This concludes Macro Horizons, monthly episode 32, Jay Powell and the Inflation Jitters. As always, please reach out to us with feedback and any ideas on 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 the 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 and edited by Puddle Creative.

Speaker 2:

This podcast has been prepared with the assistance that 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. 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.

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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
Benjamin Reitzes Director, Canadian Rates & Macro Strategist
Dan Belton Vice President, Fixed Income Strategy, PHD
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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