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Pondering a Pivot - Monthly Roundtable

FICC Podcasts Podcasts October 04, 2022
FICC Podcasts Podcasts October 04, 2022

 

Margaret Kerins along with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton and Ben Jeffery from BMO Capital Markets’ FICC Macro Strategy debate the impact of heightened uncertainty and decreased liquidity on their outlook for US and Canadian Rates, IG credit, and foreign exchange. The market continues to grapple with slowing economies in the US and abroad versus the Fed’s ability to maintain its unwavering resolve to contain inflation at any cost. Volatility remains front and center with daily swings in US rates of 20 bp or more becoming a regular market event.


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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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Margaret Kerins:

This is Macro Horizons' monthly episode 45, Pondering a Pivot, presented by BMO Capital Markets. I'm your host, Margaret Kerins, here with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton, and Ben Jeffery from our FICC Macro Strategy team to bring you our debate about the impact of heightened uncertainty and decreased liquidity on our outlook for US and Canadian rates, IG Credit, and Foreign Exchange.

Margaret Kerins:

The market continues to grapple with slowing economies in the US and abroad versus the Fed's ability to maintain its unwavering resolve to contain inflation at any cost. Volatility remains front and center with daily swings in US rates of 20 basis points or more becoming a regular market event.

Margaret Kerins:

Each month, members from BMO's FICC Macro Strategy team join me for a round table focusing on relevant and timely topics that impact our markets. Please feel free to reach out on Bloomberg or email me at margaret.kerins@bmo.com with questions, comments, or topics you would like to hear more about on future episodes. We value your input and appreciate your ideas and suggestions. Thanks for joining us.

Margaret Kerins:

The US rates market is swiftly repriced off the recent yield highs as the market questions the Fed's ability to hold the terminal rate in restrictive territory, and not just restrictive, meaningfully restrictive, for as long as it takes to return inflation to 2%. This has brought two-year yields back down to just above 4% and about 25 basis points below the recent highs.

Margaret Kerins:

At the same time, 10s have outperformed, deepening the inversion in 2s/10s. There are three main implications of higher for longer for the US Treasury market. First, the market will remain sensitive to every data point, subjecting 2s to heightened volatility. As two-year yields represent a 24 month rolling window, the market will continue to price eventual rate cuts, keeping 2s below the 4.60 terminal rate messaged by the Fed.

Margaret Kerins:

However, the fact that the Fed's dot plot shifted so dramatically from June to September adds another risk element on the hawkish side to twos, depending, of course, on the evolution of the economic data, therefore, we remain bearish on the front end.

Margaret Kerins:

Second, 10 year yields will react to the slowing economy and move closer to 3% than 4%. This leaves our deep inversion call intact with twos holding near 4% and 10s falling closer to 3%.

Margaret Kerins:

Third, the Fed is pushing hard on the higher for longer narrative and the idea that they will fight inflation at any cost. The Fed will not want to risk under delivering on taming inflation. This stance, coupled with the long invariable lags of monetary policy, implies that they will keep rates too high for too long. But the market is questioning this resolve.

Margaret Kerins:

So let's kick it off with Ian. Ian, the market narrative is swinging between the notion that the Fed will remain in restrictive territory until they see the whites of the eyes of decelerating inflation versus the idea that they will pivot when something breaks. Last week's story was higher for longer, while this week seems to be that the cycle peak in yields is in. How should we be thinking about Treasury yields in this environment into early next year?

Ian Lyngen:

Margaret, I think that you make a very good point that we're at a pivotal moment for monetary policy and market expectations. One of the biggest questions we've been grappling with is whether or not two year yields can sustainably trade under effective Fed funds. Now, we've learned over the course of the last several cycles that 10 year yields can trade comfortably below effective Fed funds. And in part that's based on the assumption that monetary policymakers will, over time, be able to keep inflation expectations well anchored, and that has led to reasonably well contained breakevens, even if front end rates need to be higher for a given period of time.

Ian Lyngen:

What makes this cycle so unique is that the market seems content to take the Fed effectively at face value, in saying that the FOMC will bring policy rates above 4% and attempt to hold them there at least until we're well into 2023.

Ian Lyngen:

Now, the Fed will most likely attempt to communicate that the timeframe for holding policy rates in restrictive territory should be measured in quarters and not months. However, as you pointed out, that will be a function of how the economic data unfolds, and it's in this context that we see 10 year yields drifting below the roughly 3.60 level currently, much closer to 3%, perhaps dipping below 3% into the end of the year.

Ian Lyngen:

Now, this will be accompanied with a deeply inverted yield curve in 2s/10s, we could easily envision negative 75, if not negative 100, basis points. Now, the caveat here is that we are certainly cognizant that the big macro trade in rate space for 2023 will be timing the bull re-steepening of the curve once the Fed concedes they ultimately won't be able to keep policy rates on hold in restrictive territory indefinitely.

Ian Lyngen:

Our view is that it's too soon for that trade, simply because the Fed has at least two more significant rate hikes ahead of it, if not the full trio that they've promised, which is 75 in November, 50 in December, and 25 in February. There is a growing camp in the rates market, however, that suggests that the Fed is on the precipice of a pivot. We're certainly skeptical that the Fed would be willing to change so soon, given the realities of inflation and the overall strength in the employment market.

Margaret Kerins:

So Ian, you've been out speaking with clients about our view for 10s to rally back down closer to 3%, and you were speaking about this view while 10s were over 4% just last week. How did clients react to this call for 10 year yields in the 2s/10s inversion?

Ian Lyngen:

Well, frankly, Margaret, I was kind of surprised that people generally did buy into the constructive outlook for Treasuries, perhaps not as low as 3% 10s, but, more importantly, there seemed to be a universal acceptance that the 2s/10s curve would re-invert, it would push below negative 58 basis points, challenging negative 75 basis points. And I found it fascinating that the degree of buy-in to a deeper inversion was almost universal. However, there was some pushback in terms of the outright levels that we were forecasting.

Ian Lyngen:

That said, the client feedback that we've received this week so far has been skewed a lot more sympathetically towards our view on 10 year yields at the moment.

Ben Jeffery:

And a big source of the anxiety that we heard from a variety of clients that we've spoken to has been that the global economy and the market has spent such a lengthy period of time with interest rates very low and inflation effectively non-existent. So now that we've entered this new regime, or at least new since the 1970s, where inflation is back in full force and policy rates are well off the lower bound and into restrictive territory, now the market is in a far worse place to withstand any shocks that may materialize simply because the era of cheap access to capital is now in the rear view mirror.

Ben Jeffery:

And especially as we watched 10 year yields move above 4%, which was entirely a function of higher real rates, even as breakevens dropped as low as 2.15, what our clients were most concerned about is that real rates this high run the risk of something truly breaking in the financial system. And I would argue some early indication of that was what we saw take place in the UK with the Bank of England needing to step in in an emergency fashion to support the gilt market. But there's certainly no shortage of risks, not only in other sovereign bond markets, but I would argue risk assets as well.

Margaret Kerins:

So Ben, you mentioned the cracks appearing in the UK and certainly the UK is not alone in suffering the ramifications of the strong US dollar. So Stephen, you have remained consistently negative on sterling. As the picture remains grim, how should we be thinking about the pound’s fundamentals given what's taken place in credit markets in the macro picture?

Stephen Gallo:

Well, I haven't turned significantly more upbeat on UK or European fundamentals, Margaret. And when I'm looking at the bullish price action, the extension of it in cable this week, it feels to me that this is a reflection mainly of the fact that market sentiment in multiple asset classes had become extremely downbeat in Q3, that in early Q4 there's really nowhere else for sentiment to go but up after the Bank of England intervened and cable is continuing to get caught up in that move.

Stephen Gallo:

So to answer your question, here is what we're saying. We think the British pound has probably had its so-called cathartic moment versus the US dollar for this cycle. In other words, we think the low in cable is probably in, but within one to three months, we think a retest of levels below 110 in cable is more likely than not, so we don't want to be aggressively long of cable as we sit and wait here for this eventual Fed pivot north of 110.

Stephen Gallo:

But we're also, I think, leaning towards the view that in Europe, the UK may not be the only casualty of the QT world that we're now in. And I get the impression that maybe some of the price action this week so far, this quarter so far, reflects the fact that there's speculation out there that the UK is the only European casualty. We would for the time being lean against that view. I mean we saw a liquidity event in a G7 sovereign debt market, which is a very big deal, and I just need to continue to try and hammer the point home that I've been making for a number of months, which is that in this QT world that we're in, large current account deficits and heavy government borrowing need an adjustment in risk premia in order to proceed, in order to be financed. And that risk premium can show up in the FX market, it can show up in credit markets.

Stephen Gallo:

So given the risks still lingering out there in Europe, we think that there is room for euro/dollar to have its cathartic moment like cable did, and we think 94 cents in euro/dollar within one to three months is still achievable.

Margaret Kerins:

So Stephen, you think that the lows are in for the pound, but we could retest the 110 level. Obviously the sterling market was under some pretty big pressure last week. At the same time, one of the markets in the US that really has performed okay during the past month while everything else seemed to have been breaking, was the IG credit market. We did see some widening pressure, but less than what one might expect given the volatile backdrop.

Margaret Kerins:

I'll pass it to Dan Belton. How are you thinking about the IG credit market and the risks regarding potential spread widening into a downgrade cycle?

Dan Belton:

Yeah, Margaret, you mentioned it. Credit spreads were extremely resilient throughout September. We had spreads trading about 20 basis points inside of year to date highs, while other asset classes like equities, mortgage spreads, even CDX, were trading at year to date wides. And so we spent most of the last month wondering how long credit spreads could be supported. And it's clear to us the source of that support was primarily market technicals. September is usually the heaviest month of issuance in the IG market with about 160 billion on average over the past three years. Last month we only saw $80 billion worth of supply in IG, and so investors who typically earmarked money to put to work in September were kind of scrambling to find paper to invest in, and that really kept spreads anchored for much longer than we had anticipated.

Dan Belton:

However, we think we started to see the beginning of a durable move wider in credit spreads starting last week. Spreads were out about 16 basis points last week, and that's the largest single weekly move wider in credit spreads since March of 2020. And with volatility set to continue to be the dominant theme in credit markets, the next question is, at what level are we targeting for year-end spreads? We've revised wider our target for credit spreads at year end from 175 basis points to 190 basis points, reflecting our expectation for another 25 basis points or so of widening in credit spreads in the fourth quarter.

Dan Belton:

At the same time, given the recent move wider in credit, as well as the high all in yields that the market is seeing, some investors with a longer time horizon could see some value in starting to establish long positions in credit here, particularly in the highest rated segments in the more liquid names in the market.

Dan Belton:

At this point, we think that further widening in credit is going to be driven by primarily two factors, tighter financial conditions and a continued deterioration in fundamentals. And both of these factors typically lead to spread decompression, so we think there's some value right now in moving up in credit and moving up in liquidity, investing in the double A and high single A rated names, particularly given that spread relationships are not as decompressed as we would typically expect them to be at this point in the cycle.

Margaret Kerins:

So Danny, you mentioned that supply in September was extremely light, which really isn't that surprising in the backdrop of extreme volatility in the US rates market. Part of the volatility in US rates that we're seeing is based on the uncertainty regarding the economic outlook, and part of it is liquidity. What did new issue concessions in the IG credit market look like while supply was much lower than expected in September, and how are you framing up the liquidity in the IG credit market?

Dan Belton:

Concessions remain very elevated by historical standards. In September, concessions averaged about 9 or 10 basis points throughout the month, but it's hard to give a more updated view on concessions, particularly given last week's widening, just because of how light supply has been. So we're waiting for a session or a week where we get more supplies so we can get a little bit better of a view of where concessions are likely to be trading going forward.

Dan Belton:

But they've been consistently elevated this year, and even though they were slightly down in September from July and August, they're still at 9 or 10 basis points, much higher than any issuers would like to see to be comfortable coming to market, particularly some of the higher beta borrowers or less liquid borrowers.

Dan Belton:

In terms of liquidity, that's been very challenging for the market and it seems to be only getting worse in the past few months, and we're expecting that to be the same. As long as this uncertainty remains around Fed policy, volatility is likely to be elevated and liquidity should be poor as long as that's the case.

Margaret Kerins:

Well, thanks, Danny. And swap spreads of course have not been immune to this volatility, so let's turn to Dan Krieter. What is your view of swap spreads going forward in into Q4 and early next year?

Dan Krieter:

Margaret, I think swap spreads definitely bear talking about after the volatility we've seen in recent weeks. Certainly the conversation topics we've focused on so far in today's podcast, are we going to see a pivot from the Fed and poor liquidity in the market, have driven significant volatility. Just last week we saw record moves in swap spreads on two of the five trading sessions, moves that we hadn't seen in many decades. So that's just obviously indicative of liquidity.

Dan Krieter:

But to start with the pivot question, if we are going to see a pivot from the Fed, clearly that would be a widener for swap spreads and the curve would likely move flatter. But my views align with Ian's, I don't think that we're at that point yet. So we continue to favor swap spreads moving narrower with the curve steepening for the next few months.

Dan Krieter:

I think the drama in the UK that Stephen talked about earlier really highlights a significant question that I think markets are going to be grappling with in the next few months, and that, is what is the clearing level for sovereign debt as financial reserves fall and central banks continue hike rates? That clearly puts downward pressure on swap spreads, particularly this quantitative tightening really begins to start meaningfully removing financial reserves from the system here.

Dan Krieter:

That said, our favorite trade is to prefer swap curve steepeners, and that view is driven by three primary factors. The first, is central bank intervention, which we expect to remain a prevalent theme going forward, which has an outsized impact on the short end of the curve. Just like in 2015, the first few months of central bank intervention tends to see an outsized flow out of the short end from foreign central banks and that makes particular sense this time around, given constrained liquidity further out the curve.

Dan Krieter:

Second, Dan Belton talked about lower IG supply here, and that's an important support for belly spreads if we're going to see less financial supply going forward. Financial supply has been extremely heavy so far to date, and as those deals are swapped, we tend to see upward pressure on belly spreads.

Dan Krieter:

I'll just note the evolution of Federal home loan bank advances, which saw a big increase in the second quarter, and we've seen in recent weeks very attractive levels for Federal home loan bank advances that indicate that advanced demand remains very high. Now, that's obviously a function as reserves as the system banks rely to a greater extent on FHLB funding, but it could also be a result of banks potentially wanting to avoid the IG market that is sort of unstable right now and rely on a greater extent on home loan bank funding, so that means less financial supply supportive for belly spreads.

Dan Krieter:

And third, we've seen increased chatter from Fed officials in the last few weeks about the potential for a permanent exemption to the SLR for reserves and/or Treasuries. Kansas City Fed President Esther George has talked about it for a long time, but now we've seen new Vice Chair of Supervision Michael Barr talking about it, and Governor Bowman talking about it in a speech last Friday. So any chatter around a permanent exemption there would lead to more support for belly spreads.

Dan Krieter:

So bottom line here, I think volatility is going to remain very high amid poor liquidity, but in the medium term we favor swap spread narrowers and spread curve steepeners.

Margaret Kerins:

Dan, I just have a question and clarification. Your first point in support of favoring the front end belly steepeners was that central bank intervention would have an outsized impact at the front end of the Treasury curve. Can you clarify what you mean by central bank intervention in this case?

Dan Krieter:

Sure. Simply just that as central banks sell US dollar assets to defend local currencies, they will do so by selling their most liquid holdings, which tend to be short end securities, which still see strong demand from short end money. We know that's where a lot of money is now. We still see very elevated levels at the RRP. So with liquidity poor further out the curve, you probably don't want to sell a lot of long end securities, you'll go to what's more liquid, which is the short end now.

Margaret Kerins:

So Dan, you mentioned central bank intervention with regard to currency markets. Greg, how is this showing up in the currency markets?

Greg Anderson:

So Margaret, we have had one very noteworthy episode of intervention over the last several weeks, and that is from Japan by the accounts that we've got something in the order of 20 billion US dollars worth of reserves were spent to defend the yen. Other countries don't report in the same way, but it is likely that there are other Asian economies, China would be an example, but there are others in emerging Asia that are likewise selling USD out of their reserves portfolio to stabilize their currencies.

Margaret Kerins:

So Greg, clearly the intervention was due to the US dollar spike that occurred last weekend, which seemed like it could be a blow off top number. How are you thinking about the US dollar from these levels going forward?

Greg Anderson:

So yeah, I would argue that the price action in the dollar index last week had some elements that I was looking for in a blow off top. So I would say capitulation by anybody who had short dollar exposure, we seem to see that liquidity drying up sort of the chaos and dread that I would like to see associated with a market extreme.

Greg Anderson:

But I'll be honest with you that I think you have to look at it pair by pair. And Stephen mentioned sterling is a case where there clearly was this cathartic moment and we've had the hard reversal since. I'm going to argue that probably for dollar/Canada, I think we had that moment with the move above 138 that was associated with the market basically pricing in the Fed going 50 basis points beyond the Bank of Canada. But there are other pairs where I don't think that we've had it yet, and so I'm reluctant to say that for the index, which is some weighted average of all of these, that I'm confident that the top is in. And I sort of still think there are some dominoes left to fall.

Margaret Kerins:

So Greg, you mentioned that the Fed's terminal rate is about 50 basis points higher than what we're hearing messaged from the BOC. Ben Reitzes, How are you thinking about that in terms of expectations for Canadian rates and the outlook for the terminal rate in Canada?

Ben Reitzes:

Well, Margaret, what we've seen over the past six weeks or so is a big shift in sentiment, as you mentioned, and as Greg mentioned. There's 50 basis points more price for the Fed than the bank, but that's taken a while to develop. For a long period of time, much more was priced in for the bank than for the Fed and that shifted in line with our view. At the end of the day, the Canadian economy is just much more sensitive to rates than the US and that provides the Fed with that much more runway to push rates higher, and we've seen that move really right across the curve. We've seen Canada outperform significantly as the market has sold off, and in recent days as rates have pulled back, we've seen Canada unwind some of that outperformance. We don't expect Canadian rates to consistently underperform, they should continue to trade well through the US curve, but flows, especially in the long end, will determine how that spread trades over the coming days and weeks.

Ben Reitzes:

In Canada, the December 1st coupon payment and maturity extension does loom pretty large and does tend to provide a fair amount of support for Canada, especially in the long end, so if we see continued relative weakness in Canada out there, that could definitely be an opportunity heading into December 1st.

Ben Reitzes:

Curve wise in Canada, similar to the US in that what we've seen over the past few days is the terminal rate while we think will probably finish out at 4%, we've pulled back a little bit below that, which means there's still some upside in rates in the front end and still some room for the curve to continue to flatten looking at 2s/10s, so we probably at least revisit the flats in the days and weeks ahead. And really what it comes down to at this point for the bank, and probably most central banks, is, what does the next CPI print do and how does the employment situation evolve over the coming months? And that will determine whether we get a similar type of pivot from the Bank of Canada that we saw from the RBA overnight or whether the bank maintains their aggressive posture.

Margaret Kerins:

So Ben, pretty similar story in Canada as we are having in the US. Let's move on to our rapid fire. We have covered a lot of territory, so I am going to start it off with Ian. Ian, Rapid fire. What are your thoughts on US Treasuries?

Ian Lyngen:

The market seems to be content to push back against the Fed at the moment, but ultimately the adage, don't fight the Fed, will become relevant in the fourth quarter as they push forward with rate hikes, further inverting the yield curve.

Margaret Kerins:

Danny Belton?

Dan Belton:

The moving credit has begun, even if it lagged other risk assets. We see another 25 basis points of widening and credit spreads into year end, but could see some value in higher quality liquid products.

Margaret Kerins:

Dan Krieter?

Dan Krieter:

I think a big question for the market in the months ahead is, what is the clearing level for sovereign debt? For credit spreads, that means widening pressure is the risk of crowding out grows. And for swap spreads that likely means narrowing.

Margaret Kerins:

Stephen Gallo.

Stephen Gallo:

We think the low point for the cycle in cable, in pound/dollar, is probably in, but we don't want to be aggressively long, building an aggressive long position in cable north of 110 while we await this eventual Fed pivot. We think there's room for the cathartic moment to still happen in euro/dollar, and so we're saying within one to three months, 94 cents in euro/dollar is achievable. And we think probably the risk/reward is better to be buying euros at lower levels than they're currently at.

Stephen Gallo:

In terms of the risks out there, we still have the geopolitical element, we have to get through the winter weather season, and there are going to be still, I think, very ugly inflation prints that the ECB has to deal with and markets have to absorb.

Margaret Kerins:

Greg Anderson?

Greg Anderson:

The dollar top is in dollar/Canada, but it's not yet in dollar/Yen. The way to trade this, be long CAD Yen, 106 now. We were at 110 three weeks ago. We're going back there.

Margaret Kerins:

Ben Reitzes?

Ben Reitzes:

We're comfortable with our call for the Bank of Canada's terminal rate to be 4%. That suggests there's a little bit more upside for the front end of Canada continuing to flatten the curve and we like playing Canada/US from the long side, but we'll need to see some underperformance here near term to initiate that trade.

Margaret Kerins:

Okay, and that's a wrap. Thank you to all of our BMO experts and thank you for listening. This concludes Macro Horizons monthly episode 45, Pondering a Pivot. As always, please reach out to us with feedback and any ideas on topics you'd like us to tackle.

Margaret Kerins:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. We'd like to hear what you thought of today's episode. You can send us an email at margaret.kerins@bmo.com. You can listen to the show and subscribe on Apple Podcasts or your favorite podcast provider, and we'd appreciate it if you could take a moment to leave us a rating and a review.

Margaret Kerins:

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 is produced and edited by Puddle Creative.

Speaker 9:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries. For a full legal disclosure, visit bmocm.com/macrohorizons/legal.

 

Margaret Kerins, CFA Head of FICC Macro Strategy
Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist
Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy
Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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