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Reassessing Recession - The Week Ahead

FICC Podcasts July 15, 2022
FICC Podcasts July 15, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of July 18th, 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 180. Reassessing Recession. 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 July 18th. And for anyone who has yet to hear about the institutional investor survey, congratulations, we now know who should receive the best email filter award.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or for 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 passed the treasury market received what is arguably the most important single data point, and that was CPI. In this case, it was Headline CPI, which came in higher than expected at 1.3% month-over-month in June. And that brought the yearly pace up to 9.1%. That's the highest since 1981. For context, 10-year yields remain comfortably below 3% and the front end of the market continues to sell off as investors debate how the Fed will ultimately respond to this elevated degree of inflation.

Ian Lyngen:

Our baseline assumption at this point remains that we will see a 75 basis point rate hike at the July 27th meeting. Now there is a non-zero probability of 100 basis point rate hike. But following comments from monetary policy makers on Thursday and Friday, as well as the surprise decline in the University of Michigan's 5 to 10-year inflation survey response, which was 2.8% down from 3.1 in June, which was revised after initially printing at 3.3%. It follows intuitively that the Fed's preferred survey measure of inflation expectations has revealed the type of moderation afford inflation expectations that should, all else being equal, err the Fed on the side of 75, as opposed to 100.

Ian Lyngen:

Now, in the upcoming week there's very little economic data aside from some reads on housing that could potentially skew the probability for the Fed to be more aggressive. But that's not our base case scenario at this point. Moreover, as we think about the impact of the slightly stronger than expected retail sales numbers on the Fed, it does bolster the case for two 75 basis point hikes: one in July and one in September, even if we don't ultimately see 100 basis points at the end of this month.

Ian Lyngen:

The week just passed also saw an impressive inversion of the 2s/10s yield curve. This benchmark spread dropped as low as negative 27 basis points effectively marking the extremes this curve has seen since the 2000 cycle. So with the curve as inverted as it's been in more than 20 years, investors are continuing to ponder how far this spread might ultimately push. Historically, we've seen it as low as negative 55 basis points. And between now and the end of the year, we are targeting a retesting of the range of negative 40 to negative 55 basis points. This will come in an environment where the Fed is pushing forward with rate hikes, and whether the terminal rate is ultimately a range of 3.25 to 3.50, or 3.50 to 3.75 remains to be seen.

Ian Lyngen:

But that doesn't mean that two year yields can't trade below effective Fed funds, and that's precisely what we are anticipating. And so we're continuing to hold our year end call for two year yields at 2.9% and 10-year yields at 2.25 and the implied 40 basis points of inversion in 2s/10s. Now, when we think about the cyclical steepener that will occur sometime in 2023, all else being equal, and be triggered by either fine tuning cuts by the Fed or a more material de-risking as the labor market comes under pressure and investors operate under the assumption that the longer it takes the Fed to deliver the first rate cut of the next cycle, the larger that cut will ultimately have to be.

Ben Jeffery:

Well Ian, we got CPI with a nine handle. We got 5s, 30s back to inversion, a surprise 100 basis point rate hike from the Bank of Canada, chatter about 100 basis points from the Fed, and then push back maybe 75.

Ian Lyngen:

Maybe 100.

Ben Jeffery:

Maybe 50.

Ian Lyngen:

Not 50.

Ian Lyngen:

Could be 75 though, or maybe 100.

Ian Lyngen:

That was the tone of the treasury market during the last two days of the week, following the higher than expected headline in core CPI print. CPI came in decidedly above expectations, both for the headline and the core, and this triggered chatter for the prospects for the Fed to up the proverbial ante with 100 basis point rate hike instead of 75.

Ian Lyngen:

Now we're certainly sympathetic to this debate, particularly given what happened after the May CPI data. I.e. the Fed went from signaling 50 basis points was a given to putting 75 basis points on the table using the financial media during the Fed's radio silent period. So the fact that we have had several Fed speakers since the CPI release should have given the market, ideally, a better sense of precisely what the Fed was thinking. Instead, we were left with dueling Fed commentary regarding the prospects of whether or not we should assume 75 versus 100 basis points. And as a net result, this debate will likely continue until the Fed meets on the 27th of July.

Ben Jeffery:

And in terms of the market reaction to both the CPI data itself, and also the rhetoric from Waller, Bostic, Bullard around the question of 75 or 100 basis points. The two most telling reactions was first 2s/10s reaching negative 27 basis points for its most inverted level since 2000, but also despite 9.1% headline CPI, after the kneejerk sell off in 10s, we actually saw 10-year rates close net lower on the day on Wednesday. Speaking to this idea that we've reached the point in the cycle and recession fears have become pronounced enough that the level at which dip buying interest is going to start to emerge to take advantage of backups and yields has been lowered.

Ben Jeffery:

A selloff that stalls out below 3.10 10-year yields really diminishes the prospect for another re-challenge of that 3.497 level that we got to in early June. And this of course is in no small part due to the fact that recessionary worries have picked up in a very significant way, and even if the economy was in a recession in the first half of this year, the fact that the labor market remains so tight means that the Fed is going to continue hiking, potentially, by even more than 75 basis points.

Ian Lyngen:

It's also not lost on us the timing of the FOMC meeting versus the second quarter real GDP numbers. On Wednesday, July 27th, the Fed will announce whether they're going 75 or 100 basis points. And the next day at 8:30 in the morning, investors will get the first look at the second quarter GDP numbers.

Ian Lyngen:

Now, we've made the point in the past and it remains relevant that for the same amount of nominal GDP, the more inflation that there is in the system, the higher the probability that growth dips into negative territory. And following Bullard's comments that perhaps the real GDP numbers are not accurately illustrating what's going on in the US economy, monetary policy makers seem to be acknowledging the fact that underlying growth might be solid, but higher prices are weighing on real spending power. And that could ultimately flow through to the economic data.

Ben Jeffery:

And on the issue of spending, we did get June's retail sales figures that yes, surprised on the upside, and maybe some of that edge was taken off by downward revisions to May's figures. But in real terms, even an 8 tenths of a percent increase in the control group, is more than erased by the monthly gains in CPIs. So in practical terms, this means that the optical increase of dollars spent in retail sales, is more than entirely accounted for by inflation.

Ben Jeffery:

Clearly there's no shortage of reasons for consumers not to be particularly confident or particularly strong spenders in the current environment. Think about gas, food prices, what's becoming an increasingly cloudy outlook for the labor market. All of these factors do not bode well for an acceleration in growth from a departure point in the first quarter, that was still negative in real terms.

Ian Lyngen:

And I do think that it is relevant that in the breakdown of the retail sales numbers, what we saw was an emphasis on necessity spending. We know that gasoline prices and food prices have continued to increase. And so it does follow intuitively that that is taking up more of the consumer wallet share as the cycle moves forward.

Ian Lyngen:

Now, the lingering question still remains, how long before the increase in initial jobless claims begins to shift the narrative around how healthy the labor market actually is at this stage. Recall that employment is a notoriously lagging economic indicator. Given the cycle time of hiring, it takes quarters before we would actually expect to see a material change into the unemployment rate. And Ben, to your point, if the Fed is going to be willing to hike even if we're in a technical recession, the Fed will be willing to hike even if the unemployment rate is trending higher. If for no other reason than they have repeatedly stated that the employment market is running hot. And by offsetting some of the pressure, they can take the upside risk off of wages. And that will further help prevent a wage inflation spiral.

Ben Jeffery:

But that's only going to be true up until the point. And unfortunately, as with so many things in the real economy, we probably won't realize that point until well after we've passed it. Yes, the Fed wants to see a gradual and probably relatively modest increase in the unemployment rate. However, once we start to see that increase, presumably we'll have yet to see the full impact of all of the Fed’s tightening. And that will mean that once the comfort point is reached, the lagged influence of monetary policy will continue to serve as an economic headwind, beyond what would be the ideal outcome from the Fed's perspective.

Ben Jeffery:

In fact, in his comments on Thursday, Waller, went as far as to site explicitly this in his laying out a 75 basis point hike as a base case. He said that it's important not to overdo it on rate hikes and that while yes, the Fed needs to move aggressively to contain inflation, a 75 basis point hike is still a huge move in the context of the last 40 years and the risk of overdoing it is an important bullet point in the argument against 100 basis points.

Ian Lyngen:

And looking at the TIPS market, what we can see is that breakevens have demonstrated an increasing amount of confidence in the Fed's ability to keep forward inflation expectations anchored. Now, this is relevant as the Fed continues to reinforce their commitment to a 2% inflation target. The most compelling argument against our year end target for 10-year yields at two and a half percent is a scenario in which the US economy is entering a phase where year-over-year inflation is trending higher than it has been for the last decade.

Ian Lyngen:

So instead of 2% in vision world, in which inflation runs closer to three and a half or 4%, in such an environment, investors would need more inflation compensation to go further out the curve into tens and thirties. But what we have seen from the Fed, even in their decision to go from 50 to 75 basis point rate hikes, to say nothing of the fact that a hundred basis point move should conceptually be on the table, is that the Fed is willing to do whatever it takes to combat inflation. And by maintaining that 2% target, combined with increased hawkishness, breakevens will continue to drift lower. If nothing else, this test of the Fed's credibility as an inflation fighter seems to be breaking in Powell's favor.

Ben Jeffery:

There's also a component of this front-loading hikes dynamic that came up in conversation several times with clients this week and is something that's actually reflected in the shape of the Fed funds futures curve. Which is that if we're going to get to last cycle's terminal rate, or maybe even beyond by the end of this month, does that mean we're necessarily going to see a higher finish line for this hiking cycle or do the larger hikes just mean we're getting to the same finish line that would've ultimately been the case anyway, just much faster than was previously assumed? So 75 basis point rate hikes don't necessarily mean that the terminal Fed funds rate is going to be north of 3%, but it does mean that we will get to wherever terminal ultimately ends up being, far more quickly and then the Fed will then be able to shift to an on-hold stance, to allow some of this tightening to price out.

Ben Jeffery:

In terms of Fed funds, futures pricing we have terminal priced to 360, more or less, sometime in the first half of the year. But beyond that, and very much keeping with historical precedent, we're starting to see an increasing amount of rate cuts priced in by the end of 2023. We know that the Fed usually can't keep policy at terminal for more than six, nine, maybe 12 months. And given the condensed timeline on which rates have been moving up, it's certainly not unreasonable to bias that terminal hold period, shorter as well. This is definitely going to be a communications challenge for Powell at the July meeting, yes, but also the remaining meetings over this year and into early next.

Ian Lyngen:

This quicker-up and quicker-down on Fed funds narrative plays into why we have seen the two year treasury note comfortably yielding below the terminal funds expectation. The notion as you point out Ben, is that while the Fed might be in a hurry to get to terminal, they won't be able to keep rates there for very long. Not only has this, combined with the recession chatter, contributed to the depths of the inversion in the yield curve, but it also reinforces our core call that we're going to struggle to see three handles in the treasury market by year end.

Ian Lyngen:

In contemplating the potential depths of the inversion, we think it's reasonable to target a negative 40 to negative 55 basis point range into 2s/10s between now and the end of the year. Part of that will be simply a function of pricing in a slower growth outlook, recessionary or not, it goes without saying that expectations are for far more significant economic headwinds, in the second half of the year.

Ian Lyngen:

The other aspect of our contained rates bias comes in the form of Fed credibility. As we mentioned earlier, breakevens are trending lower and the more convinced the market becomes of the Fed's reaction function to higher inflation, the more we will expect breakevens to compress. Do we get 10-year breakevens back into the 1.75 range by the end of the year? That's ultimately going to come down to how CPI performs.

Ben Jeffery:

And along with breakevens, we've seen the Fed give a fair amount of weight to some survey based measures of inflation expectations as well. Now, the realities of how those softer metrics are collected really gives gas prices a more outsized impact than probably should be warranted. And the fact that we've seen crude, RBOB and frankly, commodities on the whole, start to pull back from their peaks on some of these recessionary concerns, also adds to the moderating inflation case over the second half of this year.

Ben Jeffery:

Now moderating from such elevated levels means that the Fed will continue to move aggressively, but as the committee presumably becomes more concerned about a slowdown, pointing to progress in fighting inflation, especially on the core side, will presumably give some cover for the Fed to downshift from 75 basis points to 50 basis points, or even back to the now, decidedly out of style, 25 basis point hike.

Ian Lyngen:

I miss the quarter point hikes.

Ben Jeffery:

I miss quarter telephone calls.

Ian Lyngen:

I miss quarter loaf bread.

Ben Jeffery:

Was that actually a thing?

Ian Lyngen:

Right after quarter a gallon of gas, that's quarter of a dollar, not quarter of a 20.

Ian Lyngen:

In the week ahead, the treasury market has remarkably little in terms of economic data with which to contend. We do have a few housing measures. Housing starts and building permits on Tuesday, as well as existing home sales on Wednesday. Our expectations are for a continued cooling in the residential housing market. This is consistent with the obvious outcome from a tighter monetary policy environment, as well as the run up in mortgage rates that we're seeing during the second quarter.

Ian Lyngen:

The week ahead also sees supply in the terms of a $14 billion 20-year auction. Admittedly, a point on the yield curve that has certainly struggled in the secondary market versus the longer duration 30 year, as that curve continues to be inverted. We also have Thursday’s new 10-year TIPS auction of 17 billion. This will be a meaningful litmus test of investors demand for inflation protection in an environment where the Fed has stepped up their aggressiveness in fighting inflation, while at the same time, headline CPI continues to print higher than expected.

Ian Lyngen:

On net, we expect a reasonable showing for tips with the caveat that we are at an important inflection point in the cycle, where the increase, even probability, that the US faces a recession in the next 12 months, will serve to further anchor inflation expectations. We anticipate that the market will continue to refine expectations for the July 27th FOMC meeting. The debate between 75 basis points versus 100 basis points, is currently skewed in favor of 75 basis points.

Ian Lyngen:

And while upside surprises on the economic data could skew expectations higher, at the end of the day, we anticipate that the Fed, assuming that 100 basis points is not fully priced in, will err in favor of 75 basis points. However, we do expect that the press conference will be skewed more hawkishly as Powell ultimately leaves another 75 basis point move on the table for the September medium. Needless to say the traditional summer doldrums period is approaching, however, given where we are in the monetary policy cycle and the depths of the inversion in the 2s/10s curve to say nothing of the flattening further out, we're not expecting a typical, low commitment, low volatility period between now and labor day.

Ian Lyngen:

In fact, it's reasonable to anticipate that the tone and the trajectory of US rates for the balance of the year will be decided in the next eight weeks.

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 CPI running at levels, not seen since the early 80s, we cannot help but be nostalgic for Atari, parachute pants, and of course the Oregon trail died of dysentery, again.

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 podcast or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the Thick Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

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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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