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Long Run, All Terminal - The Week Ahead

FICC Podcasts Podcasts December 16, 2022
FICC Podcasts Podcasts December 16, 2022


Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of December 19th, 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 202, Long Run, All Terminal 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 December 19th. It's effectively the last week of the year, the last game of the World Cup, but not the last time we'll play the beloved Macro Horizons music and disclaimer. Hit it.

                                                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 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.

                                                In the week just passed, the Treasury market received a great deal of meaningful fundamental information as well as a truncated supply calendar. The three year auction at $40 billion stopped through two tenths of a basis point. The 10 year, however, 32 billion tailed a significant 3.8 basis points. Similarly, the 30 year on Tuesday tailed 3.3 basis points. That was 18 billion and that takedown came as the market was rallying, however. So the fact that there was ostensibly supply indigestion was masked by the significance of the rally.

                                                Now, the bulk of the rally was triggered by the lower than expected inflation report on Tuesday. CPI for November printed up just one tenth of a percent month over month. Core CPI increased two tenths of a percent month over month below the consensus and more importantly, conforming to the increasingly consensus peak inflation argument. When we break down the details of core CPI, the surprising aspect of it from our perspective is the fact that OER increased eight tenths of a percent. This was a reversal of the moderation that we saw in October when OER printed up six tenths of a percent. So in essence, core CPI continues to be driven by the shelter sector. Now, when we look at some of the other details, we see confirmation that used car and truck prices continue to provide a drag on inflation as well as lower airfares. Medical costs also added to the downside surprise.

                                                Now, this was certainly a welcome report from the perspective of the FOMC and the Fed delivered the widely anticipated downshift to 50 basis points from the prior 75 basis point cadence. The FOMC statement itself was remarkably unchanged. In fact, it's probably a career low for the number of words that were actually changed in the statement. For all intents and purposes, the Fed simply said, "We moved from 75 to 50 basis points and we're not done with the hiking campaign." Now, within the details of their updated projections, we did see a higher terminal rate, which contributed to some of the selling pressure in the front end of the market and more importantly led to a retesting of negative 80 basis points in 2s/10s. That has been an important level. The window between -80 and -85 in 2s/10s will be difficult to convincingly break through, but eventually we do see another 10 to 15 basis points lower in the 2s/10s curve before market expectations stabilize.

                                                In addition to the statement and the SEP, Powell reiterated the Fed's hawkish stance and this was somewhat at odds with expectations for a dovish 50 basis points hike. In fact, what we saw was a hawkish hike and the Fed has effectively outlined the path forward to another 75 basis points in aggregate of rate hikes. That's either going to be 50 in February, 25 in March or a series of 25 basis point moves. As it currently stands, we'd err on the side of assuming another 50 in February followed by a capstone quarter point in March. The week just passed also contained troubling evidence that prior rate hikes might have finally begun to erode consumer demand, specifically retail sales printed below expectations. Now we also saw weaker than expected Empire State and Philly Fed manufacturing surveys, all of which contributed to downward pressure on yields, particularly in the long end of the curve. The 3.40 to 3.45 range for 10 year yields has proven an attractive selling opportunity. Although as with the depths of the inversion, we anticipate that the path of least resistance will be a drift lower from here.

Ben Jeffery:                        Well, it was a long week of an undeniably long year and the three-year auction Monday morning feels like it took place approximately 15 years ago, but nonetheless, we learned a lot this week in the Treasury market. We had supply, CPI, and of course the Fed meeting that showed the first non 75 basis point rate hike we've seen since May and the Fed's acknowledgement that while yes terminal will be higher, that is a level that we are quickly approaching.

Ian Lyngen:                         More importantly, within the terminal estimate, I'll make the argument that it wasn't precisely what was priced into the Fed fund's futures market, but it was consistent with the broader discourse i.e. 5.1 versus 4.8 was a difference, but not really a material one given how much progress the Fed has already made in tightening monetary policy. It's also worth making the observation that there is a higher degree of confidence in the Fed's terminal estimate at this point given the proximity to the end of the hiking cycle. We are assuming that the Fed delivers the final 75 basis points of tightening in one of two ways. Either we see 50 basis points in February followed by 25 basis points in March, or we see 25 basis points in February, March, and May. The latter scenario would allow greater flexibility for the Fed because if the committee finds itself in April and inflation is moderating more rapidly than anticipated or the unemployment rate is increasing at a greater pace than the Fed would like to see, then the Fed can simply call terminal at 5% instead of 5.25.

                                                Also embedded in the SEP was the projections for 2024. Now we came into the process assuming that the most effective way for the Fed to signal their intention to keep policy on hold for an extended period of time would be the compression of the inverted spread between '23 and '24. In September the Fed estimated 75 basis points worth of rate cuts in 2024. Via the most recent update to the projections, the Fed is now suggesting 100 basis points worth of rate cuts in 2024. So if nothing else, what we have learned is there is a limit to how long the Fed actually believes that it can keep policy and restrictive territory. The rhetoric around terminal has been will reach terminal and stay there for an atypically long period of time, and to be fair, if the average is six or seven months, the Fed signaling 12 to 16 months is longer than one might typically expect. Nonetheless, it's not 24 plus months, which to some extent is why the two-year sector has ceased to view effective Fed funds as a floor as two-year yields drop below the funds rate.

Ben Jeffery:                        And within the press conference, Powell did receive the question that is the same one that we've been receiving for the better part of the last month, which is how is the committee viewing the easing of financial conditions that we've seen since mid-October and is the fact that the FCI has come materially off the peaks a challenge for the Fed? After all, the higher terminal forecast and other 50 basis point hike and all of the rhetoric we've heard thus far all suggests that the Fed wants to keep financial conditions tight and push back against this easing that we've seen. Now, this gets at what we'll argue is still one of the more dramatic mispricings we're seeing in the market, and that is an aggregate of 50 basis points in rate cuts over the second half of 2023. It's the potential for these cuts to more accurately reflect a period on hold that still holds bearish implications for the front end, even if twos are now well below funds as you touch on Ian.

                                                And so the path of real yields and equity volatility, which in turn will drive financial conditions is going to be something that we and the Fed are watching very closely both into the end of the year, but also as we move toward the February meeting. Now, between now and the February meeting, there's only one NFP read and one CPI read that we're going to receive. And in terms of the deciding factor of whether or not that hike's going to be 25 or 50 basis points, there's not a great deal of fundamental information that really holds the needed weight to swing the Fed one way or another, which will leave the performance of financial conditions, probably the determining factor in whether that is 25 or 50 basis points.

Ian Lyngen:                         Also in the press conference, Powell was asked another question that we had been pondering for some time and that was regarding the Fed's willingness to reexamine the 2% inflation target. It was very striking to us how quickly Powell shut down that line of questioning. He effectively said, we're not even thinking about reviewing the 2% inflation target. It is what it is and the monetary policy makers are going to do everything needed to make sure that realized inflation comes back in line with target.

                                                Now, this question has come up a number of times with clients and we're very sympathetic to the idea that in fact, because of de-globalization and the risk of a structurally lower labor force participation rate, that the reality is inflation over the course of the next several years will be running at what is ostensibly a structurally higher rate. Alas, if the Fed were to revisit the 2% inflation target and increase it to two and a half or 3%, that would be an extremely bond bearish development for the Treasury market, and we would anticipate that breakevens would gap higher and nominal rates would follow suit. The most direct path to five or 5.5% 10-year yields is for the Fed to materially increase their inflation target. It's for that reason that we took a great deal of solace in the fact that Powell pushed back as directly as he did on the topic.

Ben Jeffery:                        And it wasn't only the Fed we heard from this week, we got rate hikes from the Bank of England, the Swiss National Bank, and the ECB. That all took similar steps in delivering slightly smaller rate hikes than we've been seeing as the stewards of monetary policy in Europe also close in on what are likely going to be their own respective policy rates. And it's this cross-border dynamic and timing what we're expecting is going to be a meaningful steepening of the curve that offer some food for thought and interesting trade ideas as we get into 2023, specifically how long other central banks will hold terminal in relation to the Fed and if the economic challenges faced in the UK, Canada, Europe will necessitate a sooner dovish pivot in those places than they will in the US.

                                                As for what this means for the steepening, a big part of our call on US rates in 2023 is that it's still too soon to look for the big moves steeper in the 2s/10s curve, just given the fact that the Fed is going to fight to keep rates in restrictive territory for as long as possible. Now initially that line of thinking certainly applies to other central banks, but the differences surrounding energy prices, how the housing market responds to interest rates, and other geographically specific economic factors means that we might need to see an unwind of some of the tightening sooner and other places, which in terms of the curve means that we might see the UK curve, the Canada curve, the German curve steepen a bit sooner than the US one until we hear a more material pivot from the FOMC.

Ian Lyngen:                         It's also notable that the recent shift by the Fed puts it in a unique position, and by that we mean the Fed has gone from focusing on the low unemployment rate as an opportunity to hike more aggressively or confirmation that the US economy is on strong footing, to an outright focus on increasing the unemployment rate. So, in practical terms, this means that the Fed will have more runway before the conversations regarding the potential for having overtightened become more topical. The Fed even increased its 2023 unemployment target to 4.6% up from 4.4%. This is an indication that monetary policy makers are willing to accept a greater erosion of the labor landscape to ensure that longer term price stability expectations are reestablished. We were also struck by the Fed's willingness to downgrade the GDP estimates for next year to effectively zero. So for the Fed to come out and say that they expect aggregate growth next year to be up two tenths of a percent, that's the committee conceding that there's even odds that will actually see a net contraction over the course of the year.

                                                What will be interesting is the extent to which the market is willing to see real GDP decline and continue to have confidence that the Fed won't pivot dovishly in the way that they would have during prior cycles. To be fair, it is a unique cycle. Decades high inflation will require excess demand destruction to ensure price stability going forward. The question ultimately comes down to is the Fed going to be able to remain politically independent enough to achieve this objective? For lawmakers to lament higher inflation is one thing when the unemployment rate is at 3.5%, it's entirely a different issue when it has a five handle.

Ben Jeffery:                        And this is another big uncertainty for 2023, which is the fan favorite question, will there be a recession? And in response to that, we'll offer one of the most useful tools in the strategist toolkit and answer the question with a question, what's the definition of recession? Sure, it used to be back to back quarters of negative real GDP, but that was when inflation was relatively contained. Hiring was slowing and joblessness was increasing. So even if we have real growth decidedly a negative territory like we did in the first half of this year, if the unemployment rate is still relatively contained, call it below 4.6% that the Fed laid out in the SEP, is that really a recession or does the fact that hiring is continuing and layoffs are contained make it not really a recession? So maybe the Fed doesn't have to reverse course at all.

Ian Lyngen:                         I would add to that line of reasoning that in light of the lagged impact of monetary policy and the data collection timing, we might be in a meaningful economic slowdown long before the data reveals it, and as a result, the market will be beholden to the Fed's definition of a recession first off, but also the Fed's definition of a hard landing versus a soft landing. We as a market spend a great deal of time discussing whether there's going to be a recession or not, and if there is a recession, is it going to be a hard landing or a soft landing? The fact of the matter is the Fed controls a narrative on the severity of the slowdown because they are causing it by design. This isn't a typical recession in which the Fed overshoots and there's a argument that they have created a policy error. The Fed knows precisely what they're risking, and a recession might in effect not be a policy error, but rather a policy trade-off. And if it is a policy trade-off, which is our operating assumption, then the Fed's response to a more significant weakening in real GDP in the second and third quarter of next year will not be the typical dovish pivot.

Ben Jeffery:                        And as we watch the 2s/10s curve reclose in on that -85 basis points we saw set a few weeks ago, that 2023 will likely, in a similar fashion to 2022, still be defined by a deeply inverted yield curve as we're already starting to see increasing evidence that long dated bonds are becoming attractive. For much of this year, the operative stance was any rally was a good opportunity to sell or get short, but now the price action points to the inverse emerging. A selloff is a good time to cover or start to get long, and it's this dynamic that's probably going to become more pronounced on the other side of the new year and as the slowdown, whether it's officially a recession or not, takes hold.

Ian Lyngen:                         So Ben, in short, what you're saying is if you don't get it, pivot, get it?

Ben Jeffery:                        Not really, but that's okay.

Ian Lyngen:                         In the week ahead, the Treasury market will have what we are characterizing as the last trading week of 2022. Now, technically the market is open during the final week of December, but the wholesale lack of new information and what we expect to be a thinly staffed market will imply that any price action resulting in that period will be faded in one direction or another when the market reopens on Tuesday, January 3rd. During the week ahead, we'll see updates from the housing sector, specifically housing starts for November, which are anticipated to be down 1.8%. Building permits similarly seen down 0.8%, but more importantly, existing home sales on Wednesday are anticipated to reveal a 4.9% contraction in the month of November. More importantly, within that series will be the median home prices. Now we know that sales have been contracting.

                                                We know that the higher mortgage rate has been largely responsible for the slowdown in the housing sector, and as was revealed via the most recent Case-Schiller home price index, the three month annualized rate is tracking at -18.4%. For context, by this measure in the extremes of the housing crisis, we only got as low as -34%. Now, this suggests that there is more downside yet to be realized, and as the Fed contemplates the extent of demand destruction that they're willing to see it goes without saying that the de-wealthing effect in the housing sector as well as the equity market is going to be topical going forward.

                                                There are two supply events in the week ahead worth noting. First being Wednesday's auction of 12 bn 20-years as well as Thursday afternoon's auction of 19 bn 5-year tips. All else being equal, we'd expect that the auctions will be relatively well received. Long end Treasury supply in an environment in which the curve is as inverted as it is might intuitively be unattractive, but as conversations regarding the probability of a more meaningful economic slowdown or a recession in 2023 begin to increase in both frequency and conviction, it'll be unsurprising to see dip buyers come out in the longing of the curve.

                                                Now, as for five year tips, simply the liquidity provided by the supply event in and of itself suggests a reasonable take down. The one caveat there being that if inflation actually has peaked and the trajectory is going to be lower going forward, the correct valuation of inflation protection does come into question. Let's not forget on Friday we'll get the updated personal income and spending data, both of which are seen increasing two tenths of a percent. Within the series, core PCE will be of relevance and mark the end of the economic data for the year. Our take on the market remains that while it is too soon to play for the cyclical re-steepening of 2s/10s, other curves should soon begin drifting higher, specifically 5s/30s and 5s/10s. It also isn't lost on us that effective Fed funds has given way as a floor to yields across the curve as effective Fed funds is now at 4.33, the exception to this being six month and 12 month bills.

                                                Having now seen effective Fed funds give way, we anticipate that this will no longer be a guiding principle for participants in the Treasury market, and therefore, as the Fed delivers the last 75 basis point rate hikes, there's nothing to suggest an implicit bias higher in yields across the curve. This is especially true for 5s, 7s, 10s, 20s, and 30s. We're certainly sympathetic to the argument that we should see some more upward pressure on 2s given, not so much the additional 75 basis points of hikes that are been priced in, but rather the fact that we believe that the Fed is going to push back more aggressively on the rate cuts that the market has priced in for 2023.

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 as we prepare to shift from economic fear to holiday cheer, we're reminded of the joys of visiting TSA’s little helpers as we once more returned to the fray of holiday travel. We were going to call them TSA's elves, but feared the repercussions from the National Elf Association. Hey, whatever it takes to stay off the naughty list.

                                                Thanks for listening to Macro Horizons. Please visit us at 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 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 3:                           The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit


Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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