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Low Light, Low Liquidity - The Week Ahead

FICC Podcasts December 17, 2021
FICC Podcasts December 17, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of December 20th, 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 151, a low light, low liquidity. 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 20th. And as Tuesday is the shortest day of the year but in the longest of years, we'll just go ahead and call that a wash.

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. Please feel free to reach out on Bloomberg or email me at I-A-N. L-Y-N-G-E-N@ 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 US rates market got a variety of meaningful fundamental inputs, not least of which being the F1C's decision. Specifically, the Fed followed through on the hawkish pivot by announcing an acceleration in the pace of QE tapering from $15 billion a month to $30 billion a month. That includes 20 billion of Treasuries and 10 billion of mortgages. This means that by the middle of March 2022, the Fed will have conducted its final balance sheet expanding bond purchase. The Fed meeting also included an update of the SEP or the Feds forward projections. The most notable aspect there being an increase to the 2022 Fed funds rate projections.

Ian Lyngen:

The Fed is now signaling that it will hike three times next year. This is a market shift from what the Fed had previously been indicating, but it was consistent with the pricing in the Fed funds futures market. Nonetheless, it was a bit of a surprise and the front end of the curve, at least initially repriced to higher rates on that. The price action that developed in the wake of the Fed meeting however, was somewhat perplexing. We saw a re-steepening of the curve with twos, threes, and fives outperforming on an outright basis, late Wednesday and it accelerated during Thursdays session.

Ian Lyngen:

Our take is that this was primarily a position squaring issue as investors closed out of core flattening positions that had been in place to take advantage of the recent trend toward a flatter curve, particularly in fives, 30s. Also, embedded in that was a version of sell the rumor buy the fact. We knew that the Fed was going to deliver on the hawkish side. They frankly, over delivered. This was followed by the Bank of England's first rate hike and still 10 year yields remain well below 150. Said differently, given the degree of hawkishness delivered this week, one might have been excused for assuming that the overall rate complex would be higher.

 

Ian Lyngen:

So when faced with this reality investors covered positions and we're reminded the last two weeks of the trading year tend to be low liquidity and prone to choppy price action. In addition, we're now left with a really interesting question. The Fed has delivered on the hawkish side. We've got a roadmap for the amount of hikes to expect. The terminal rate will be somewhere between two, two and a half, if the Fed is to be believed. And so what happens next? And I think that in addition to the positional shifts in the landscape, the market is contemplating the risk that the Fed is actually comfortable with tightening at a pace could ultimately result in a more dramatic slowdown or even potentially a recession.

Ben Jeffery:

So Ian, let's talk pivot. We got the Fed confirming an acceleration of tapering and probably the biggest surprise of the meeting was the FOMCs now for forecasting three rate hikes next year.

Ian Lyngen:

Yeah, Ben, I think that that aspect of the FOMC decision was somewhat unexpected. Although it did come with all the normal caveats from Powell, including that the SEP or the Feds projections, shouldn't be viewed as a clear guide to forward monetary policy expectations. Nonetheless, the Fed has up the ante in terms of hikes for 2022 and 2023. What I find notable is that the pace of rate increases now appears to be very front loaded, which is consistent with how the market traded it, frankly. The initial knee-jerk response was strong selling pressure in twos, threes, and fives with the longer into the curve effectively unchanged. And ultimately what we saw as the week unfolded was that the flattening resumed and the longer into the market routed on an outright basis, leaving our year in target range of 125 to 135 easily achievable in the last two weeks of the year.

Ben Jeffery:

And on the path suggested by the dot plot, the fact that we saw three hikes penciled in 2022 and then three, not four hikes forecasted in 2023 was very telling. And I think what this resonates with most is this idea that the current inflationary backdrop warrants a bit more policy tightening earlier to give away to a more moderate pace of hikes later. There's also this dynamic that you've touched on several times, Ian, which is that given the timing of some of the base effects around inflation and just the simple passage of time in helping work out some of the supply side issues, the degree to which inflation moderates in the middle part of next year and as we get toward 2023 could allow the Fed more patients than simply raising rates, 25 basis points at a time on a quarterly basis.

Ian Lyngen:

Another aspect of the year ahead that will continue to be debated in the coming months is not only when we see the Feds lift off rate hike, but to your point, Ben, whether or not an accelerated cadence is warranted. There's nothing to stop the Fed from going once a meeting. Although even our baseline expectations are that the Fed will keep to the quarterly cadence. On that topic, the house call is for three rate hikes next year, starting in June, followed by September and another one delivered in December. This is very much in the market at this point, consistent with the Feds guidance. And I'll argue that if anything, the risks around that timeline should be focused on whether or not the June meeting is the true liftoff point.

 

Ian Lyngen:

Now there surely will be people calling for a rate hike in March, but we'll suggest that as the data comes into focus next year, the ultimate takeaway will be that the risks are for a later, rather than earlier start. Now, the logic there is relatively straightforward. The Fed had been focused on the temporary nature of inflation and the potential for an easing in the upward trajectory of consumer prices in the second and third quarter of next year. Now we know the Fed has abandoned the transitory narrative, but that doesn't change the math of what's going to happen in April, May, and June of 2022, specifically the year over a year gains in consumer prices are going to moderate if for no other reason in the prior years, CPI and PCE numbers were just so strong.

Ben Jeffery:

And there's also a calendar component to thinking about when it is the Fed will lift off that I think is worth discussing. Powell went as far as to explicitly say that QE will be running through mid-March. That means that the Fed's last bond purchase will likely be in the week before the March meeting. So in the event the committee would want to actually execute liftoff in March, that means Fed speak over the coming monthly, leading into the January meeting would really need to start probably fairly aggressively laying the groundwork for that policy move. For context during the last cycle, QE ended in late 2014 and the first rate hike of the cycle didn't come until December 2015. So almost a full year in between ending balance sheet expansion and liftoff.

Ben Jeffery:

Now this cycle is clearly very different. And so I think it's safe to say, we're not going to get that long of a lag. Powell went as far as to explicitly say that much. But to me, just a matter of days between the last coupon pass and liftoff seems a bit accelerated. The May meeting will also probably be debated as a potential liftoff opportunity. But I do think exactly to your point, Ian, all it's being equal, the committee would like to have more inflation data rather than less before ultimately deciding to bring rates off zero.

Ian Lyngen:

As we continue to contemplate the sequencing of Fed policy, there's a subset in the market that has floated the idea that the Fed would start to normalize the balance sheet before hiking rates. And I think that that's an interesting notion and one that's worth exploring. The Fed's experience in normalizing the balance sheet between 2017 and 2019 doesn't serve as a true guide in this situation because the Fed has introduced RRP. RRP creates a meaningful buffer of reserves in the event that there might have otherwise been moments of reserve scarcity, like what was experienced in September of 2019. So with this backdrop, there's a solid argument to be made that the Fed should consider letting the balance sheet run off before hiking rates. I suspect that while the Fed is considering this option, the optics associated with hiking rates in the face of inflation, rather than letting the balance sheet organically run off will tilt the committee in favor of hikes, at least for the first 75 or 100 basis points worth of tightening.

Ben Jeffery:

Yeah, Ian, I completely agree with of that. And another aspect supporting that notion is that while we haven't yet gotten the first cycles rate hike, it's probably not too soon to start thinking about what lies on the other side of this economic cycle. And given what we've seen from the Fed in the past, they would much rather use policy rates than their balance sheet in order to set the outright accommodativeness or tightness of monetary policy. Up until this point, using the balance sheet has been most closely associated with crisis-esque economic situations, think the pandemic, think the global financial crisis. And so in my opinion, the Fed would rather have capacity to cut rates on the other side of the next cycle, rather than be more quickly forced into using the balance sheet once again. So higher rates with a larger balance sheet seems to be more preferable than lower rates with a smaller one.

Ian Lyngen:

So with that backdrop, one of the most common questions that we've received over the course of the last week has been given that the Feds poised to enter a tightening cycle, the Bank of England delivered its first hike of the cycle. Why then do 10 and 30 year yields not only remain low, but have actually declined over the course of the last several weeks? In way of an answer, it's easy to point to position squaring into the end of the year, which has been one of our bullish touchstones. But I think that there's something more nuanced and with potentially longer term implications. Specifically throughout the course of 2021, the market had been hyper focused on inflation with calls of the Fed being behind the curve and the need for monetary policy to respond to the realities of higher consumer prices. This combined with a shift in terms of how the Fed has been framing the pandemic, as well as the depressed labor market participation rate led to what we have at this moment, which is a Fed that's unwilling to risk its credibility as an inflation fighter at this particular juncture.

Ian Lyngen:

Said differently, those more hawkishly disposed in the market got exactly what they were looking for. This then leads investors to say, okay, what's next? The debate about the terminal rate, that resonates. And we expect that that will come into the play in the beginning of next year, but we're now in an environment where the Fed is going to actively address inflation even if it risks slowing the recovery more quickly than they might have otherwise wanted to. As a result, the only way that we can get a steeper twos, tens, or fives, 30s curve would in the event that there's so much more inflation evident in the first quarter of next year, that the Fed's hawkish pivot is viewed as insufficient to address it or the Fed for whatever reason, feels compelled to dial back on the rate hike fronts in 2022 or 2023.

Ben Jeffery:

And as we watch incoming Fed communication on this issue, one potential inflection point could be a shift in Powell or frankly, any other committee members, characterization of how they're viewing the pandemic in terms of what it means for inflation. What I mean by this is that a critical component of the latest hawkishness has been that the FOMC now views the pandemic as a supply shock, which will only serve to exacerbate the supply side driven pickup and consumer prices. In the event that the pandemic situation deteriorates to such an extent that it once again becomes a demand side issue, think more and more people working from home, maybe restrictions on in person commerce, that demand hit would be inflation negative. And ultimately give the Fed a bit more flexibility or a bit more patience in bringing rates off zero. It's still far too soon to say we've reached that point yet, but if we've learned anything over the last 18 months, it's that the fluidity of the situation around the coronavirus can lead to some very meaningful and very fast economic changes, even though we've already made such meaningful progress through the pandemic.

Ian Lyngen:

So from a macro perspective, we have a game plan for expectations in 2022. But what then does the position squaring that we're seeing in the balance of this year imply for the first quarter?

Ben Jeffery:

Given the yield moves we've seen over the past few weeks and 10s that have now moved back decidedly below 140, we're going to be coming into 2022 with a far more balanced positional bias than what had been a market that was decidedly short throughout pretty much the entirety of 2021. So in keeping with our more bearish call for Treasuries in the first half of the year, the fact that the market is going to be incorporating some of these more macro issues that we've been discussing from a place where investors are not nearly as short as they were throughout the majority of this past year means that as we move toward higher yields, there's going to be less of an impulse from short covering and more capacity for Treasury market buyers or sellers in this case to push rates higher. Now that certainly doesn't mean 250 10s is going to be a reality in January, but it does clear the way for rates to grind steadily higher now that the economy is setting out from a much stronger place than where we were at the end of 2020.

Ian Lyngen:

In addition, the monetary policy stance of other major central banks has shifted more hawkishly. So that should further contribute to the upward pressure on rates, particularly twos, threes, and fives. And we do anticipate the longer end rates will come along for the proverbial ride, but the big theme next year for 10s, 20s and 30s, we'll remain a range trading market just with a higher floor and higher ceiling as we move further into the Feds tightening cycle.

Ben Jeffery:

After all it is the time of year to be focused on the belly.

Ian Lyngen:

Elastic is fantastic. In the week ahead, there's remarkably little economic data to provide trading direction for the Treasury market. Not only is the calendar effectively empty until Thursday, Thursday has an early close and the market is closed on Friday. This is an environment in which we'll be wary of the potential for more dramatic price action exaggerated by relatively low liquidity and frankly, reduced risk taking capacity as books are closed for the year. In terms of tradable event, the biggest number is going to be Thursday's PCE report. We have personal income, personal spending, and of course, core PCE. Given the strength of November CPI number, it goes without saying that core PCE will be similarly impressive. That being said, in the context of a more hawkish global central banking backdrop, we expect that for the next several months that the inflation numbers will be deemphasized at least marginally as we contemplate the potential fallout from the Omicron variant and a winter wave of the coronavirus.

Ian Lyngen:

We do have a couple supply events, namely the 20 billion 20 year on Tuesday, as well as the 17 billion five year tips reopening. Recent Treasury auctions have been met with mixed receptions. Although given the outright level of rates, it's difficult to say that there'll be a lack of sponsorship for Treasuries even at these levels. The balance of December will be a prime environment for the technicals to increase in relevance. In terms of momentum, stochastics in 10 and 30 year yields had been skewed in favor of higher rates. Although much of that influence has moderated somewhat given Friday's price action. If anything, as with the position landscape, if anything, this sets up the beginning of the year to offer a clean read in terms of investor sentiment around the new year and the implications for the outright level of rates from a Fed who has signaled its intention to increase policy rates three times in the year ahead.

Ian Lyngen:

In recognition of the passing of the event risk, the debt ceiling issue has been resolved with frankly, remarkably little fanfare. The proverbial can has been kicked all the way until after the 2022 midterm elections. So this will allow the Treasury department much needed flexibility in terms of funding the deficit. 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 Omicron has the market tucked in for a long winter's nap, we'll remain vigilant for anything on the lawn that might arise such a clatter. After all, we all really know what's a matter.

Speaker 2:

I don't.

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 the 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. 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 a suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 2:

It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast comes institutes investment, legal, accounting, or tax advice, or a representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise it constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts, and commodity options or any other activity, which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act.

 

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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