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Out of Office Day - The Week Ahead

FICC Podcasts August 13, 2021
FICC Podcasts August 13, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of August 16th, 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 133, Out Of Office Day, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you thoughts from the trading desk for the upcoming week of August 16th. And as we look ahead, it's notable that Friday's calendar is completely empty. Is August 20th a market holiday? Perhaps it's national out of office day, at least an early close.

Speaker 2:

The views expressed here are those of the participants and not those of the 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, 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.lyngena@0bmo.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 passed, the Treasury market had a variety of fundamental inputs that helped guide trading direction. We will argue that this is probably the most price action that we'll see out of the Treasury market until after labor day. What was delivered was a mixed CPI print headline as expected with a slight underperformance on the core series. Within the composition of CPI, we saw some of the transitory categories, most specifically used auto prices shift from 10 plus percent increases every month to being effectively flat.

Ian Lyngen:

Now, this has certainly contributed to the transitory argument and therefore the fact that headline CPI was half a percent higher didn't have the potentially bond bearish effect that one might have otherwise assumed. We also had PPI and claims, but really the most important data point of the week was consumer prices. The takedown of the August refunding was also telling, and there was a very strong showing for the 41 billion new 10 years stopping through 3.2 basis points. The 30 year tail, but then 30 year typically tails.

Ian Lyngen:

When we look at the composition of bidding interest, the 10-year ended up with less than 10% going to the dealer community, which leaves the vast majority of supply in the hands of end users. If anything, this dynamic confirms that there is ongoing sponsorship for Treasuries, even in this lower yield range and that bodes well for the range trade continuing as the summer comes to a close. It's challenging to expect a material sell off between now and the point when investors have greater clarity on the fallout from the Delta variant and what it implies for firms attempting to bring workers back into the office and the implications from that for frontline service sector firms that are designed to cater to those businesses in densely populated urban settings. The week was also one defined by what didn't happen. What we didn't see was a wholesale rejection of the lower rates thesis.

Ian Lyngen:

Sure. 1.126 has been rejected twice in 10 year space. However, it did not translate to a back-up of 10 year yields beyond that 142 level. We've been watching the range of one 112 to 142 that we expect to define the market until we're into the fourth quarter with a narrower range within there at effectively 120 to 140 expected to hold in the very near term.

Ian Lyngen:

The front end of the market remains anchored to monetary policy expectations as is typically the case. Even as we start to run up against concerns about the Feds liftoff rate hike. The impact of timing the Feds anticipated first step toward policy rate normalization will really play out in the five-year sector. So any inflationary concerns or stronger growth indicators that the market expects should prompt the Fed to deliver the liftoff rate hike sooner rather than later, will lead to a bearish move in Treasuries focused in the five-year sector. Said differently, we've transitioned from the longer into the curve, leading both sell offs and rallies to a point where the belly of the curve will be the focus because it simply is a monetary policy issue at this stage.

Ben Jeffery:

Well, Ian, it was something of a big week in the Treasury market. We had July CPI data in addition to a 10-year refunding that showed the largest stop through since July, 2012. And yet here we find ourselves.

Ian Lyngen:

Yeah, Ben, you make a good point. It was an interesting CPI release and 10 year yields remain in a range of let's call it 125 to 140 as the process of consolidation continues. Now, headline CPI matched expectations, increasing five tenths of a percent month over month in July. Core CPI disappointed, but only marginally printing at three tenths of a percent, rather than four tenths. What I find most notable within the composition of CPI, however, is the transition that we're seeing in auto prices. As we know over the course of the last several months, there has been a steady increase in used auto prices along with new auto prices. What was revealed in July was that used auto prices were effectively flat. Now this shift is certainly consistent with the Fed's narrative of transitory inflation resulting from dislocations associated with the pandemic. And it also sets up the balance of 2021 as an important litmus test for this notion of temporary influences on inflation.

Ben Jeffery:

And this is emblematic of the progress that the world has continued to make out of the pandemic. We've now had nearly six months with viable vaccines, widely distributed, at least in the US and the fact that the economy is now maybe as reopened as it's going to be, has allowed sufficient time for some of those supply chain issues that we've been discussing to work themselves out. Just this past week, we saw some headlines hitting the tapes around drops in lumber prices, and it's this dynamic of supply being re-established to meet this new demand that will likely continue as autumn gets underway and should one would think add to this trend of a moderation of some of those pandemic specific pockets of inflation. Now that doesn't mean the Fed is not still going to be on guard for a broadening of the pickup in prices, but July's data was encouraging for those on the Fed and the transitory camp, at least on the margin.

Ian Lyngen:

In addition to the details with the used auto prices, we also saw airfare prices decline modestly. Again, this is very consistent with this notion that the first half of the year was spent redefining the price structure based on supply and demand dynamics coming out of the pandemic. And as the balance of the year unfolds, the onus will be on a broadening of the categories where inflation is evident. We continue to maintain that the definition of transitory isn't owned by the market, it's owned by the Fed. Said differently, as long as the Fed calls inflationary pressures transitory then for all intents and purposes, they are transitory, because it's only when the Fed acknowledges any shift in the trajectory of consumer prices, that it could potentially have an impact on monetary policy. So as a market, the challenge is to get in front of any such a move on the part of policy makers.

Ian Lyngen:

Recent Fed speak has made it abundantly clear that the Fed is on track to deliver tapering with an announcement sometime in the fourth quarter implementation and the beginning of 2022, and the process will run somewhere between six and 12 months. We have seen a lot of questions answered recently from the Fed in so far as the composition of tapering. Specifically, there was an open debate about whether or not we would have a simultaneous taper or if mortgages would be tapered first. That question has been effectively answered by Powell. And we now know that when taper starts, it will be simultaneous both Treasuries and mortgages. What we don't know and where there's a degree of flexibility to be introduced into the system is the pace at which the Fed will cut bond buying. I think it's safe to say that a hurried end to QE condensed to say three months is highly unlikely and extended wind down beyond a year is also highly unlikely.

Ian Lyngen:

So we're somewhere between six and 12 months. And I suspect that will ultimately come down to the performance of the real economy between now and the time that the announcement is officially made. What I would also suggest is that the Fed is not actively debating whether or not to wind down asset purchases, instead they're simply trying to calibrate the pace accordingly. For that reason, I'd err on the side of assuming that the announcement comes later rather than sooner, especially if the Fed would like to implement at the beginning of 2022. The logic there being that the more data and the more information on the real economy that the Fed has before setting the pace of tapering, the less likely it will be that they'll have to change it and then process.

Ben Jeffery:

And even with this consensus and a bit of uncertainty surrounding tapering now well discussed in the market, the strength of the 10-year refunding speaks to a very relevant dynamic around the impact that tapering has. And what I mean by this is that while at a first pass reduced Fed demand should be a bearish impulse for the long end of the Treasury curve. Instead, what we saw at the 10-year refunding was a very strong willingness to buy the dip that had emerged over the prior week. Remember, following ADP 10 year yields, once again, challenge that 1.126 level. And so the fact that the auction was very strong at a yield over 20 basis points higher than that. Although even that level at 1.34% is hardly elevated in the historical sense, illustrates that the stimulative impact of QE or I guess the removal of it is more consequential in terms of trading direction. Less Fed accommodation, slower growth, lower inflation has evidently had a more meaningful impact on the price action of 10-year yields. Then the fact that the Fed is going to begin winding down it's $80 billion a month in bond buying.

Ian Lyngen:

And to your point, Ben, we are seeing a bit of a shift in the outlook in so far as expectations for a stronger reopening and a reflationary narrative to dominate Treasuries have given way to concerns with the Delta variant. And more importantly, what that implies for future variants going forward. Our take has been that 10 year yields didn't make it to 1126 twice because there is so much concern over the Delta variant specifically, rather that was just a function of pricing in an ongoing variant risk that will be with the real economy for the foreseeable future. So implicitly, if the economy adjusts to this new reality and we move forward with successful ways of countering the variance, then that will meaningfully remove that risk. We'll see a revival of plans to push forward with the return to office schedule and then presumably a restaffing of frontline service sector firms designed to cater to the densely populated urban centers.

Ben Jeffery:

So what you're saying is we're back to trading Q1. Pickup and inflation, reopening, people once again re-engaging in in-person commerce?

Ian Lyngen:

To some extent, yes. However, I don't think that we're going to see the same price action as a result of a delayed reopening with variant risks implied. In fact, I'll argue that the true reopening reflation re-engaging in in-person commerce momentum that occurred during the first quarter has completely run its course. And what we'll see is a retreading of what's ostensibly the same narrative, but in fact has more cautious undertones. So in practical terms, after Labor Day, investors who were leaning short on the market will press the positions, we'll see a back-up in rates that will come up against dip buy and interest, and we'll establish what will be the ceiling for yields during the fourth quarter. My expectation is that ceiling will not be 177 in 10-year yields, but it will largely be a function of how willing investors are to push that trade and if there's any supporting or offsetting momentum on the global growth front.

Ben Jeffery:

And Ian, it's that global dynamic that I also think is very important to consider in determining where the peaks for yields are going to be over the balance of the year. While yes, domestically, the vaccination process has been reasonably successful and restrictions are effectively completely rolled back. That is by no means the case everywhere, particularly in some notable emerging markets. So the risks that COVID-19 and the variants that follow are going to operate as a drag on the global recovery will also naturally inspire demand for Treasuries and limit the extent to which we can see yields rise while not knowable until the investor class data is released. That's arguably another dynamic that appeared at the 10-year auction as rates north of one 30 look, especially compelling to investors who would otherwise struggle to get a positive yield in their own domestic markets.

Ian Lyngen:

So all of this sets up the final two weeks of August to be relatively uneventful in terms of a trending versus range-bound market in Treasuries. And we continue to err on the side of a range and in this particular instance, a relatively narrow one, let's call it for sake of argument, 122, 140 for the next two weeks and that includes absorbing retail sales, the FOMC minutes, the final auctions of August, and then at the end of the month, the Jackson Hole Symposium. We're also assuming that, to a reasonable extent, the Fed has laid the groundwork for Powell to follow through with more details at Jackson Hole regarding tapering, but nothing that will be truly new information to investors.

Ben Jeffery:

So do you want to say it or me?

Ian Lyngen:

Say what?

Ben Jeffery:

We're going to Jackson!

Ian Lyngen:

Wait, no, we're not.

In the week ahead, the Treasury market will have only a few fundamental inputs. The most notable on the data front will be retail sales for the month of July. Expectations are currently for an effectively flat print for retail sales. And when we put this in the context of the fact that retail sales are not adjusted for inflation and July just printed a headline inflation number of half a percent that suggests that market participants are expecting real spending declined in July. Now it's worth noting that the July figures not only inflation and consumption, but also the payroll's growth all preceded the pickup in Delta variant concerns. Our assumption is that many of the hiring decisions that were implemented in July completely predated concerns associated with a rolling variant that will be in place for the foreseeable future.

Ian Lyngen:

This doesn't mean that we're expecting the jobs gains to be reversed, but rather a moderation in hiring as uncertainty replaces reopening optimism. That said, this isn't a trade for the last two weeks of October. Meaningful clarity on the jobs front won't come and tell the August nonfarm payrolls report at the earliest, but in practical terms, it won't be until we have September and October's data in hand that the market will be comfortable in assessing the ultimate fallout from this most recent wave of the pandemic. We also hear from Powell on Tuesday, as well as received the FOMC minutes from the most recent meeting. There has been sufficient Fed speak since the last meeting, however, that it would be surprising if there was any decided tone shift in terms of the progress toward tapering and expectations that that will come to fruition. If not at the end of this year, then the beginning of next. There's still an open debate on the precise timing of when QE tapering is announced and when it is actually implemented, but the more important debate actually centers around the pace at which the Fed chooses to taper.

Ian Lyngen:

We came into the summer assuming that at Jackson Hole, we would hear from Powell in terms of the composition of tapering, i.e. Treasuries and mortgages or mortgages first. But that question has already been answered by the chair and as a result, the last piece of the puzzle that we could see any insight on from Powell when he speaks at the end of August will be any guidance on the size of the cuts to expect in terms of monthly bond buying and the amount of flexibility the Fed wants to embed in the system, in case the economic data doesn't perform as expected. There are two Treasury auctions in the week ahead. The 27 billion, 20 year auction and the 8 billion, 30 year tips reopening. Neither of these have been tone setting of late for the Treasury market, but that doesn't mean that there won't be some attention paid particularly to the long dated TIPS auction.

Ian Lyngen:

We're reminded that while there is plenty of chatter around this idea that the reflationary trade has been priced out with the rally and Treasuries that we have seen over the course of the last couple of months, the fact is if you look at 10 year break evens, which are effectively at 240 basis points, the reflationary trade is still very much embedded in pricing in the Treasury market.

Ian Lyngen:

What has occurred is we have seen a decline in real yields as the outlook for the global recovery has come into question. Going forward, if in fact the Fed is correct and their characterization of inflationary pressures is transitory, we would then expect some downward pressure on breakeven's, which would in effect cap the degree to which nominal rates can back up between now and the end of 2021.

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. While we sympathize with those who are concerned today is Friday the 13th, we take comfort from Michael Myers and Freddy Krueger when they say, hey, what's the worst that could happen? With that thought we'll sign off until next time. Maybe.

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 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. Not withstanding 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:

It does not take into account to the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice, or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts, and commodity options or any other activity, which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US commodity exchange act. BMO is not undertaking to act as a [inaudible 00:22:05] advisor to you, or in your best interest in you to the extent applicable who rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

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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