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The Other Side of 1.75% - The Week Ahead

FICC Podcasts March 19, 2021
FICC Podcasts March 19, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of March 22nd, 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 112, the other side of 1.75%, 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 March 22nd. And while March madness from home on a data list Friday afternoon suggests more yellow than green dots, we're reminded of the gray dot option, a dot for every occasion as it were.

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, this 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 Treasury market had a fair amount of fundamental information to digest and the net was a bearish tone that brought 10-year yields up to that 175 level that's been much of a focus. Retail sales disappointed. However, there's the caveat that there were strong upward revisions to the prior month and the weather in February was expected to weigh on consumption.

Ian Lyngen:

Similarly, CAP/U and IP disappointed, as well as a fair amount of weakness in some of the housing data, clearly weather related. The Philadelphia Fed index, however, surprised on the upside showing the highest prices paid component since 1980. This clearly contributed to the broader reflationary theme. However, prices paid increased far more than prices received, in this particular survey at least, and that brings to mind the risk of profit compression as we move out of the pandemic. The underlying issue will be gauging how much pricing power producers actually have in pushing through costs to the end user. In the event that they are able to, this will be a net contributor to core inflation and consistent with a broader reflationary narrative. Regardless of the regional Fed surveys, the trajectory of inflation in the core CPI series suggests that the reflationary boom has yet to truly take hold.

Ian Lyngen:

The recent auction takedowns were strong with a 2.6 basis point stop through for the 20 year and a 2 basis point stop through for the 10-year TIPS reopening. The Treasury market also received the long-awaited SLR announcement. The decision was made not to extend the decision for Treasuries, and as a result some of the bearish price action that preceded the announcement itself did find justification in the decision. Now, the announcement was a nonevent in terms of that price action. However, as we go forward this will be yet another bearish touchstone that will presumably limit how far 10 and 30-year yields can decline in the event that we have a meaningful reversal and/or a significant risk-off event that puts in a bid for Treasuries.

Ian Lyngen:

In the context of achieving that 175 level in 10s combined with what appears to be a sell-the-rumor/buy-the-fact event with SLR, we are constructive on the market from here. We do see at a minimum a period of consolidation as the market digests the information from the Fed and the reality that monetary policy rates will be on hold for a considerable period, even if we ultimately see inflation come back into the system, the employment rate decline and sidelined workers once again reintegrated into the labor force in a post-pandemic world.

Ben Jeffery:

So going into the FOMC, one of the biggest unknowns was what the fate of that 2023 median dot was going to be, and what we saw was that rates are projected to stay lower for longer at least until 2024.

Ian Lyngen:

And 2024 is frankly a long time away in terms of monetary policy. There's a lot that could happen. We could see inflation accelerate even beyond what the Fed is projecting, which is one of the risks that the market is grappling with at this point. And that's why as part of the most recent run-up in yields, we saw the belly of the curve, particularly the five-year sector, start to underperform as the market brought forward rate hike expectations. One of the other takeaways from the FOMC meeting was that the Fed is clearly pushing back on this dynamic, although Wednesday's rally in the belly of the curve was quickly reversed as yields ultimately netted higher with yields reaching that 175 target that we've been focused on.

Ben Jeffery:

And it was also especially interesting to see what didn't happen in the equity market as a function of that repricing to 175 tens. Sure, there was a bit of weakness focused primarily in big tech given that sector’s sensitivity to higher rates, but generally speaking risk assets have held in extremely well, even without the promise of more Fed accommodation. Now to be clear, monetary policy still is extremely accommodative, but the fact that a surge in volatility, a meaningful pickup in the VIX which tightens financial conditions, has been avoided for now, should continue to allow the FOMC to be patient as they demonstrated at the latest meeting.

Ian Lyngen:

There's another aspect of the price action and risk assets that I think warrants a nod, and that is a rotation from essentially the pandemic winners to the pandemic losers, i.e., out of the tech sector and into everything else, and this is very consistent with the broader theme of reopening optimism. The administration has announced that the path towards inoculation has become shorter with all adults in the US having access to a vaccine presumably by the middle of May. I'll argue this has contributed to an already ambitious outlook that risks bringing forward all of the upside that the market was expecting to occur in the second half of this year into the first half, and that has ramifications for how quickly we move on past the stimulus impact as well as what the actual economic data tells us as we get into the third and fourth quarters of this year.

Ben Jeffery:

And a really poignant example of this has been the moves and break evens. We saw ten-year break evens reach 2.34%, which is the highest of the cycle and a substantial reversal from the collapse we saw last year. But at this point given three month annualized core CPI is running it just 0.7%, I completely agree with you, Ian. At some point, there's going to have to be a rationalization of the divergence between expectations and the realized data. Now that could certainly come in the form of the data itself picking up to match expectations, but I think you and I are on the same page that may be more likely is that some of these expectations need to be moderated at least on the margin.

Ian Lyngen:

Well, let's think about what ten-year break evens are telling us in context. So they're effectively saying that over the course of the next 10 years inflation is going to be running at two and a quarter percent on average. That's a significant divergence from what we have seen, certainly over the last 10 years, and while it's easy to be sympathetic to the reflationary argument it also is predicated on this idea that the Fed is going to be successful in shifting the market's understanding of how they'll respond to inflation. Recall the framework shift to target an average year-over-year inflation implies that once inflation is finally back in the system that the Fed will be content to remain sidelined, keep policy rates up against the effective lower bound, and let inflation run hot. While this is certainly consistent with higher break evens, it does contrast with the way that the market was trading before the Fed; i.e., inflation expectations were higher and lift-off timing was brought forward as evidenced in the Euro dollar market. So if investors are assuming that the Fed is going to respond to increased inflation expectations similar to the way they have in prior cycles, then assuming that the long-run inflation numbers are going to be that far above 2% really does present an interesting contradiction.

Ben Jeffery:

What about in the more near term? We're clearly entering a period where base effects from last spring are going to distort a lot of the year-over-year figures not solely on inflation but economic data as a whole, but as the vaccination process rolls on restrictions are rolled back and presumably we have a pretty good look at what the new normal looks like by the middle of summer. Do you think this pent-up demand and consumption that is supposedly waiting in the wings is going to be released on the scale that many are expecting?

Ian Lyngen:

Well, I do think that it is going to be a significant net positive for consumption. I think it will lead to inflation in the service sector, but I'm concerned that it won't get aggregate growth in real terms in the US to the Fed's projected 6.5%. That's a pretty impressive number if we think about what has occurred historically, and also the fact that so much of growth will ultimately be concentrated in the first quarter because of the contribution to consumption from the stimulus efforts. So once we work through the upside from the stimulus checks and the real economy transitions into the new normal, there will be a bit of a reckoning, I anticipate. Not so much that I would challenge the timeline for reopening, but rather the assumptions that simply because businesses reopened that patterns of consumption developed during the pandemic won't prove stickier; i.e., we're not going back to 2019 anytime soon.

Ben Jeffery:

And in economic terms, the proverbial "back to normal" seems to be 2019. But even in that case and well before the pandemic, remember that the Fed was struggling to stoke the type of inflation they wanted to see. Even before COVID-19, Powell needed to walk back some of the Fed's tightening efforts, sure, as a fine tuning, but in a pre-coronavirus environment the fact that inflation could not meaningfully accelerate beyond the Fed's target leaves me at least a little bit skeptical that on the other side of the pandemic consumption and inflation really will pick up to such a degree as to recast that paradigm that we saw from 2014 to 2019.

Ian Lyngen:

And Powell's comments at the press conference really reinforced that idea. The observation that one can only go out for dinner once an evening really does resonate when we think about how quickly reopening will lead to higher consumer prices. Now higher consumption and more spending on the service sector goes without saying. It's the translation of that into sustainable, i.e., non-transitory upward pressure on consumer prices that is going be this year's biggest question and uncertainty.

Ben Jeffery:

But nonetheless, the developments of the past week did get us slightly through 175 10-year yields.

Ian Lyngen:

Staying alive at 175.

Ben Jeffery:

The question from here becomes is this the dip to buy before yields begin to move lower, or are we simply in for a period of consolidation in the 170-175 area before investors turn their attention to a two handle?

Ian Lyngen:

In that context, I've been watching the calendar and the end of the Japanese fiscal year, which is March 31st. Now as we've seen in the moth data, over the course of the last four weeks Japanese investors have sold a net of $36 billion in overseas notes and bonds. Now, presumably the vast majority of that is going to be in Treasuries. Now, this is a typical process of profit repatriation. This isn't new. It's historically contributed to bear seasonals in the beginning of the year. But what remains to be seen is what happens on April 1st besides some joke that I don't understand that makes me look like a fool. I'm skeptical that on April fool's day we see a rush of Japanese buying the day before the March non-farm payroll print, although over the course of April it will be prudent to watch the primary offerings of Treasuries, particularly fives and sevens. Because as we saw in February, part of the dynamic that led to that dismal seven-year auction was a pullback of overseas buying. Now, that was arguably reversed with the 20 year, which saw a record strong takedown with a 2.6 basis point stop through for that $24 billion reopening. So as we contemplate foreign flows, this is a particular meaningful quarter end.

Ben Jeffery:

And outside of the Japanese fiscal calendar explicitly, this month's twos, fives, and sevens supply series is coming in at an especially intriguing time given what we saw and talked about earlier with that 2023 dot. There was certainly a subset of the market that wasn't anticipating enough FOMC members would have revised up their Fed funds forecasts to move the median off zero, but the fact that there's still such a resolute commitment to keeping policy at the effective lower bound should benefit fives and sevens as was exemplified by that knee-jerk price action you touched on earlier, Ian. So while we've not yet reached the point when we can expect typical behavior from Japanese investors, I think what we learned from the Fed on Wednesday will help the sponsorship for fives and sevens in particular on Wednesday and Thursday of this upcoming week.

Ian Lyngen:

And it is also a quarter in with some non-foreign rebalancing flows also surely to come into play.

Ben Jeffery:

And don't forget, there's also the influence of March madness to consider.

Ian Lyngen:

Huh, like this market will limit its madness to March.

Ian Lyngen:

In the week ahead, the Treasury market has a wide variety of information to digest, an ample supply of Fed speak, including Chair Powell and Treasury Secretary Yellen. We also hear comments from Williams and Bullard, and the net of the official commentary we expect will simply serve to reinforce what we heard from Powell following the FOMC decision, which is rates will remain low for a considerable period, 2024 being the first reasonable opportunity that the Fed might see to lift off. It's also notable that tapering expectations continue to be focused on the beginning of 2022. So said differently, that means that the Fed's bond buying of $120 billion a month, $80 billion in Treasuries, $40 billion in mortgages, will remain in place throughout the balance of this year. Next week also contains the two, five, and seven-year auctions. While typically not events that truly define the outright level in US rates, the experience of the February seven-year auction will put emphasis on the performance of Thursday's auction of $62 billion in sevens. Keep in mind that a contributing factor to the disappointing results in February was the lack of foreign participation. Now, while the recent 20-year auction showed strong overall support, that isn't an issue that's typically favored by overseas buyers. So as we look at fives and sevens, any potential weakness could presumably be attributed to the Japanese fiscal year end with the assumption that that is poised to reverse in the second quarter.

Ian Lyngen:

In terms of economic data, the biggest highlight will be the February personal consumption report. We have spending expected to decline six-tenths of a percent, personal income expected to be off seven-tenths of a percent. More importantly, core PCE is currently projected to increase just one-tenth of a percent. We're still early enough in this year's data cycle that disappointments on the core inflation front won't derail broader expectations.

Ian Lyngen:

Inflation expectations won't really be vulnerable to a rethink until we're into the summer months; i.e., through the first stages of the reopening, vaccination levels continue to increase, and the real economy is somewhat back on track. It largely comes down to whether or not service sector inflation can pick up the mantle from goods inflation that was so pervasive throughout 2020.

Ian Lyngen:

We're at the stage in the cycle where we're beginning to lean a bit more bullishly on the Treasury market. The experience of the last week suggests that two-handle tins might prove a bit more challenging to obtain than the market had been assuming as March got underway. This doesn't imply that the risk of 2% 10-year yields is completely off the table. However, even if such an eventuality comes to pass, we still think that at the end of 2021 10-year yields will be holding a range closer to 125 to 150.

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 with this weekend's spring equinox comes the harsh reminder that it's the only equinox visit that we've had in a very, very long time. That covid-15 ain't going to make itself.

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.

Ian Lyngen:

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

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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