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New Year, New Fed - The Week Ahead

FICC Podcasts January 14, 2022
FICC Podcasts January 14, 2022


Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of January 18th, 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 Marco Horizons Episode 154: New Year, New Fed. 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 January 18th. And as we hear chatter about some potential out of the box monitor area policy ideas for the year, we're reminded that the box is there for everyone's protection.

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 U.S. 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 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 past the treasury market went through a meaningful round of consolidation in so far as after 10-year yields backed up to roughly 180 we've seen rates grind effectively sideways with a slightly bullish skew. We're reluctant to interpret this as any broader tone shift, other than simply to acknowledge that bearish repricing have a tendency to occur in a step function as opposed to simply being a one-way move to a sustainably higher rate plateau.

                                                Said differently, a 25 basis point sell-off followed by a round of consolidation before attempting to press yields even higher is very consistent with the way that the treasury market has historically traded. It's also in line with what we tend to see at the beginning of year. Historically, the first and second quarter of the year have a bearish skew to them, not dissimilar from what appears to be playing out in 2022.

                                                The fundamental inputs this week were meaningful as well, particularly the higher than expected CPI data. Both the headline and the core came in above expectations with core CPI in December printing at an impressive 16th of a percent month-over-month. It follows intuitively that this led to a fresh round of decades high year-over-year numbers and reinforced the Fed's urgency to begin the rate hiking campaign.

                                                Our baseline assumption continues to be that March will be the liftoff rate hike followed by a move in June with the balance sheet runoff announced in September. And then in December, the Fed will restart the quarterly cadence of 25 basis point rate hikes into 2023. The market is yet to really focus on the terminal rate debate. Before attention shifts there, we suspect that we'll have to get the first rate hike of the cycle and a better understanding of how the Fed intends to proceed.

                                                There is a reasonable risk that the Fed decides to be more aggressive than simply 25 basis points a quarter, and instead chooses 25 basis points a meeting. Now, that would have much different implications for the markets assumption for the terminal rate, i.e, higher. Although all it's being equal, we're on board with the notion that the sooner the Fed starts hiking rates, the lower the terminal rate might ultimately be.

                                                Whether that ends up being 175 or 275 will ultimately be a function of the performance of inflation as 2022 plays out. Let us not forget that the retail sales numbers for December disappointed rather dramatically so. While this didn't elicit a great deal of price action in the treasury market, it arguably reflects some of the supply chain issues ahead of the holiday season. And the idea that consumers brought forward spending in anticipation of goods scarcity around the holidays.

Ben Jeffery:                        Well, Ian, we got a bearish early start to the week. 10-year yields made it above 180, but it seems we're settling into something of a period of consolidation, maybe a slight bullish drift.

Ian Lyngen:                         I think that's a fair characterization. However, I would note that we're still very early in the quarter, very early in the year. And the idea that all of the bearish positions that are going to be established have been established doesn't really resonate.

                                                There's a reasonable argument that part of the consolidation that we saw this week had to do with profit taking and the fact that we didn't extend into a higher rate environment. Let us not forget this week contained some pretty bond bearish developments, not least of which being the higher than expected CPI print.

Ben Jeffery:                        And in thinking about that CPI print, the details were very much in keeping what it is we've been seeing throughout the bulk of the pandemic. A large portion of the gains were centered in OER and used auto prices. And while on the former specifically, we've yet to see the entirety of the pickup in the real estate market flow through to the inflation complex. As rates begin to rise, presumably some of the edge in housing is going to be taken off and we'll see not necessarily a deflationary environment and housing, but also not a consistent 0.4% month-over-month rise in owners' equivalent rent.

Ian Lyngen:                         For context, there tends to be about an 18-month lag between increases in new and existing home prices and that ultimately flowing through to the OER data. So that suggests that at least for the next several months, OER will remain a key pillar to the core inflation series. What I will find fascinating is what happens when the base effects hit in the second quarter and the year-over-year inflation figures become less headline-grabbing than they have been recently?

                                                We'll be at a point where the Fed has already started the rate normalization process. And if we find ourselves an environment where the yearly inflation numbers are moderating somewhat, it will, if nothing else take some of the urgency out of the Fed's tightening campaign.

Ben Jeffery:                        And just to bring it back to the price action very briefly. What was your takeaway in terms of the knee-jerk response to CPI? At a first pass, higher than expected prices should have exacerbated the sell-off that we've been seeing. But instead what we saw was actually a knee-jerk draw up in yields still well above 170 in the 10-year space, but nonetheless intriguing, don't you think?

Ian Lyngen:                         Yes, I would characterize that as a version of a strong inflation print already being priced in. What we saw was that headlining core inflation were above consensus, but not so far above consensus as to imply that the market's expectations for Fed hikes would be insufficient to counter the rise in consumer prices.

                                                And I think that that's an important nuance because what the market is saying is that as long as inflation continues to increase at the pace it has been and doesn't accelerate even further, the Fed's 25 basis point a quarter cadence with a balance sheet runoff sometime later this year should be sufficient to keep inflation expectations anchored. And at the end of the day, that's really the Fed's primary goal at this moment.

Ben Jeffery:                        And looking at the tips market, Ian, that precise notion is reinforced on a week-over-week basis, we've seen 10-year real yields increase at a pace that we've only seen three times in the last 10 years. One of those instances was the volatility associated with the early days of the pandemic.

                                                And from the Fed's perspective, the speed with which real rates are rising and breakevens have continued to moderate dropping below 250 over this past week has got to be encouraging for monetary policy makers if only because it indicates that the market is showing faith in the Fed's ability to offset higher inflation, exactly as you point out.

Ian Lyngen:                         And I think that that is one of the risks that the market faces over the course of the next three or four months. And that is what happens if we start to see a further acceleration in consumer prices and the Fed doesn't have another hawkish pivot to offer. That would make a solid argument for a bear steepener or at a minimum 10 and 30-year yields drifting higher as the debate shifts to what the ultimate terminal rate will be for this cycle.

                                                But on the flip side, envisioning a scenario in which the Fed's baseline expectations for inflation moderation in the second quarter come to fruition, then that continues to bode well for the curve flattener specifically in the 530s spread, which has been drifting between 51 and a half and 62 basis points as of late.

Ben Jeffery:                        And using some of the events of this past week as an indication for that dynamic, despite a Fed that's clearly committed to raising rates and growing optimism on the path of the pandemic and the path of the recovery, we still saw generally solid sponsorship for both 10s and 30s at their reopening auctions. Small tails were needed as a last minute accommodation.

                                                And the outright cheapening we've seen so far this year definitely helped bring in some demand, but nonetheless, two good results for those benchmark litmus tests of primary market demand speak to the idea that there is dip buying willingness out there. It's just a question of at what level it will come in.

Ian Lyngen:                         That's a good point, Ben. And I would add that we know that there remains a fair amount of cash on the sidelines waiting to be put to work, but there's no real sense of urgency yet after all we're still in the first month of the year.

Ben Jeffery:                        And as the year is progressing, we are getting a greater degree of clarity on what path monetary policy normalization will probably end up taking. Governor Waller was out later in the week saying that as a baseline, he still favors three rate hikes in 2022 and Chicago Fed President Evans said the same thing.

                                                So from that perspective, at this point, it seems that the consensus tightening timeline is a 25 basis point rate hike in March followed by another 25 basis point move in June. And then a period exactly as Waller said to evaluate what the inflation landscape looks like before delivering balance sheet normalization in September. And then with all the applicable pandemic caveats considered, another rate hike in December.

                                                So while from a broader perspective, balance sheet rundown might be "worth a hike" that would still be three rate hikes, which would be in line with what we saw at the last revision to the dot plot in December.

Ian Lyngen:                         And while there does seem to be consensus forming around the timing of rate hikes and the balance sheet runoff announcement, there's a fair amount of divergence in terms of market participants' expectations for exactly what the balance sheet rundown will look like. On the one hand, there's a subset in the market expecting a much more rapid rundown of the balance sheet than we saw during the last cycle.

                                                Now, taking a queue from the December FOMC minutes, it does follow intuitively that one should expect the process to occur sooner this cycle than last. However, we reminded that there was a 22-month lag between the first rate hike and the balance sheet rundown last cycle. And so containing it all in 2022 by definition makes the process quicker this round. The bigger question becomes whether the caps are achieved immediately for the balance sheet rundown or if they stagger in over time. And if they do stagger in over time, will it be a 10, 12-month period before we reach the maximum runoff velocity or will it be four or six months?

                                                Those investors assuming that it will be a four to six-month timeframe are more acutely focused on the way in which the Treasury Department will choose to fill any funding gap. All else being equal, if the roll off runway is longer, the impact on the Treasury Department's borrowing needs in 2022 will be much less significant and easily absorbed in the bill market. In the event that we reached the caps in 2022, I think then the Treasury Department has a lot more or weighty decisions to consider in terms of where they increase issuance.

Ben Jeffery:                        There's another component of this that's worth discussing and something that we've heard offered in terms of A. How fast the Fed will endeavor to run down the balance sheet. And B. Whether or not they might consider a rate hike every meeting. And fundamental to this question is the fact that the longer-term are more structural, deflationary pressures that we experienced during the decade before the pandemic have not gone away.

                                                And if anything, the coronavirus has accelerated some of those trends toward automation and the factors that made it so difficult for the Fed to achieve their 2% target from the downside during the last cycle. So we've been considering whether the FOMC is wary of the risk that if they act too aggressively, they could unintentionally push us back into a low inflationary environment similar to the last cycle when we only saw core PCE reaching 2% in a handful of months.

Ian Lyngen:                         There's also been chatter about the notion that the Fed could choose to sell bonds directly into the market out of SOMA in addition to letting the charities run off. This strikes us as a very dramatic policy response and one that I suspect would be very difficult to get the committee to buy into if for no other reasons that it carries with it a pretty significant risk, specifically envisioning a scenario in which the Fed announces that they'll be selling, let's call it 20 billion a month in the 10-year sector over the course of a four-week period.

                                                The knee-jerk response is going to be a sell-off in treasuries of let's call it 25 basis points in 10-year yields. Then I suspect that would actually shortly be followed by a rally of let's call it 35 or 40 basis points leaving 10-year yields lower than the point prior to the Fed announcing this version of QT. Now, the logic here is that the power associated with selling bonds into the market is going to have such a potentially dampening impact on demand as even more tightening impacts the system, that investors will simply look to the downside associated with growth and the downside associated with inflation as a result of an even more aggressive Fed.

                                                This does tie into the idea of term premium and the degree to which the Fed is frustrated by the fact that they have signaled with great clarity their intention to begin hiking rates in March. It will be a tightening cycle. It won't be a one-off and still 10 and 30-year yields remain relatively contained, particularly in the context of the move seen in twos, threes, and fives.

Ben Jeffery:                        And looking at the price action in the longer end of the curve, at least temporarily a period of consolidation right around 170 10-year yields would resonate with not only the momentum backdrop that continues to rationalize from oversold, but also market that's eager to catch its proverbial breath after a very exciting start to the year until the next monetary policy update is revealed at the end of January.

Ian Lyngen:                         End of January? Oh, you mean when the gym will be empty again?

                                                In the holiday shortened week ahead, the treasury market will have remarkably little in terms of fundamental data to help provide trading guidance. We do see housing starts and building permits as well as existing home sales, which will update the market on the housing sector. That being said, while how inflation has been a key component of the inflation figures, the broader macro narrative remains focused on gauging the Fed's hawkishness and the extent to which there's a fair amount of eagerness to begin the rate normalization process.

                                                On the supply side, we do see $20 billion in 20 years on Wednesday and a 16 billion new 10-year tips issue on Thursday. In evaluating the primary market demand for tips, it's important to keep in mind that the perception is the Fed's QE program and potentially QT on the other side have disproportionately impacted tips given the relative liquidity profile versus nominal securities. So this will leave the focus on auction performance to get a better sense of the outright demand for inflation protection in the current environment.

                                                All else being equal, we suspect that there will be a sufficient sponsorship for the 10-year tips benchmark with the caveat that as the Fed moves more aggressively to offset the risk of inflation, it would follow that we would see less aggressive bidding for inflation protection. So given the relatively light data and event calendar in the week ahead, our expectations are for the bulk of the week to be spent refining market calls associated with the Fed, as well as what that means for the shape of the curve and the outright level of yields.

                                                We maintain that one of this year's primary theme will be the flattening of the curve, particularly 530s as pricing in a full tightening cycle results in upward pressure on rates in the front end of the curve, while the ramifications of a less accommodated monetary policy contain how far 10 and 30-year yields are able to back up as the global economy continues to struggle with the coronavirus. And all of the associated implications for both real growth, as well as the implications for a higher inflationary environment at least in the near-term.

                                                We've reached the point in this week's episode where we'd like to offer our sincere thanks and condolences to one who has managed to make it this far. And as the Fed reads to begin decreasing policy accommodation, we are reminded of the hollowed words of then Dallas Fed President Richard Fisher in 2015 when the Fed was preparing for a similar shift that, "We're not going from wild turkey to cold turkey, and it wasn't even Thanksgiving."

                                                Thanks for listening to Macro Horizons. Please visit us at As we aspire to keep our strategy effort as interactive as possible, we'd to hear what you thought of today's episode. So please email me directly with any feedback at

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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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