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N.B.E.R.: The National Bureau of Evading Recessions - The Week Ahead

FICC Podcasts July 28, 2022
FICC Podcasts July 28, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of August 1st, 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 182, NBER, the National Bureau of Evading Recessions, 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 August 1st. And with two consecutive quarters of negative real GDP growth now in hand, all eyes will soon shift to NBER Dating Committee. There should be an app for that. Just swipe down.

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 ian.lyngen@bmo.com with questions for future episodes. We value your input and hope to keep the show as interactive as possible.

Ian Lyngen:

So that being said, let's get started. In the week just passed, the Treasury market received a lot of new fundamental information from which to derive a sustainable trading direction. We saw the FOMC decision to increase policy rates by 75 basis points. This was largely in line with consensus, and despite some of the recent stronger than expected inflation prints, the Fed made it very clear that the market got ahead of itself in pricing in a 100 basis point hike, which ultimately wasn't delivered.

Ian Lyngen:

We also heard from Powell at the press conference that the Fed is cognizant of the risk of a recession. However, the risk of elevated inflation expectations far outweigh the risks of a slower economy. Powell also did a very good job of reinforcing that inflation is public enemy number one for the real economy, both in terms of forward consumer price expectations, but also as it relates to hiring. He reiterated the notion that price stability is important for maintaining a strong labor market. This is notable because the Fed is actively attempting to cool the jobs market somewhat, but clearly that's a moot point at this stage.

Ian Lyngen:

We also learned that real GDP during the second quarter contracted 0.9%. Now this is on top of the -1.6% print that we saw in Q1. And while typically, one might assume that the US economy has entered a recession, the reality is that given how low the unemployment rate remains and the insistence of Fed officials that the economy is not in a recession and is in fact in good standing overall, has created a meaningful divergence between the perception of market participants and the official line of monetary policy makers.

Ian Lyngen:

And as a result, it's not unsurprising to see an increase in growth concerns manifest themselves in the form of lower Treasury yields. 10-year yields got to that 2.64% level, representing the lowest level that rates have been in several months. And more importantly, I would argue, reinforcing the idea that the yield peaks for the cycle are in, and for tens, that is 3.50% and that any path to a 3.75% or 4% 10-year yield level is going to need to be revised or quite frankly, pushed forward to the next cycle.

Ian Lyngen:

So it's with this backdrop that the deeper inversion of the 2s/10s curve played out. We did see that occur immediately in the wake of the Fed, but once investors saw the negative GDP print for the second quarter, we saw a round of bull re-steepening. Nonetheless, 2s/10s remains well into inverted territory at -20 basis points. And this is a trend that we expect will continue and ultimately come to define the summer months.

Ben Jeffery:

So Ian, we learned a lot this week, but most notably, the Fed raised rates by 75 basis points, but yet, 10-year yields are falling through 2.70% and back to, dare I say it, within range of 2.50%?

Ian Lyngen:

Yeah. That 2.50% year-end target for 10-year yields does seem to be approaching a lot more quickly than we had originally anticipated. That said, historically, the summer months tend to be bullish for the Treasury market, so a move lower in yields from here continues to resonate. And while the curve has re-steepened in the most recent rally, I suspect eventually another round of deeper inversion will be in the offing, if for no other reason than the Fed isn't going to start cutting, they're not going to pause in their rate hike campaign, although it is notable that we've now seen two back-to-back quarters of negative GDP. That has historically been the rule of thumb for a recession.

Ian Lyngen:

However, even at the press conference, Powell made it very clear that the US economy is not in a recession, given how low the unemployment rate is and other aspects of the economy that continue to show ongoing strength. The one caveat that I would add to that is we continue to see disappointing consumer confidence numbers. We continue to see upward pressure, albeit modestly, on initial jobless claims. And the reality is that Powell conceded that while the Fed does not intend to trigger a true recession and he sees a path forward that doesn't involve a recession, that path has just gotten a lot narrower.

Ben Jeffery:

And the market's interpretation of the Fed decision was very notable. The language of the statement itself was almost entirely unchanged with, of course, the exception of the actual amendment of the target range, an acknowledgement of the increases in food prices, along with the other baskets of inflation that we've been seeing. But within the press conference, Powell emphasized that at this point, the Fed is now transitioning away from pre-committing to rate hikes of a certain size, and is now of the opinion that they're going to be deciding monetary policy on a meeting by meeting basis.

Ben Jeffery:

I'll characterize this as the 2022 version of data dependence, but most relevant for the shape of the curve and the overall level of yields, was the fact that Treasuries read this change as dovish. And that despite the fact that Powell said 75 basis points is on the table for September, we're now seeing the Fed Funds Futures Market, the front end of the coupon curve, and the overall shape of the rates landscape now reflect a much less aggressive presumed path of hikes from here.

Ben Jeffery:

To me, the September question is still between 50 and 75 basis points, although admittedly, we do still have next week's NFP data, two more CPI prints, and of course, August's employment data as well that we'll get in early September that will help refine the market's collective expectation for just how quickly Powell will get to terminal.

Ian Lyngen:

One of the questions that we received on a number of occasions was whether or not the Fed is going to move further away from forward guidance. Powell's decision not to commit to a specific size of a rate hike in September is in part reflection of the fact that as the Chair noted, monetary policy rates are now at the neutral level, but it's also a reflection of how difficult it is to accurately signal to the market what the committee is going to decide.

Ian Lyngen:

So we're certainly on board with Powell's decision not to actually say 75 or 50 basis points, but it's also worth highlighting that there's still a ton of forward guidance provided by the Fed, whether it's the forward looking language in the FOMC statement or the SEP, which will be updated at the September meeting. I think it's pretty safe to say that the Fed's communication strategy hasn't materially changed. And I'd argue that this is the one aspect of the recent communications from the Fed that has gone somewhat under the radar, is they're sticking to the 2% inflation target. If in fact, monetary policy makers believed that the post-pandemic structure of the US economy meant that inflation was going to be sustainably higher, we would be having a different conversation around whether 2% was the right level.

Ben Jeffery:

And I'm happy you touched on the SEP, Ian, because even though we've seen terminal assumptions brought down very significantly over the past few weeks, Powell went as far as to say that the SEP still provides a good guide for how the Committee is thinking about the shape of the hiking cycle, when terminal will be achieved, and how long they'll be able to keep rates at that level.

Ben Jeffery:

According to the last dot plot, that does not include rate cuts in 2023, which means that as next year draws closer, we're either going to need to see a capitulation from the Fed and acknowledging that maybe some sort of fine tuning adjustment is going to be required next year, or a commitment to terminal and keeping policy in restrictive territory. Admittedly, there's varying degrees of restrictive, but nonetheless, above neutral will mean that if the market is pricing in some probability of rate cuts, in the event those rate cuts are not realized, that's going to continue tightening financial conditions, which will by design help bring down inflation, but also come to the detriment of equity valuations and overall growth from a departure point when we've already seen the economy contract during the first half of 2022.

Ian Lyngen:

There's a very unique dynamic playing out in financial markets at this moment, and it has to do with two distinct timeframes. One is the timeframe that the Fed is operating on, and the other is the timeframe that market participants are more concerned with. At the moment, monetary policy makers are attempting to retain decades of hard won inflation fighting credibility. The Fed's commitment to the 2% inflation target and their credibility at achieving that came into question in 2021. Since November, 2021, Powell has pivoted dramatically in favor of fighting inflation, and the Fed needs to follow through. And so, while the market is content to say that the Fed will ultimately get to a lower terminal rate and begin rate cuts in 2023, the reality is, the Fed is cognizant that to keep forward inflation expectations anchored, they're going to need to be more hawkish. Now, I anticipate that that manifests itself in a terminal rate above 3%, 3.25% that's achieved by the end of the year. But instead of quickly reversing monetary policy.

Ben Jeffery:

As the market is currently pricing.

Ian Lyngen:

The Fed will continue to maintain terminal for longer during this cycle than the market currently anticipates and is pricing. One underlying motivation for that is that the Fed truly wants the balance sheet runoff to go as long as it can, and the Fed can't cut rates while the balance sheet is unwinding in the background, certainly not if prior episodes are any guide. So this implies that once we get to 3.25%, that's going to be static even if we start to see the unemployment rate overshoot the Fed's expectations for this year and into 2023. The takeaway in terms of market pricing is that is going to be a deeper inversion and ultimately constructive for the 10 and 30-year sector of the Treasury market.

Ben Jeffery:

On the issue of potentially cutting while also running down the balance sheet, Ian, I completely agree that from a monetary policy perspective, that's pulling on opposite ends of the same rope. But one potential way that we've heard offered that the Fed could actually bring rates down while still continuing balance sheet normalization would be if they explicitly communicated that the rate cuts we were seeing were not going all the way back to zero, and rather the downward policy adjustments were simply with the goal of getting Fed funds back to neutral, or maybe slightly less restrictive territory. Obviously, this would be a big communications challenge for Powell and the rest of the Committee, but as we think about the different levers that the Fed and other central banks are going to need to pull at the next point in the cycle, this is certainly something worth considering.

Ian Lyngen:

There's little question that the Fed has a challenge ahead of them over the course of the next several quarters as the economy continues to readjust to the new post-pandemic realities, and inflation presumably starts to come back in line with historic norms. Another unique aspect of this cycle is how focused the Fed has been domestically. Recall that prior to the pandemic, the Fed had been content to be the de facto central bank to the world. But given the significance of inflation during the 2021 and 2022 period, the Fed has returned to being super focused on the US, and even within that, super focused on inflation.

Ian Lyngen:

Fast-forward to the end of this year, and it isn't unreasonable to anticipate that once inflation begins to moderate, overall global financial conditions become more relevant and all argued that to a large extent, that's the reason we're seeing 10-year yields closer to 2.50% than to 3% at the moment, because overseas investors have been conspicuously absent in Treasuries. But as the economic outlook continues to dim with both the Fed and now the ECB being more aggressive, at the end of the day, sideline buyers are going to re-enter the Treasury market and further cap the extent to which we can envision 10 and 30-year yields backing up.

Ben Jeffery:

And while supply has admittedly taken a backseat in the current macro environment, recessions and Fed uncertainty are always going to overwhelm Treasury auctions in terms of dictating the price action. We do get August's refunding announcement on Wednesday, where we're expecting Yellen is going to continue with the process of reducing coupon auction sizes in favor of more aggressively leaning on the bill market, both to bring bills as a share of debt outstanding higher, but also to capitalize on the massive amount of demand that continues to exist in the front end of the curve. We're expecting that 2s, 3s, 5s, and 7s are all going to continue to be cut at the pace of a billion dollars a month in the next quarter, with 10s and 30s also being dropped by a billion dollars for the quarter at refundings and reopenings respectively, versus the last refunding cycle.

Ben Jeffery:

Given the relative performance of 20s that we've seen since they were reintroduced in May, 2020, we have heard some questions on the Treasury Department's commitment to the 20-year program and whether or not one should expect a more structural change to the shape of 20-year issuance at the August refunding announcement.

Ben Jeffery:

While that might be something that eventually comes to fruition maybe later this year or early in 2023, on Wednesday, the extent of that discussion that I would look for would be within the details of the TBAC charges, or maybe some other corner of the quarterly refunding document release. For this quarter, we're expecting that 20s are going to be cut by a bit more than 10s and 30s. We're looking for a $2 billion reduction, although there are certainly those out there that are looking for more, $3 or $4 billion. And while we don't really see a catalyst that's going to reverse the trend of 20s under-performance on the curve, for the time being, by which I mean through at least the end of this year, 20s are here to stay, even if they are a bit more expensive from a cost of funding perspective in Washington.

Ian Lyngen:

I think in practical terms, the most realistic way that we see 20s/30s uninverting will occur when we move to the next stage of the cycle, and the Fed is actually cutting and we see a wholesale bull steepener in place. But until then, that anomaly further out the curve, I suspect will continue to define the longer end of the Treasury market.

Ben Jeffery:

So much for roaring twenties.

Ian Lyngen:

Well, at least they're not the boring twenties. In the week ahead, the Treasury market will continue to digest the weaker than expected growth data in the second quarter, and contemplate the extent to which that will ultimately impact the Fed and monetary policy expectations going forward. Now, clearly, at least for the time being, the market is reducing the probability that we see a 75 basis point rate hike in September. That said, we don't think that it should be off the table, at least not yet. We have two employment reports as well as two updates on headline and core inflation that will meaningfully influence monetary policy makers, and could ultimately result in another 75 basis point rate hike.

Ian Lyngen:

What will be the most compelling near-term input for the Treasury market in the week ahead will be Friday's nonfarm payrolls print. The market is looking for July payrolls to have increased by 250,000. In addition, investors see the unemployment rate unchanged at 3.6%, and average hourly earnings increasing 0.3%. Keep in mind, however, an average hourly increase of that magnitude when translated back into real terms, will continue to be negative. The year-over-year, real average hourly earning numbers are deeply into negative territory, and that's part of what the Fed is attempting to address in its wholesale hawkishness, i.e., real purchasing power remains under pressure, especially for the bottom quartile of consumers.

Ian Lyngen:

And it's that divergence that we anticipate will ultimately lead the Fed to be more hawkish, despite what occurs in risk assets, equities, and even to some extent, the housing market. We have started to see housing data routinely disappoint, but that's primarily on the volume side. What we haven't seen is any material decline in prices, perhaps a slowing, which was only to be expected, given the amount of tightening that has occurred and the run up in mortgage rates. The week head also contains the refunding announcement. The details of what we're looking for include $42 billion in three-years, $35 billion in 10-years, and $21 billion in 30s. Now those actual auctions don't occur until the following week, so supply won't be a major consideration for the Treasury market.

Ian Lyngen:

Instead, we'll be focused on any insight from monetary policy makers. As it currently stands, we have Evans and Bullard scheduled to speak on Tuesday, as well as Mester on Thursday. We anticipate that the incoming Fed speak will de-emphasize the negative Q2 GDP print and any recessionary implications, and instead stress the ongoing strength of the labor market and the fact that the Fed's endeavors to cool the labor market will ultimately contribute to the sustainability of an overall strong labor market. It's somewhat counterintuitive, to be sure, but long-term price stability is good for hiring, and if the Fed can effectively contain forward inflation expectations, then the ultimate outcome should then be a net positive for the jobs market in the medium term.

Ian Lyngen:

Our concern embedded in that assumption is the fact that the Fed can tweak the unemployment rate higher without overshooting. Again, very difficult to engineer a soft landing, and if history is any guide, the Fed is more likely than not to overshoot and trigger a meaningful recession sometime within the next 18 or 24 months.

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 as the heat wave extends, Treasure yields melt down, and energy costs begin to bite, we're reminded of two time-tested adages. Stops are for buses, and the road to fun employment is paved with positive carry.

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 Thick Macro Strategy Group and BMO's Marketing Team. This show has been produced and 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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