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March's Mulligan - The Week Ahead

FICC Podcasts April 09, 2021
FICC Podcasts April 09, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of April 12th, 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 115, March's Mulligan, 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 April 12th. And while our invitation to Augusta National was surely lost in the mail yet again, green isn't really our color anyway. After all, as Twain aptly noted, golf is just a good cart ride ruined. Well, close enough that we'll count it.

Announcer:

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 in 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 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 most notable price action in the Treasury market occurred in tens and thirties, where we saw a steady decline in rates throughout most of the week. Now, there was a end of the week cheapening presumably to accommodate the incoming supply, but the fact of the matter is, yields have pulled back steadily in a 10-year sector after reaching 177. This is notable because the price action has occurred despite a more than one million NFP print, if one includes provisions, as well as the highest ISM services print on record.

Ian Lyngen:

This suggests that the market is transitioning to a period in which the economic data will need to either continue to surprise even greater on the upside to trigger any meaningful price action in Treasuries, or we're simply transitioning beyond the sentiment data, as well as the optimism implied in certain prices, notably the 10-year break even space, to a period where the real data needs to conform with those expectations or the market will find itself in a situation where the repricing will be materially challenged.

Ian Lyngen:

We did hear from monetary policy makers echoing the same sentiment, specifically saying that progress toward the Fed's goals will need to come in the form of the actual or the hard economic data, as opposed to the sentiment measures or a one-off strong employment report. The issues that this presents for financial markets are twofold. On the one hand, in the event that the data doesn't conform to expectations, the assumption would then be that the Fed would need to continue a pace with providing monetary policy accommodation if not pushed forward into additional efforts towards easing.

Ian Lyngen:

That creates some upside potential for risk assets in the event that bad news becomes good yet again. We don't expect that that will be the next stage in the recovery. In fact, as the economic data continues to show that the reopening is having the predictable impact of driving greater consumption and with that inflationary pressures, we expect that the optimism will remain in the market for at least a couple more months.

Ian Lyngen:

It isn't until the summer that we expect a more significant reckoning in terms of how the real economy is performing versus expectations and what that ultimately means in terms of the growth and inflation profile for the course of 2021.

Ian Lyngen:

All of this contributes to a broader backdrop of uncertainty, where while the economic data continues to reflect reopenings and the reengagement of the sideline service sector workers, the bigger concern quickly becomes whether or not this is all being front-loaded and we will find the market in a situation where it's faced with uninspired economic data throughout the summer, which would ultimately necessitate an in-range correction and bring 10-year yields back closer to that 135 to 150 range as the real economy struggles to meet the Fed's projected 6.5% growth for the GDP figure.

Ben Jeffery:

Well, I think the most relevant takeaway from Treasuries this week was that it was a bullish one. We saw 10-year yields move well off that peak. They sat last week at 177 and even crossed briefly below 162.

Ian Lyngen:

There's no question it was a bullish week for Treasuries up until the end where we saw a little bit of weakness in the wake of the PPI data, which came out remarkably late in terms of an economic data release about half an hour after its scheduled time. Now, part of the reason that I bring that up is simply because it put a greater degree of focus on the data as opposed to if it had just come out at the normal scheduled time.

Ian Lyngen:

Nonetheless, PPI did print higher than expected, and it led the market to refocus on the prospects for a stronger than expected inflation print in the upcoming week CPI release, which is March's data, and the consensus as it currently stands is for a two-tenths of a percent increase in the core measure.

Ben Jeffery:

And on the topic of inflation, comments from both Powell and Clarida this week emphasized something that is especially relevant at this point in the recovery. And that is that the Fed needs to see, and I'm quoting here, "actual progress towards its goals before there will be any meaningful potential for policy normalization." This highlights something of a theme that you and I have talked about, Ian, which is that divergence between expectations and the realized data. And especially ahead of CPI on Tuesday, it will definitely be a space to watch.

Ian Lyngen:

And I'd add that that actually has been the trade of 2021 thus far, and that is building expectations both on the inflation side, as evidenced by higher 10-year breakevens, and on the reopening recovery side, as we saw a 10-year real yields start to drift off the lows. The question is, and I think it's a very valid one from the chair, how long is this divergence going to be able to persist before there needs to be a more confidence in inspiring proof of concept.

Ian Lyngen:

If we find ourselves at the end of the second quarter with inflation continuing to muddle all along and all the service sector rehiring that's going to occur during the first wave having been conducted, that will leave the market in the precarious situation of wondering what's next, especially in the absence of additional fiscal stimulus from Washington.

Ben Jeffery:

And we've touched briefly on the price action and tens, but I also want to highlight the moves in the belly of the curve, fives and sevens in particular, and their outperformance in the earlier part of this past week. What we saw was a bit of a rationalization of those normalization ambitions as evidenced by the Euro dollars market.

Ben Jeffery:

And that translated to a pretty meaningful retracement of what had been some sustained weakness in the belly of the curve, given where liftoff ambitions had run as the upside to the outlook, translated to a bit more aggressive Fed assumptions than the message that Powell and Clarida ultimately delivered.

Ian Lyngen:

We also had the FOMC minutes, which to your point, Ben, really reinforced this idea that the Fed is going to be on hold for a long time. I keep returning to this notion that the market seems content to adjust the price action, assuming that the Fed is going to respond to inflation or increasing inflation expectations in the same way that it had prior to the framework change. And the fact of the matter is that the Fed has come out and repeatedly reinforced this idea that the Fed is approaching inflation markedly different than they had in the past.

Ian Lyngen:

And that's not only evidenced by the shift to an average inflation target, but rather an acknowledgement that the Fed will be content to be behind the curve in terms of realized inflation, as opposed to attempting to jump in front of any concern that consumer prices are going to accelerate beyond the control of monetary policy.

Ben Jeffery:

And while he's not a voter this year, Dallas Fed President Kaplan came out and said explicitly that, that the Fed's reaction function in this cycle is going to be different than it has been in previous ones. A less preemptive FOMC in terms of reacting to inflation in my mind adds some staying power to the move in breakevens we've seen. But in terms of where we go from here, it has been encouraging to see that the emphasis from monetary policy makers at least is shifting away from expectations and toward realized data.

Ben Jeffery:

Now, I think it remains to be seen whether trading mirrors that, but not an unreasonable expectation as we move further through the second quarter.

Ian Lyngen:

In terms of expectations, I think another interesting development over the course of the last week were the comments from the New York Fed's Lorie Logan. These comments were primarily focused on the composition of the Fed's buy in. The New York Fed has now acknowledged that because of the change in the Treasury department's issuance patterns in favor of longer dated securities, namely the 20-year benchmark and tips, that the Fed is going to need to adjust the composition of buy-in. Now, this doesn't represent a stealth operation twist nor frankly any change in the existing monetary policy.

Ian Lyngen:

Rather, this is simply following through on the Fed's commitment to buy bonds in a way that is consistent with the composition of the US Treasury debt. So while it did trigger a little price action, namely the outperformance of the 20-year sector versus tens and thirties, at the end of the day, it doesn't change the overall direction of rates nor should it really be construed as a move on the part of the Fed.

Ben Jeffery:

I completely agree that this doesn't represent our monetary policy decisions, so much as the Fed incorporating the new information. That is the updated issuance profile exactly as you say, Ian. In terms of trading during this next week, I do think it does introduce at least a bit of an event risk around the next QE schedule announcement, which will happen on Tuesday afternoon, the same day as the inflation data. And it's reasonable to expect the overall size of the Treasury buying will stay consistent at $80 billion a month.

Ben Jeffery:

And what we'll likely see is an upsizing in the long and nominal passes, as well as tips likely at the expense in equal parts of the other portions of the curve just to avoid any potential interpretation that this is a shadow operation twist.

Ian Lyngen:

Regardless of how it plays out, the one thing that investors have learned is the degree to which issuance needs to change for the Fed to respond. I think that that's the biggest takeaway from the Lorie Logan comments and the reason that the market will be paying attention to next Tuesday afternoon's release.

Ben Jeffery:

And aside from any QE adjustment, there were also some comments worth acknowledging both in Lorie Logan's speech and also from Powell that we saw in the minutes about the situation in the front end, continues to be an excess of cash in the very front end of the market, which is putting downward pressure on repo rates.

Ben Jeffery:

And while thus far Fed funds has been fairly resilient at seven basis points, the fact that the Fed both via the minutes and Lorie Logan's speech went as far to acknowledge the potential for an adjustment in some administered rates, think IOER, could be the groundwork for another technical adjustment like they've done several times in the past. Now, the critical caveat here was "undue pressure on funding costs." Intentionally ambiguous to be sure, but this is one of the first instances that we've seen the Fed introduced the idea that a money market plumbing adjustment may not be in the too distant future.

Ian Lyngen:

One of the other key aspects from those comments to note was that the point was made that it could be an intermediate adjustment, which takes the emphasis off of the normal scheduled meetings, but also de-emphasizes the relevance of such an adjustment. Because if it's something that can occur as a one-off intermitting with little explanation needed, it's safe to interpret that the Fed's lack of emphasis on such a shift should be a cue for the market in terms of its relevance and importance for guiding future monetary policy expectations.

Ben Jeffery:

We've been focusing on inflation, monetary policy, the Fed's bond buying program, but I think we'd be remiss not to discuss the influence that this week's auctions may have, especially on Monday and Tuesday. The schedule is a bit different than usual, and that will get threes and tens on Monday, followed by thirties on Tuesday, given where the 15th of the month falls during the week. All else equal, could we see a bit of a concession coming out of the weekend?

Ian Lyngen:

A lot of the pre-auction concessions that we have seen thus far in 2021 have actually occurred on the Friday before the auction. To some extent, I would argue that a good portion of the backup in Treasury yields seen on Friday does have its origin in the upcoming supply. Nonetheless, as we start the week with a limited data calendar until Tuesday's CPI, all else being equal, it's difficult not to assume that there'll be a grind higher in yields. What I would be surprised by is if we saw 10-year yields up against that 175, 177 yield peak before the reopening.

Ian Lyngen:

In such a situation, it wouldn't be very difficult to envision a uninspired auction take down leading to cycle high 10-year yield prints ahead of CPI, only to have the range reinforced when CPI comes in good, but not paradigm shiftingly high.

Ben Jeffery:

And let's not forget, we've also made it to the new Japanese fiscal year, what should alleviate some concerns on further weakness in terms of overseas demand that was so relevant around February and March's seven year auctions. And given where we are in terms of the price action itself, relatively even footing within this new range, all else equal, a decent bid at least for tens and thirties seems to be the path of least resistance to set the tone early in the week.

Ian Lyngen:

And you make a great point about the potential return of Japanese investors. When we look at US Treasuries hedged back into yen, we can see that there's a significant yield pick up, which we expect will create a bullish underpinning for Treasuries as the second quarter plays out. The caveat that's worth adding here is that from the perspective of a Japanese investor, this week offers CPI as well as the March retail sales figure. And in that context, there's a potential for a breakout to a higher yield plateau.

Ian Lyngen:

That coupled with the fact that investment plans are scaled in over the course of time rather than a specific trigger date, per se, does suggest a degree of flexibility in terms of the timing of Japanese flows. And it will leave that as a potential backstop even if we don't see those materialize in the very near term.

Ben Jeffery:

And on the topic of foreign demand more broadly, we're starting to see a bit of a divergence between the US and especially Europe in terms of the vaccination process and prospects for the economic recovery. COVID mitigating restrictions continue to be extended on the continent, which is intuitively weighing on the outlook versus the US, where the pace of vaccinations is only accelerating and there's already been 175 million doses administered.

Ben Jeffery:

With the White House coming out and saying that shots should be available to all who want them by April 19th, this discrepancy should also create a backstop of demand for Treasuries from overseas investors over the next several months.

Ian Lyngen:

Ben, essentially what you're saying is as goes the pandemic, so goes the economic recovery, and it goes differently in different regions at this stage.

Ben Jeffery:

So it goes.

Ian Lyngen:

In the week ahead, the Treasury market will be faced with an early auction schedule that sees 38 billion 10-years on Monday at 1:00 PM, followed by 24 billion 30-years on Tuesday. Now, we do get the core CPI release in between on Tuesday morning, and this will provide further context for the divergence between inflation expectations and realized inflation. As we've already seen with the headline PPI print, the year over year changes are going to gain momentum in the March, April, and May period for the data.

Ian Lyngen:

This is simply a function of the base effects created by the declines in inflation seen at the beginning of the pandemic. While the Fed has coached financial markets to not pay attention to the year over year figures, instead relying on the three month moving average number, we find ourselves concerned that while that might hold true in the fixed income markets, headlines related to inflation that the Fed appears unwilling to respond to might have greater ramifications and risk assets, most notably the domestic equity market.

Ian Lyngen:

It's within that context that next week also provides a fair amount of Fedspeak, as well as the Beige Book setting the tone as the second quarter gets underway. Let us not forget the retail sales print on Thursday with the consensus currently looking for a 5.2% increase in spending. This is very consistent with the numbers that we saw in January that were largely stimulus driven, that were subsequently followed by a drop in February, and then with a fresh round of stimulus expectations are for the first quarter to end on solid footing.

Ian Lyngen:

As with the broader theme of the economic data justifying expectations, we can't help but wonder whether or not the bulk of the upside in the pace of consumption has been brought forward and effectively condensed into the first quarter and the beginnings of the second quarter.

Ian Lyngen:

That would undoubtedly raise the bar for spending to continue throughout the course of the year and put into a broader context the relevance and importance of fiscal stimulus that was designed to function more as a bridge for the consumer to make it to the other side of the pandemic, rather than represent the traditional character of stimulus which would simply add to the existing momentum in the economy with the goal of bringing growth to a greater plateau.

Ian Lyngen:

Said differently, given that the traditional pathways for consumption changed during the pandemic, it's very difficult to compare the prior stimulus endeavors with those seen in 2020 and 2021. As a result, as the US economy reopens and endeavors are made to establish the new normal, we'll be watching for signs that the increase in inflationary pressures in the second quarter ultimately proved to be transitory, as the reality is that most people didn't see a net pay increase during the pandemic, even though savings, net income, and consumption were supported by the fiscal programs.

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. With vaccinations in the US now outnumbering COVID cases nearly six to one, we're left to ponder how quickly our social interactions will take on a decidedly cooler tone once masks are abandoned. Faces made for quarantine and all. 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.

Ian Lyngen:

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 edited by Puddle Creative.

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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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