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Liftoff Imminent - The Week Ahead

FICC Podcasts March 11, 2022
FICC Podcasts March 11, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of March 14th, 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 162, Liftoff Imminent, 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 March 14th. As Spring approaches, we cannot help but ponder: if April showers bring May flowers, what do March hikes bring? Curve flatteners? Seems about right.

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, this 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 one primary data point of relevance, and that was the February CPI numbers. The headline CPI printed up eight tenths of a percent month over month, and core CPI gained five tenths of a percent month over month, making both of the year-over-year levels the highest since 1982. This was a decidedly strong print, albeit in line with expectations. One aspect of the post-CPI price action that I found notable was that Treasury sold off, but they didn't sell off to such a great extent, all things considered. This is in part a function of the fact that geopolitical risks remain, especially as the weekend was approaching. Now, when we think about what this implies for the shape of the curve over the course of the next several weeks, we do have the FOMC on deck for March 16th and an anticipated 25-basis-point rate-hike at that point. All odds being equal, that should contribute to the flattening bias, especially over the longer term.

Ian Lyngen:

The biggest wild-card in this context is what the market is expecting in the SEP dot-plot and what the Fed is comfortable delivering. At this current moment, there are three rate-hikes priced in. As of December, there were 325 basis-point rate-hikes indicated in the dot-plot. That has to be updated to reflect the realities of inflation coming through the system in the US, and there are two schools of thought on this topic. First is the group that believes the range of possible outcomes is four or five rate-hikes for 2022 reflected in the SEP. The other camp suggests that given market pricing, the Fed would be prudent to signal to the market that it plans to increase between six or seven 25-basis-point hikes this year. We are in the former camp, especially in the context of all of the uncertainties facing the recovery at this stage. That's not to say that there's no path for the Fed to increase six or seven times this year; rather, that the updated Fed projections will not be that ambitious.

Ian Lyngen:

So this implies that the curve-flattening trade that we've been focused on throughout much of the last several months could be challenged, particularly in 2s-10s space, if the Fed effectively pushes back against the markets more aggressive pricing. For context, we don't think that re-steepens the 2s-10s curve by 20 or 30 basis points, but rather leads to a knee-jerk under-performance of the five-year sector as the market shifts the conversation from this year's rate-hikes to what will ultimately be the terminal rate for this cycle. In terms of trades around this, a tactical twos-fives steepening certainly resonates, especially at the 20-basis-point level. We could see this extending as far as 29 to 30 basis points over the course of the week. Again, this is simply a function of recalibrating market expectations based on what we anticipate will be a dovish hike.

Ben Jeffery:

Well, Ian, we came into the week with 10-year yields reaching 167, but it doesn't seem like that's where we're going to end this trading week.

Ian Lyngen:

Certainly not. It has been a decidedly bearish period for the Treasury market, but that's consistent with the fundamental information. We saw a very strong CPI print, both on the headline and the core measures, and we've also seen an important reframing of the war in Eastern Europe from the perspective of monetary-policy makers. Specifically, the ECB came out and delivered a hawkish surprise, certainly on the margin, but more importantly, during the press conference, the war was very clearly identified as an inflationary impulse on the margin. There should be some growth concerns, to be fair, but at this moment, global central bankers are approaching what had been a risk-off impulse from the perspective of yet another reason to tighten monetary policy.

Ben Jeffery:

And we did get some new details on the next leg of Russian sanctions earlier this week via both the US and the UK's decision to ban the import of Russian oil. This clearly has a significant impact on the energy market, and it was this decision that contributed to the upward pressure we saw on 10-year break-evens that reached a new all-time high as the market continues to evaluate what the world will look like with oil prices now holding in territory that we haven't seen since 2008.

Ian Lyngen:

And I think that’s what we're seeing now is going to shepherd in a new dynamic to the way that the market trades the incoming inflation data. At the moment, there is little differentiation between headline inflation and core inflation from the perspective of the US rates market. Now, this is in large part because both measures are at their highest year-over-year levels since 1982. So regardless of whether the Fed is focused on headline inflation or core inflation, we're looking at prints we haven't seen in 40 years.

Ian Lyngen:

Fast-forward to the second half of this year, and if the ECB and the Fed are correct in focusing on the war in Eastern Europe as inflationary for energy prices and food prices, then what we'll see is a divergence between headline and core inflation. That will put the Fed in a very difficult situation. Specifically, the Fed has already conceded that the type of supply-chain-driven inflation that has come through the system isn't best addressed by monetary policy per se. Nonetheless, they're choosing this opportunity to begin the process of policy-rate normalization. What will be telling is during the summer months, as the third quarter gets underway, how has the Fed narrative shifted toward the risk of stagflation in this current environment? We know that employment is a lagging indicator, so any negative fallout from higher prices on the stagflationary front won't really be evident in the data until the second half of this year, but let's face it: the year-over-year inflation numbers are daunting in any context.

Ben Jeffery:

And Ian, something you just said is really important to consider in evaluating the global economic fallout from the war in Ukraine. The market has been, appropriately, very focused on the implications for the oil market, but let's not forget: that part of the world is also a significant producer and exporter of food. So you touched on the divergence between headline and core CPI as potentially something to monitor as we get through this year. But to me, the somewhat unique nature of the supply-chain issues that arise from the conflict in Ukraine point to higher energy prices, clearly, but also higher food prices.

Ben Jeffery:

And as we continue to think about this risk of stagflation, it's exactly that type of inflation in food and energy that is going to necessitate spending in those necessity areas at the expense of consumption and thus growth overall. And looking at the reaction in the rates market over this last week, I would say that we're not at the point when the market is calling into question central banks' ability to contain inflation, simply given the fact that we saw 2s-10s reach 19 basis points, so the front end continues to be beholden to a hawkish global monetary policy backdrop, while, relatively speaking, the long end is outperforming on concerns that growth in the short and medium term is probably not going to be so good.

Ian Lyngen:

Let us not forget that there has been some material wage pressure in the US in terms of average hourly earnings increasing 5% roughly year over year. But when translated back into real terms, as we saw in the CPI report, real wages actually decreased on a year-over-year basis 2.6%. Now that is a reversal of some of the initial bounce that we saw, but throughout the bulk of the pandemic, real wages have actually been in negative territory.

Ben Jeffery:

And that's another critical detail as we think about what the rest of this recovery is going to look like and how it's ultimately going to play out in the shape of the curve. But even though we're seeing fairly significant negative real wage growth, that's not going to prevent the Fed from executing on its liftoff rate-hike on Wednesday, and what's going to be extremely topical is how the first revision to the SEP since December is going to reveal how the committee is thinking about the path of rates after liftoff and where they ultimately aspire to bring monetary policy during this cycle.

Ian Lyngen:

There's a big debate about whether the dot-plot will show four or five rate-hikes in 2022 or six or seven rate-hikes in 2022. The fact of the matter is the number's going to be higher than it was in December, but how much higher is what's going to really influence the Treasury market. We are operating under the assumption that we'll probably see four or five rate-hikes for 2022 reflected in the SEP. Now that doesn't mean that we can't see that revised higher as the year plays out, but given the distribution of the dots at this moment, that seems the path of least resistance. In that context, we would expect the 2s-10s curve to flatten even more dramatically, and frankly, if the SEP indicates that the Fed intends to hike six or seven times in 2022, that would almost immediately invert the 2s-10s curve.

Ben Jeffery:

Only 25 basis points to go.

Ian Lyngen:

Don't I know it.

Ben Jeffery:

And in addition to the formal forecast laid out in the SEP within Powell's press conference, it's also not unreasonable to expect that the chair will get a question as a follow-up to an idea he laid out in his Humphrey Hawkins testimony that the Fed could move rates by 50 basis points at a meeting in the event that inflation does not begin to moderate. Now, he explicitly said next week is going to be a 25-basis-point affair, but if Powell doubles down on that idea of a half-point move at some point over the next several quarters, that would be another development on Wednesday that would add a meaningful amount of flattening pressure. 2s-10s quickly to 15 basis points and maybe even into single digits would absolutely not be out of the question if we heard such hawkish rhetoric at the press conference.

Ian Lyngen:

So when considering the price action itself in the week just passed, I do think that it's relevant that there were moments of steepening, although clearly, the core trend has been toward a flatter curve. Those steepening moments occurred in and around long end supply and that obviously resonates, given the need for some type of an accommodation, but we also had some pretty significant corporate issuance hit the market, some of which brought some paper to the longer end of the curve. What this development also signals is that some of the apprehension associated with the war in Ukraine has eased. So credit markets are functioning. We're seeing the return of borrowers who are looking to capitalize on the current environment to lock in financing. All of this is a relatively constructive sign for overall financial conditions.

Ben Jeffery:

And in-keeping with that idea, what we've also seen in the very front end of the market and surrounding funding rates is some easing of the pressure that materialized for the demand for dollars that arose after the initial invasion of Ukraine and some of the more troubling headlines. So at this point, it's fair to say that while the situation in Ukraine is highly uncertain, financial markets have entered at least a temporary period of equilibrium and are functioning well enough, considering everything that's going on in Europe and the global economy as a whole.

Ian Lyngen:

And we've also seen the equity market rebound somewhat on what had been relatively sharp sell-off given the uncertainties linked to Eastern Europe at the moment. What will be notable is if we can see that positive sentiment continue with firming in risk assets, even as the Fed starts the process of removing monetary policy accommodation. One of the biggest risks as we think about the balance of 2022 is that the Fed's normalization endeavors occur at a point when ostensibly the real economy is on strong footing, but because of the fallout from higher prices, we see a recalibration lower in terms of outright growth expectations, and that would subsequently put pressure on the Fed to rethink exactly where the terminal rate should be.

Ben Jeffery:

And that dynamic is not solely a domestic one. Even before the war, Germany was struggling to keep real growth in positive territory, and now that we've seen this major disruption to economic activity and everyday life on the Continent, it's reasonable to assume that on a global level, growth is not going to be able to pick up to the degree that may have initially been assumed. Europe, obviously, but several growth engines in Asia as well were already on somewhat shaky footing. Add into this oil north of $120 a barrel and inflation in the US at a 40-year high, and it's easy to see that there's an abundance of headwinds facing the global economy over the rest of this year.

Ian Lyngen:

Wait, you mean this year isn't over yet?

Ben Jeffery:

It might be soon.

Ian Lyngen:

In the week ahead, the Treasury market will be focused on the FOMC and its announcement and subsequent press conference on Wednesday. At this point, it's consensus that the Fed will increase the policy rate by 25 basis points, and we are on board with this. In addition, we expect that the other managed rates, interest on reserves and RRP will increase the same amount, and managing effective Fed funds within that corridor is an important objective, but given all the other signaling that the Fed is going to need to accomplish over the course of Wednesday afternoon, we suspect that a fine-tuning tweak to the size of the range will be delayed until there's more obvious pressure in the very front end of the market.

Ian Lyngen:

In terms of communications around the risks associated with the outlook at this point, clearly, Ukraine represents yet another inflationary impulse given the supply-chain issues, as well as the run up in energy prices that we have seen. It's important to bear in mind that the Fed's decision to frame monetary policy in the context of a labor market at this point has been to note that price stability is key for hiring decisions. What this allows the Fed to do is to defend that it's adhering to the dual mandate as it begins to hike rates, even if we begin to see some weakness in the labor market. That said, given February's strong non-farm payrolls report, it's difficult to see a reversion any time soon, certainly not one of major significance.

Ian Lyngen:

We'll also note that the ECB delivered something of a hawkish surprise on Thursday when it was stressed that the situation in Eastern Europe is inflationary above all. So as has been the case with the Fed, while there are clearly underlying growth risks associated with war in Eastern Europe, the reality is that central bankers are viewing this from the inflationary side.

Ian Lyngen:

The price action that closed out the week was very much in-keeping with the broader sentiment in the Treasury market, and that is one of being short into the tightening cycle. The fundamentals behind that might resonate. Certainly in the very front end of the market. However, we'll note that there's already a fair amount of hawkishness priced in, with two-year yields up against 173, 175. So the risk in this context is that we don't see a further emphasis on the hawkish aspects, but rather, we come out of the FOMC meeting under the impression that Powell and company will deliver a predictable and measured removal of monetary policy accommodation, very much in-keeping with the way the Fed has performed throughout the years.

Ian Lyngen:

On net, we expect that this will further reinforce the flattening of the curve, 5s-30s in particular, as the belly under-performs, with investors quickly shifting their focus to the terminal rate assumption, even if we don't expect long run dot to be increased from the 250 level that's currently reflected in SEP. That said, a shift to the long run dot is an option, and would obviously further flatten 5s-30s.

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. And with Daylight Savings on Sunday, we're looking forward to traveling into the future without the assistance of a DeLorean.

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. 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 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:

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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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