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Just Like 10-Year Yields - The Week Ahead

FICC Podcasts December 10, 2021
FICC Podcasts December 10, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of December 13th, 2021, 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 150, just like 10 year yields. 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 Monday the 13th. With virtual holiday party season at hand, we're virtually looking to seeing our colleagues. Alas, fun with word order.

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.

Ian Lyngen:

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 past, the Treasury market got a fair amount of new information, both in the form of economic data, as well as a better sense of investors response function to recent developments. CPI was clearly the marque data release. We saw a slightly above expectations headline print, but the core number came in as expected, increasing five tenths of a percent month over month. This pace of inflation, while certainly above trend, wasn't enough to get the market truly concerned about inflation getting out of the Feds control, at least not thus far. As a result it wasn't surprising to see a modest bid into the weekend that brought 10 year yields back below 150.

Ian Lyngen:

It's also notable the one thing that didn't happen was the November inflation report did not lead to a whole wholesale repricing of the Treasury market. This is particularly meaningful in the context of how low outright yields are at the moment, or at least outright yields further out the curve. In the very front end, we continue to see a grind toward higher yields with twos, threes and fives the decided under performers.

Ian Lyngen:

When we look at the Fed Funds Futures market, what we see is that the market has fully priced into rate hikes for 2022, and is for all intents and purposes, attempting to cement a full pricing of a third rate hike. We remain in the two rate hike camp for 2022, but are certainly cognizant that there's a real risk that if inflation doesn't moderate in the second quarter of next year, that the Fed will need to push forward more aggressively with policy rate normalization. This isn't however, an issue that will be resolved in the very near term. As Biden's recent comments outlined, there's downward pressure on energy prices that will eventually work its way through to the inflation data, as well as the assumption that elevated auto prices will eventually moderate.

Ian Lyngen:

The week just passed also revealed a collective reluctance to truly re-steepen the yield curve. We continued to see a steady grind flatter in the shape of the curve, with the one exception being a supply concession around the 10 and 30 year auctions. This was most notable in the 30 year auction which tailed more than three basis points and was associated with the steepening in fives thirties that got this pinch mark spread back to 63 basis points. While the curve has since moderated, we continue to see potential for five thirties to flatten even further with an objective of breaking through the 50 basis point level between the FOMC meeting and the end of the year.

Ben Jeffery:

So obviously the most important event of this past week was Friday CPI data. We saw a fairly impressive flattening into the release and the generally as expected print actually gave way to a little bit of a steepening. What's the take here Ian?

Ian Lyngen:

So my interpretation of the price action suggests that what we had been assuming was the default position of flattening would be carried through into the December 15th FOMC meeting did meet a material challenge. Ben, you noted that CPI was the biggest event and I'll agree that it was the biggest fundamental event of the week, but the 30 year auction tailed more than three basis points and that actually ended up leading to the most dramatic price action. So the long end of the curve cheapened up into the auction and after the fact, and this contributed meaningfully to the fives thirties re- steepening that brought this benchmark curve as high as 63 basis points before correcting back into the zone that has been in place.

Ian Lyngen:

The biggest question in my mind becomes how far can we flatten in the wake of the FOMC? I expect price action to be relatively choppy between now and the point in which the Fed announces its decision regarding accelerating the tapering of QE. If nothing else, one should anticipate that will go into the Fed at the flats.

Ben Jeffery:

I'd characterize CPI as good enough in two senses. The first being that the read was not so weak as to materially call into question whether or not the Fed will speed up tapering at the meeting on Wednesday. The second good enough sense is that it wasn't so strong as to call into question the ability of the Fed to offset the variety of inflation that we're currently experiencing. Add to this fact President Biden's comments ahead of the report on Thursday, and I think it's fair to say that there were some in the market position for an even stronger read than the generally consensus print we saw.

Ian Lyngen:

Yes, I recall Biden's comments specifically said that the decline in energy prices, associated with the release of oil from the strategic petroleum reserves, wouldn't be reflected in November CPI, and that's precisely what we saw. A slightly higher than expected headline figure that was driven by elevated energy costs.

 

Ian Lyngen:

Biden also noted that the expected moderation in the pace of car prices wouldn't show up in the data, and again, he was correct. Easy to forecast when you have the numbers ahead of time. What we saw in practical terms was a slowing, but a still meaningful contribution from new and used auto prices to the core CPI print. On an unrounded basis, core CPI was up 0.535%. Said differently, it was a high 0.5. Nonetheless, the year over year figures came in as expected.

Ian Lyngen:

Another aspect of the data that's worth highlighting is when one drills down to rent and owner's equivalent rent, we see another impressive four tenths of a percent month over month increase. The overall shelter costs however, increased five tenths of a percent, and that difference was made up by the fact that hotels and the lodging away from home category accelerated in price. This is very consistent with the rebound in the travel industry and something that we expect will be closely followed as the first quarter unfolds.

Ben Jeffery:

While Paulo has retired the transitory characterization of inflation, as we think about the path of inflation throughout 2022, it is worth mentioning that the factors that originally led to transitory are still going to be in place. The supply chain issues and pandemic specific increases in prices are still going to work themselves out. As the Fed has said, it's just taken longer than was initially presumed. Taking this fact ,combined with the Fed that's leaning hawkishly and prepared to offset inflation from the demand side, it's going to be difficult to see an acceleration in realized prices and also inflation expectations as we start to get through the first half of next year.

Ian Lyngen:

Let us not forget the importance of the base effects that come into play in 2022. Effectively a reversal of Q2 2021 i.e. the bar is now much higher for the year over year pace of inflation to continue to accelerate during the months of April, May and June of next year. This is something that the Fed has referenced directly in the past and I suspect that even though the transitory language has been retired, the reality is that the Fed would like to see those numbers before they make any decision related to rate hikes. The nuance of this timing implies that it will be very difficult to justify pricing in a March rate hike.

Ben Jeffery:

There's also something that the November CPI data didn't do and I think that is really press this idea that we may need to see a higher terminal rate this time around than in prior cycles. We were watching the shape of the twos fives curve to offer context around this dynamic and the fact that twos underperformed and we saw twos fives flatten speaks to this dynamic that while inflation is robust enough to keep the presumed path of normalization quarterly rate hikes to somewhere in the 175 to 225 area intact, it wasn't so out sized as to make the potential for 3, 4% Fed Funds really that likely, at least not yet.

Ian Lyngen:

This brings us back to one of the primary debates in the market at this moment and that is the flattener versus the steepener. We are clearly in the flattening camp, working under the assumption that anything that brings forward rate hikes or implies a higher terminal rate will ultimately hurt twos, threes, and fives more than it will tens and thirties. The only way that we can envision a sustainable steepener is if one of two things occurs.

Ian Lyngen:

First, the Fed signals an unwillingness to address higher than expected consumer prices and the second being that the market loses faith in the Fed's ability rather than willingness to combat accelerating inflation. At the end of the day, we don't expect either of those to be the case, but we could see episodes of re-steepening in the eventuality that the realized inflation data continues to outperform expectations as it did in the second quarter of 2021.

Ben Jeffery:

This conversation is a fairly good segue into what's probably our most often fielded question at this point. We have all this inflation, we have a hawkish Fed. We have the lowest initial jobless claims print since 1969. Why then are 10 yields at just 150?

Ian Lyngen:

I concur that that certainly is the most frequent question that we've received recently. The answer, however, is multifaceted enough as to imply explanation chasing price action. That being said, there are few key factors keeping 10 year yields this low. First is the fact that the market broadly remains short, particularly further out the curve. Again, this is a positional nuance, but nonetheless relevant as the year comes to an end. Books are closed and positions are squared in anticipation of 2022.

Ian Lyngen:

Another factor can be loosely classified as the policy error trade. Now we're uncomfortable calling it a policy error because the Fed knows precisely what they're attempting to do and the Fed is attempting to take the edge off of inflation, keep inflation expectations anchored, and the Fed is willing to sacrifice some upside in growth to achieve this objective. In that context, we'd characterize it as a policy trade off as opposed to a policy error. The error aspect of it comes in when we ponder the risks associated with putting the brakes on the real economy too quickly. In the event that the Fed over tightens or tightens at a pace that the real economy can't sustain, then there is a non-zero probability that the Fed simply hikes the US economy into a modest recession. Again, this is not our base case scenario, but nonetheless, part of the reason that tens appeared to be anchored at 150 for the moment.

Ben Jeffery:

I would also add to that through maybe a longer term macro lens, just the fact that a lot of the structural trends we saw that naturally dragged down interest rates over the last several decades remain in place and arguably have been accelerated by the pandemic. Think automation and what that does for productivity and what that means for our star. Simply a glance at a 30 year yield chart going back into the eighties, reveals precisely this dynamic. Absolutely doesn't preclude periods of selling pressure that get us back toward 225, 250, maybe even 275 and 30 year yields. But from that perspective, the structure of the economy is also going to lead to structurally lower interest rates at least in the US.

Ian Lyngen:

One of the key counterpoints to that is a trend that had been in place throughout the last three or four decades. Namely globalization has begun to see a modest reversal. Now we are not in the camp that assumes that de-globalization becomes thematic over the next 10 years, but there is clear evidence of a modest decoupling between US and overseas economies.

Ian Lyngen:

In addition, compressing volatility further out the curve is the increased transparency of monetary policy makers, both domestically and abroad. Over the course of the last 30 years, we have seen a rise in predictability and credibility of the Fed. The Fed, through forward guidance, has led investors to become accustomed to having enough predictability on the part of monetary policy makers that they're comfortable with a compressed range for rates further out the curve.

Ian Lyngen:

This cycles most relevant piece of new information was that despite the change in framework, the new Fed is an awful lot like the old Fed in regard to their willingness to respond to higher inflation. We're certainly comfortable with the notion that the Fed is unwilling to risk decades of hard one credibility as an inflation fighter for one cycle and an effort to achieve maximum employment. However, that is being defined.

Ben Jeffery:

Outside of the path of rates, there's another Fed topic that's being increasingly talked about, and that is the fate of the balance sheet beyond the end of QE. Remember back in 2014, which was the last time QE concluded, it wasn't until 2017 that the Fed began to try to run down its balance sheet until ultimately we hit that reserve scarcity period in 2019 that triggered the surge funding costs and the Feds bill purchases, not QE, ahead of the pandemic. There's been some chatter that simply given the outright size of SOMA's holdings, that the committee will want to begin the balance sheet normalization process sooner this time around, but the benefits of an ample reserve regime need to be weighed against the cons of having an excess amount of liquidity in the system.

Ben Jeffery:

Thus far, we've seen that the Fed is very comfortable to continue using the reverse repo program to defend the integrity of the lower bound. They've increased counterparty eligibility and limits so I'm not so convinced that this is going to change next year, but it will definitely be something to keep in mind as QE presumably comes to a close before March.

Ian Lyngen:

Well, one thing is for sure, it will be the end of QE as we know it.

Ben Jeffery:

And bonds feel fine.

Ian Lyngen:

In the week ahead the main event will be the FOMC meeting and the subsequent press conference. Our expectations are that the Fed will follow through on an accelerated tapering of QE, increasing the monthly decline from 15 billion to 30 billion, which would end balance sheet expanding bond buying much sooner than the Fed's earlier projection of mid-2020. This will allow for flexibility in the event that the economy performs in a way that the Fed feels comfortable or compelled to bring forward rate hikes, with the context that there's nothing to necessitate that the Fed immediately start hiking rates as soon as QE has been wound down, that won't prevent the market from attempting to price in more aggressive policy rate normalization.

Ian Lyngen:

We'll also be watching the Feds updated dot plot and are operating on the assumption that for 2022, whereas the dot plot currently suggests one rate hike, on Wednesday the updated dot plot will show two rate hikes if for no other reason than how close September's projections were to this outcome. The bar is certainly high for the Fed to signal a third rate hike through the SEP but nonetheless, we suspect that many will view that as a potential risk. As a result, we're expecting the post Fed price action to be particularly choppy in the front end of the curve. We continue to favor the flattening trend and we'll look for any steepening into or out of the Fed to serve as better placement to scale into a core flattener.

Ian Lyngen:

While secondary to the Fed, we do have the retail sales print. This is the information for November. The consensus is for a seven tenths of a percent monthly gain. In the context of the higher than expected CPI data for the month however, it's notable that the retail sales figures are reported in nominal terms so a potential slight drag for real GDP on a consensus number. More importantly, the trajectory of consumption as the fourth quarter's data unfolds, will be meaningful in engaging expectations for how the holiday spending season ultimately plays out.

Ian Lyngen:

The question is whether higher prices, particularly energy prices, function as a tax on the pace of consumption or whether or not consumers utilize the large stores of savings accumulated during the pandemic to fund holiday expenditures. The final count won't be obvious to the market until late January, but nonetheless, the pace of spending as the pandemic continues will be a key focus as the Fed actively begins to step away from the extremely accommodative monetary policy that has been in place since March of 2020.

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 we continue to parse through the details of the CPI report, we were distraught to see a spike in the eggnog from home category. Perhaps a slightly less cheerful holiday season.

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. Please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on apple podcast or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the [inaudible 00:19:57] 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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