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October of Discontent - The Week Ahead

FICC Podcasts Podcasts September 30, 2022
FICC Podcasts Podcasts September 30, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of October 3rd, 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 191, October of Discontent, 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 October 3rd. As we ponder what our spirit catastrophe would be, it strikes us that hurricane certainly wouldn't top the list. Earthquake Ian has a nice ring to it, or even Landslide Lyngen.

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. So that being said, let's get started.

Ian Lyngen:

In the week ahead the Treasury market will continue to digest the moves that occurred overseas and continue to incorporate a weaker outlook for the equity market into broader expectations. Last week saw fresh new lows established for the year in the S&P 500, and one of the questions that we've received frequently is at what level of the S&P 500 would the market begin to change its rhetoric surrounding future rate hikes?

Ian Lyngen:

For context, we don't think that there is much that could prevent the Fed from pushing rates to the point where the upper bound for Fed funds is 4.75% by February of next year. Nonetheless, in the event that the S&P 500 were to dip below 3300, we could see the forward rhetoric regarding how long the Fed will keep policy deep into tightening territory start to shift. While the softening of this language might be somewhat backward looking, in the event of such a move in stocks, what will probably be more relevant for the Fed isn't the outright level of equities, but how quickly such a selloff occurs.

Ian Lyngen:

We'll make the observation that the price action thus far has been more orderly than we would need to see for the Fed to begin to get nervous. By this, we simply mean that we haven't seen any negative 5, 6, 7% days in the S&P, at least not on a closing basis. And while the VIX is clearly elevated, the amount of realized volatility that we've seen is clearly not sufficient, at least yet, to change the Fed's messaging.

Ian Lyngen:

In the week ahead we also see non-farm payrolls on Friday. The market's expecting a 250,000 headline payrolls print with an unchanged unemployment rate at 3.7%. Throughout the bulk of 2022, the most tradeable events have come in the form of inflation data, and given how strong the labor market has been overall, non-farm payrolls has taken a second seat to CPI and PCE.

Ian Lyngen:

As the market can now see the end of the rate hike cycle, we anticipate that market volatility around employment releases will increase. The Fed has been very effective in communicating the fact that the strong underlying labor statistics have allowed the Fed to be more aggressive in fighting inflation than they might have otherwise been. At some point that will turn and as a result, not only will the official BLS data of payrolls and the unemployment rate be pivotal, but also ADP on Wednesday could set the tone of trading in the market, as could initial jobless claims and some of the other proxies, including, but not limited to, Tuesday's release of the JOLTS data.

Ian Lyngen:

Overall, as the real economy enters the next stage of the cycle, the market will be on guard for any signs of undue stress in the labor market.

Ben Jeffery:

Well, we ended last week with 10 year yields, call it right around 3.70%, and it looks like we're closing out the third quarter with 10 year yields right around 3.70%. Fairly tranquil market, I would say.

Ian Lyngen:

Yeah, to look at the week over week closes one would think that absolutely nothing happened, but that belies the fact that 10 year yields reached as high as 4%, which ended up being a very significant buying opportunity. This sentiment is also consistent with the fact that global financial markets are now beginning to feel the strain of tighter monetary policy from a variety of major central banks. Not only has the Fed continued to push forward with its hawkish agenda, but similar moves have now become the norm, whether it is the Bank of England with a potential for an inter-meeting rate hike, which was always highly unlikely, but nonetheless has recently been driving the macro narrative, and to a large extent, accounted for the weakness that we saw in the Treasury market that brought benchmark 10s to that inflection point at 4%.

Ben Jeffery:

Ian, as you and I have discussed this tightening cycle and just how aggressive the Fed would be willing to be, how high policy rates would ultimately be able to reach, the core theme has been that the Fed is going to continue hiking until something breaks. I would argue the UK bond market is one of the first things that was indeed showing signs of breaking. That is until the Bank of England surprised announced its emergency measures to delay QT and actually start buying bonds in order to preserve the long end of the gilt market.

Ben Jeffery:

But more broadly, and outside of the nuances of Britain's pension system and how that almost necessitated an emergency central bank intervention, what we've seen over the past week is that unlike over the course of recent history, we now have a materially higher inflationary regime and interest rate regime in a world when the Fed, the Bank of England, the Bank of Canada, the ECB are all aggressively moving policy into restrictive territory, which means that as shocks arise, and there's certainly no shortage of potential flash points at the moment, those shocks are not going to be as easily absorbed by the global economy, given that what was once very cheap money no longer is cheap. As you say, 10's near 4%.

Ian Lyngen:

10's near 4%, yes, but more importantly, real 10 year yield's at 1.50% That represents a much more meaningful tightening and is going to continue to have forward ramifications for investors' expectations on the growth side. While 10 year yields might not have changed that much on a week over week basis, the reality is that breakevens have compressed rather dramatically with the 10 year measure, reaching as low as 2.15%, as investors contemplate the longer term impact from a slowing global economy. It's this backdrop that we suspect the Fed can actually take a reasonable amount of solace in, because if nothing else, as a referendum on Fed credibility, Powell seems to be passing the test.

Ben Jeffery:

It's exactly this macro backdrop that framed the conversations we've had over the last three weeks, and most of which between the two of us was spent on the road talking with a variety of different types of clients, in terms of the market outlook and what it is we've learned from the developments of 2022 so far. Our highest conviction call, and one that generally seemed to resonate across the conversations, is that we expect a deeper inversion in 2s/10s and that negative 58 basis point level that we've now seen visited twice, will ultimately break and put negative 75 basis points, or even negative 100 basis points on the table in 2s/10s.

Ben Jeffery:

The one aspect of our outlook on the market over the balance of this year that did receive some pushback was the scale of our expectation of the move toward lower rates.

Ian Lyngen:

The notion that 10 year yields could end the year at or below 3% was certainly a conversation starter, if nothing else. But if one thinks about where we are in the process of pricing in a more durable global recession, the biggest disconnect isn't wanting to be long Treasuries, it's the fact that effective Fed funds is viewed, at least in the very near term, as effectively a floor for yields. We'll argue that while the Fed might want that to be the case, the reality is, and history suggests otherwise, if we look at prior episodes when the Fed has achieved its terminal policy rate objective, two year yields don't look at effective Fed funds as a floor, but rather a ceiling, and the inversion of 2s funds can not only be deep, but also durable.

Ian Lyngen:

Further out the curve, we're sympathetic to the notion that once the market starts to price in a greater probability of cuts, that that should be incrementally inflationary, i.e. less restrictive policy over the course of time, which we anticipate will lead to a steepening of the 10s/30s curve as opposed to a reason to sell 10-years outright.

Ian Lyngen:

One of the more interesting hypotheticals that we've recently been pondering, is what occurs if in fact we are edging into a truly stagflationary environment, but firms continue to hire, or at least we don't see wholesale layoffs define the next stage of the cycle? Said differently, can 10 year yields go to 3% in the case of a soft landing? We can definitively say maybe.

Ben Jeffery:

I completely agree, definitely, maybe, but implicit in this question is that along with the environment that you laid out, Ian, would be that wages stop rising as quickly as we have seen, which would be a reflection of lower demand that the Fed is actively pursuing via its tightening campaign. So while yes, firms could continue to hire in this environment, there would presumably be fewer job openings, leaving the JOLTS Survey as a space to watch, and this, in turn, would mean that the worker would have less negotiating power versus the employer, which then would also add to this idea that the cost of labor would begin to moderate.

Ben Jeffery:

I would argue, Ian, as you touch on, that this would be the Fed's ideal scenario and that ever elusive soft landing. Our skepticism that this is what ultimately will come to pass, is that we're already starting to see signs of the unemployment rate move higher, and as history has shown, the unemployment rate, yes, moves gradually lower, but higher very quickly, and it's that feedback loop that we suspect will quickly turn what might look like a soft landing, into a much, much harder one. And that's just in the US, to say nothing of what's going on in Europe and other parts of the world.

Ian Lyngen:

Ben, I think you're spot on in broadening the conversation to include what is going on globally, as opposed to simply keeping the conversation limited to the US. The fact of the matter is that Powell's Fed has been remarkably US-centric. Now, this isn't a criticism by any means. After all, the Fed is the US Central Bank, and at its essence the performance of the global economy isn't its mandate.

Ian Lyngen:

In fact, the Fed has managed to effectively narrow its dual mandate to a singular mandate, which is fighting inflation, and has been relatively effective in keeping forward inflation expectations contained. At least that's the current understanding. To be fair, 10-year breakevens got above 300 basis points at one point earlier this year. Nonetheless, as we contemplate our core understanding that policymakers will continue to lean hawkishly until something breaks, it strikes us that something breaking might not be a US development.

Ian Lyngen:

Obviously, the moves in the UK and in the gilt market highlight this risk, but as we're reminded that price stability is an objective that the Fed has over the coming decades, not quarters, the idea quickly becomes that Powell might be hiking the world into a recession, while the US, at least ostensibly, appears to be isolated for the moment. Translating that into price action, we are reminded that the two year sector is largely a function of monetary policy expectations set and outlined by the Fed, whereas 10 and 30 year yields are set by the global macro outlook, and as inflation expectations are contained, the prospects for a deeper recession in Europe come into focus, it's not difficult to envision a 50 or 75 basis point bid for duration that inverts the 2s/10s curve to negative 100 basis points.

Ben Jeffery:

And after looking at the moves in 10 yields this week, Ian, you're exactly right, a 75 basis point move in 10 year yields. If we continue to see price action like we have been, that could take place in just a matter of a few days as liquidity remains very thin by Bloomberg's measure, as bad as it was during the worst days of the pandemic, and the overall level of uncertainty is keeping investors either very short in on the yield curve, or primarily in cash waiting for a bit greater clarity on where it is the Fed is going to bring rates. I would argue it's once we reach terminal and have some sense of how long the Fed is going to endeavor to stay at terminal, that people will once again be willing to reach further out the curve and take advantage of rates that are higher than they've been in over a decade.

Ian Lyngen:

You know, Ben, like they say, we're all terminal.

Ben Jeffery:

I guess we have been spending a lot of time in airports.

Ian Lyngen:

And on trains.

Ben Jeffery:

So what you're saying is, you'll meet me at the terminal?

Ian Lyngen:

Four, six.

Ben Jeffery:

What are we talking about?

Ian Lyngen:

Who's on second?

Ian Lyngen:

In the week just passed the Treasury market saw some strikingly volatile moves, with 10 year yields at one point reaching 4%, a level that proved short-lived and brought in buying interest, and we ultimately saw the selloff reversed as ten year yields drop below 3.7%. That said, the bulk of the price dislocations can be credited to the moves in the gilt market, as inflationary concerns continue to provide the primary global narrative for higher rates, and monetary policy makers are content to push policy rates higher in response.

Ian Lyngen:

While the month and quarter end did bring with it a reasonable bid, it's worth noting that 10 year yields are still above 3.50%, and a process of consolidation in this higher rate range will eventually allow for a cleaner, less position biased response to incoming data. On the data front in the week just passed, we did see a stronger than expected core durable goods print, slightly better than expected consumer confidence, as well as core PCE for the month of August.

Ian Lyngen:

That said, the upside surprise on core PCE at 0.6% was easily dismissed, given the performance of the core CPI series. This fact was reinforced by the price action itself, as Friday was a bond bullish day, although the most defining characteristic might well have been the choppy price action of the week overall.

Ian Lyngen:

On the supply side, we saw a weak reception to the two year auction on Monday, a 1.6 basis point tail for 43 billion in supply. The five year sector performed equally as troubling, with a 1.6 basis point tail for 44 billion 5s. We did see some dip buying emerge on Wednesday, as the whole market had backed up. The seven year auction stopped through a half a basis point. This corresponded with a point in which yields peaked, and in the wake we have seen a steady grind toward lower rates. We're reluctant to conclude that the rally is a one off, but also in being intellectually honest, given the magnitude of the inter-day moves and the severity of the repricing, it is still too soon to say that 4% won't be retested in 10 year yields between now and the end of the year.

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. As October arrives and total return departs, we'll note that it's not just the leaves that are turning red and starting to fall. As the time tested wisdom holds, when stocks sell off, we all become long-term investors.

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 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 bmocm.com/macrohorizons/legal.

 

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

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