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Polar Bear - The Week Ahead

FICC Podcasts January 07, 2022
FICC Podcasts January 07, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of January 10th, 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 153, Polar Bear, 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 January 10th. With the holidays past and the realities of winter fully adding in, we're reminded that at least the days are getting longer from here. Oh, wait.

Disclosure:

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, 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 just past, the Treasury put in a remarkably exciting performance for the first week of the year. We saw rather dramatic sell-off that was an initially focused on the long end of the curve, but ultimately transformed into the belly led sell-off that we've been expecting would characterize the first quarter of the year. The obvious question quickly becomes, has the market pushed too far, too fast, or is there another leg of selling yet to be realized before dip buyers merge?

Ian Lyngen:

10 year yields got right up against that 177 yield peak. The notion that we will see cycle highs in the very short-term certainly resonates. In fact, we'd be surprised if we didn't test 185 to 190 in the weeks ahead. The flattening of the 5s30s curve continued. We made it through 60 basis points, as low as 58 basis points. And while we continued to target the 55 basis point level, there has been a slight round of consolidation.

Ian Lyngen:

More dramatic highs were hit in the front of the market with 2s, 3s, and 5s all achieving cycle highs. Now, this is very consistent with the more hawkish information that we receive from the Fed and also reinforce the idea that investors are leaning bearishly into the Treasury market as 2022 gets underway and anticipate that higher rates will be the path of least resistance for the time being. The most obvious potential limiting factor is the performance of risk assets.

Ian Lyngen:

And with that said, it was impressive to see that while equities were off the highs, generally speaking, the stock market managed to absorb a higher rate environment with relative ease. It goes without saying that risk assets will be the focal point in the coming months, particularly as the Fed appears poised to commence with rate hikes as soon as March. Friday's employment report disappointed at least insofar as the headline print came in notably below the consensus expectation.

Ian Lyngen:

What was more striking, however, was that the unemployment rate dipped to just 3.9% and labor market participation increase to a pandemic high, although it's still off of the 2019 levels. Now, part of a labor market participation issue has to do with early retirements, and so we're not actually expecting to see the overall numbers return to pre pandemic levels.

Ian Lyngen:

Nonetheless, we remain focused on the 25 to 45 year old cohort because the labor market participation in that subset is particularly impactful for the pace of consumption in the US economy. In addition, the wage numbers that accompanied the December employment report showed higher than expected month over month gains at six-tenths of a percent, which led to an out performance versus expectations of the yearly pace to 4.7. The consensus was 4.2.

Ian Lyngen:

Now, this certainly does reflect healthy wage gains for the system overall. However, as the December CPI print is expected above 7%, this still reflects negative year over year real wage growth.

Ben Jeffery:

Well, we got our bearish start to the year.

Ian Lyngen:

Yeah, we certainly did, Ben. I was particularly impressed by how dramatically the Treasury market sold loft in the first week of the year. We got back right up against some of the key extremes further out the curve, in particular, that 177 level in 10 year yields looms, although we did touch 176 in the wake of nonfarm payrolls. More interestingly, further in the curve, we saw cycle highs for 2s and 5s.

Ian Lyngen:

Now, that's certainly consistent with the Fed's reinforced hawkishness that was evident in the FOMC minutes released on Wednesday, and we find it difficult to come up with a compelling reason to fade the trend higher in yields at this point, especially given the proximity to Wednesday's CPI figures. The consensus is for a solid four-tenths of a percent gain in headline and five-tenths of a percent gain in the core CPI numbers.

Ben Jeffery:

Ian, I think you're right to highlight the CPI numbers even after what we saw in the NFP release. Because based off what we've heard from the Fed, the progress we've made on the labor market front has evidently been deemed sufficient to begin and now accelerate the normalization process. We already got the speeding up of tapering.

Ben Jeffery:

The minutes showed that the Fed is likely going to be hastier in adjusting the balance sheet than during the last cycle, and we even heard from Bullard that he rates could be coming off zero as soon as March.

Ian Lyngen:

I do think that the March rate hike question is a very important one. If we look at the Fed funds futures market, the probability is somewhere between 75 and 80% that the Fed actually does deliver the first hike of the cycle during the first quarter. Now, admittedly, that's a bit earlier than at least I had been anticipating until we got the FOMC minutes.

Ian Lyngen:

The FOMC minutes really do seem to be doubling down on this idea that the Fed is going to take advantage of the extremely easy financial conditions to normalize rates and start the process of normalizing the balance sheet. Now, in the event that the Fed doesn't move in March, they're going to need to begin to signal that relatively soon. In this context, we'll be looking at the January 26th FOMC meeting for any indication of how the committee might be leaning at the moment.

Ben Jeffery:

And even before the meeting, it's going to be critical to be attuned to the Fed rhetoric that we see before the communication moratorium at the end of the month. While Bullard seems to be keeping with his more hawkish leanings recently, we do have chair Powell and soon to be vice chair Brainard appearing on Capitol hill next week.

Ben Jeffery:

And for better or worse, the realities of the FOMC imply that it's their opinions, probably couple with John Williams, that really carry the bulk of the weight in setting the overall tone of the conversation at the FOMC. It's also worth highlighting that within the minutes, we heard some chatter that the language around the fact that the latest economic developments led monetary policy makers to expect rate hikes sooner rather than later was a hawkish surprise.

Ben Jeffery:

I would argue we saw that reality contained in the dot plot via the three rate hikes that are now formally forecasted to take place this year.

Ian Lyngen:

Yeah, Ben, you're right. That is one of the fundamental issues with the minutes because they have a lag delay. When they cover a meeting where there's updated SEP, the information risks being a bit more stale. That said, the market was looking for any reason to push the bearish narrative this week and they did find it in the form of the minutes. Another aspect of the price action that I think is worth exploring is what we saw on Monday, January 3rd.

Ian Lyngen:

We came into the year leaning bearishly, expecting higher rates across the board, but with an emphasis on the belly of the curve to lead the sell-off as we made progress toward the tightening campaign and the Fed's first rate hike. What I found most notable about the price action Monday was it was a pretty significant bear steepening. The long end of the curve, 10s, 20s, and 30s, ended up 10, 11 basis points higher intraday.

Ian Lyngen:

Now, part of the reasoning that the market was talking about was the notion that the Fed was going to bring forward quantitative tightening sooner this cycle than it had in the past. While this was reinforced in the FOMC minutes, I'd like to address the notion of whether or not this should be a steepener or simply another parallel shift higher in rates.

Ian Lyngen:

The logic for it being a steepener is that it assumes that the SOMA runoff or rather the maturities that the Fed reinvests in specific benchmark issues at auction as an add-on are reproduced one for one with higher coupon issuance from the Treasury department. In a world where this is the case, yes, the DVO1 further out the curve does warrant a steepening impulse versus the front end. However, I struggle with the notion that that would be the Treasury department's go-to response.

Ian Lyngen:

Instead, I'd assume that at least in the beginning, the Treasury department would access the bill market to cover any funding shortfalls. And when we talk about SOMA roll-off, we're talking on average over the last six months about $60 billion. Presumably the Fed would put a cap on the amount during any month of SOMA runoff and the numbers we've heard bantered about are anywhere between 35 and 50 billion.

Ben Jeffery:

And remember, during the last cycle, those caps topped out at $30 billion. Something in that ballpark in terms of a rundown terminal velocity would definitely not run counter to the information contained in the minutes that showed the Fed would want to be more aggressive in normalizing the balance sheet this time around.

Ben Jeffery:

And on the issuance front end, there's a sequencing component to this as well, at least from the Treasury department's perspective. Remember, we have yet made it one full refunding cycle with smaller coupon auction sizes. We got the first coupon auction size cuts in November, and the consensus at this stage seems to be that we're in for another round of trimming at the February refunding.

Ben Jeffery:

I completely agree that if only to keep with the tendency of regular and predictable issuance, the bill market will be the place where the Treasury department will prefer to make up any potential funding shortfall, if there even is one, given the uncertainty around whatever the next initiative out of Washington may be.

Ian Lyngen:

And to focus on the February refunding, I think it's particularly useful at this point in the monetary policy cycle. Because in the event that the Treasury department is worried about losing funding from SOMA rollovers, they could conceivably slow the coupon reduction process. I suspect that that risk will come into focus after the January 26th FOMC meeting.

Ben Jeffery:

There are a few other very good reasons why the Fed would be comfortable with more aggressive balance sheet normalization than during the 2017 to 2019 episode. And on the top of that list is probably the amount of cash that's sitting in the RRP overnight at the Fed. Roughly one and a half trillion dollars in excess liquidity hardly points to a funding market situation that is any are close to the threshold of reserve scarcity that triggered that spike in funding costs we saw in September 2019.

Ben Jeffery:

Remember, that was the reason that they ultimately called off balance sheet normalization and then implemented its reserve management purchases in the bill market in order to reestablish an ample reserves framework, which in turn limited funding market volatile. And even outside of the RRP, remember that we now have the standing repo facility formally established. So say hypothetically, we reach reserve scarcity much faster than is expected.

Ben Jeffery:

We now have the formal backstop of the Fed ready to offer repo, not reverse repo, operations that will naturally prevent a repeat of that volatility we saw in 2019.

Ian Lyngen:

So said differently, the Fed is much better prepared for quantitative tightening this round as opposed to 2019. And if anything, that should bring forward market expectations for that to be rolled out. We had a particularly astute client question this week regarding the value of balance sheet runoff. Recall that during the last cycle, there were several Fed papers published on this topic and the punchline was that the reduction of the balance sheet was worth somewhere between 25 and 50 basis points of tightening.

Ian Lyngen:

Fast forward to 2022, that then implies that once the Fed has deemed that the policy rate is sufficiently off the effective lower bound to start shrinking the balance sheet, it will replace either one or two rate hikes. I suspect that at the end of the day, the trajectory of the economic data and the overall health of the economy will ultimately influence the Fed's later cadence of tightening.

Ben Jeffery:

And then there is the most aggressive step the Fed could potentially take in decreasing its Treasury holdings, which is actually selling Treasuries into the secondary market. At this point, that seems to be an extremely outcome if we learned anything from the last cycle. But nonetheless, we did hear the idea floated if only as a hypothetical over this past week, given the amount of attention the balance sheet received, Ian, I think you and I are on the same page there.

Ian Lyngen:

Yes. I would say that it's very unlikely that the Fed actually chooses to sell securities on an outright basis from SOMA, even if it were to be a reverse twist or some type of operation that keeps the overall balance sheet either the same or at a known pace of runoff. Another important takeaway from this week's price action was the way in which investors are trading Omicron. We came into this week with record high US daily case count figures.

Ian Lyngen:

We have the seven day moving average of case counts now at the highest of the pandemic, and yet the market was content to shrug that off and focus instead on the potential reopening momentum with the ongoing concerns of inflation that's already in the system. To some extent, this reflects the notion that the most recent wave of the coronavirus appears to trigger less severe symptoms, particularly in vaccinated patients.

Ian Lyngen:

It's also consistent with the broader expectation that as we move further through the pandemic, each incremental variant or wave will become less impactful for the overall real economy. And that does seem to be the case thus far in the US.

Ben Jeffery:

But in any case, it does seem that there will be periods defined by working from home to return to office to probably work from home again for the foreseeable future. But I've already got my office set up at the Overlook Hotel, so I should be fine.

Ian Lyngen:

You can check out any time you want. Some of us already have. In the week ahead, the US rates market will have few key inputs to help guide trading as the year continues to get underway. There's no data on Monday. Literally speak of on Tuesday. However, Wednesday sees the consumer price index release for December. The consensus currently stands at four-tenths of a percent month over month for the headline and five-tenths of a percent month over month for the core figure.

Ian Lyngen:

All else being equal, the inflation data represents the most meaningful, fundamental input between now and the January 26th FOMC meeting. We're certainly cognizant to the fact that one of the biggest criticisms of the way the market interprets inflation data is by stripping out the components that are difficult for the Fed to control and tend to be more volatile and focusing only on some of the core components, which in this environment have actually been pretty instrumental in driving up the overall figures.

Ian Lyngen:

For example, on Wednesday, we'll be focused on the components of OER, or owner's equivalent rent, as well as new and used auto prices, which are expected to continue to moderate. Pockets of inflation related to the reopening and reengagement on the travel side will be notable, especially private airfares, for example, as well as hotels and lodging away from home.

Ian Lyngen:

All that being said and with a nod to the fact that another key criticism of the CPI data is that it doesn't fully reflect the realities of what consumers face on a daily basis, we'll make the observation that the measures of inflation are most useful in calibrating expectations for the Fed. And what the Fed has illustrated via the accelerated tapering in December and the recent FOMC ministry release is that the amount of inflation that's currently in the system is more than sufficient for them to take action.

Ian Lyngen:

Almost regardless of how December's CPI data comes in, it's safe to assume that the Fed is going to move forward with the rate normalization process. Now, if inflation starts to moderate more quickly than the Fed anticipates, that might become a terminal rate conversation, as opposed to a timing of liftoff.

Ian Lyngen:

After all, the Fed has done a very good job of priming market participants for a rate hike sometime in the first half and we will look to incoming Fed speak, as well as the January FOMC meeting to further reinforce the idea of a March rate hike or push back against market expectations. 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.

Ian Lyngen:

And if the length of the first week of the year is any indication, it's going to be a particularly long 2022. Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy at effort as interactive as possible, we'd love to hear what you thought of today's episode. Please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcast or your favorite podcast provider.

Ian Lyngen:

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.

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This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Inc. and BMO Capital Markets Corp. (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.

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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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