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Rebound Referendum - The Week Ahead

FICC Podcasts April 23, 2021
FICC Podcasts April 23, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of April 26th, 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 117 Rebound Referendum 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 April 26th. And with the extended May 15th filing deadline quickly approaching, we're reminded that the only certainties in life are taxes, rising prices maybe, and the knowledge that even at their best, Macro Horizon jokes leave NPR producers with unmistakable schadenfreude. After all, sometimes the purpose of a podcast is nothing more than to serve as a warning to others.

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, 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 we saw an impressive rally in the Treasury market. Now, it wasn't a rally that broke the prevailing range. However, what we did see was an extension of the underlying bid that has kept 10-year yields closer to 150 than to the peak of 177. Now the price action has also been notable in so far as it's occurred with the backdrop of a variety of economic data points that were at least ostensibly constructive for the outlook and should have put upward pressure on yields.

Ian Lyngen:

Starting at the beginning of April, we first saw the stronger than expected non-farm payrolls print, followed by better than anticipated ISM services, as well as a stronger than expected core CPI number, capped off by a notably strong retail sales print for March. All of this would suggest that everything else being equal, rate should be drifting closer to 2% than within striking distance of 150. That implies clearly that something else is afoot and as we look at the positional landscape, what we see is that some of the short base in certain sectors has been eroded. However, there has been an extension of the real money short as evidenced by the Stone and McCarthy survey, which implies that there could yet be another leg lower in yields from here.

Ian Lyngen:

There was also some chatter that an increase in corporate issuance coming out of the financial sector led to hedging flows and an impact on swap spreads that ultimately pushed the nominal Treasury curve to lower rates. Now we're somewhat skeptical of that narrative, primarily because on net hedging flows do tend to have a neutral impact on the market. Rate lock hedging or the unwinds only become relevant when they trigger important technical levels or contribute to a shift in the prevailing trend that was already underway.

Ian Lyngen:

However, given the in-range nature of the price action, we suspect that there's a different shift in the undercurrent. With the beginning of the Japanese fiscal new year, we have seen a renewed interest in purchasing overseas notes and bonds from the region. While the MoF data doesn't give the breakdown between US Treasuries and other global sovereign issues, we are working under the assumption that the vast majority of what has been purchased by Japan is in fact flowing into the Treasury market. As we think about what this implies for the balance of April, we can't help but nod to the two- and five-year auctions on Monday, as well as the seven-year on Tuesday As an important gauge of the ongoing sponsorship for US Treasury at these yield levels.

Ben Jeffery:

Well, it wasn't a busy week in terms of economic data but that doesn't mean it wasn't an important one for the Treasury market.

Ian Lyngen:

You make a very good point Ben, and we often use the adage that sometimes the price action itself becomes the story and I think that that was particularly apropos in the week just passed, primarily that simply because 10-year yields, despite the 20-year auction and even the 5-year TIPS auction, managed to grind steadily lower throughout the week. Now we haven't breached the lower bound, which is effectively 152-1/2, but we did test it now a second time, all with the backdrop of what is at least ostensibly positive economic developments on the horizon.

Ian Lyngen:

Think about the week ahead for example. We have the Fed who will surely reinforce the lower for longer narrative while being cautiously optimistic about the recovery. We'll also get the first look at Q1, real GDP, and expectations are for a quarterly annualized rate of 6.5%. It's difficult to argue that that's anything but a good start for 2021.

Ben Jeffery:

And both of our math capabilities are far from strong, but what I'm a little bit concerned about is if we get a 6.5% print for the first quarter in terms of real growth, how likely is it that we're able to at least keep that pace up over the balance of the year, or accelerate from here, given all the fiscal stimulus we've seen injected into the system?

Ian Lyngen:

To be fair Ben, no one told you there was math in this job, although it might have been implied. That being said, you highlight one of my big concerns and that is that because of the increased pace of vaccinations and the associated re openings, what we've seen is the rebound be front-loaded to the first and part of the second quarter in 2021. And that will leave one of the biggest risks being that the market takes the trajectory established early in the year and projects it out through the balance of the year. And that raises the bar for the real economy to perform in the second half, but even within that context, it's still notable that 10-year yields are a lot closer to 150 than to 175.

Ben Jeffery:

And I would argue this week's jobless claims data, which covered the April NFP survey period and showed the lowest initial filers number since the pandemic began, exemplifies exactly this dynamic. While sure versus the extreme numbers we saw in the middle part of 2020, this week's figures were encouraging, but looking back over economic cycles past, the number of people filing for jobless claims is well above any prior peak, excluding the absolute darkest days of the global financial crisis and the recession experienced in the mid 80s. So even though we've made meaningful progress out of the pandemic, both in terms of public health and economically, the fact that there's still so much slack in the labor market yet to be absorbed resonates with your concern.

Ian Lyngen:

One of the other issues that has become extremely topical is, given the inability of the Treasury market to push 10-year yields beyond 2% during the first quarter, what would it take? This is a question that we've received several times from clients, and that is, given that we stalled out at 177 in 10s, what would need to transpire over the course of the next several months to get 10-year yields to trade with the two handle? In short, we would need to see a series of very strong non-farm payrolls prints. Now we're still running at a deficit of roughly 10 million workers that have been displaced because of the pandemic. Therefore, back to back NFP prints in the two to three million range over the course of the next three months would be a really good start to rekindle the bearish ambitions that were brought into the beginning of the year.

Ian Lyngen:

That said, given the push to reopen sooner rather than later, I'm concerned that a lot of the job gains are going to be front-loaded and so we will see a strong April print and that will rekindle expectations for higher rates initially, but then as we move forward to May and June, we'll see that the pace becomes more difficult to maintain. Now note, I didn't focus on realized inflation because frankly I think that at this point in the cycle, even if we have another strong core CPI print or two, it won't be enough to really push market-based inflation expectations higher than we see in ten-year break evens at roughly 230, 235. The logic here holds that the Fed is sure to characterize some of the upside and inflation in the very near term as transitory as we look to a post-pandemic environment and the potential for wage gains to actually sustain the upward pressure on consumer prices. And that's contingent on the rebound in the labor market, which is why investors are so focused on non-farm payrolls at this point.

Ben Jeffery:

And while maybe not explicitly bullish, we have reached the point in the cycle where we're going to see what has been pointed to as a very bearish variable removed. And what I mean by that is, given the year of record net issuance that we're going to have, the fact that the bulk of the crisis level spending is behind us means that coupon auction sizes are going to start declining likely later this year. Now we do get the May refunding announcement on the fifth and generally speaking, expectations are for unchanged sizes there, but as we get to the August and November refunding announcements, it's reasonable to assume that some of these record large auction sizes are going to start coming down. And what that suggests to me is that for all the worry that supply was going to "break the Treasury market," it seems we've received an answer to what record large ten-year auctions are worth, and that is 1.77%, arguably not even that high given that that yield peak came alongside the surging optimism that we saw during much of the first quarter.

Ian Lyngen:

And reinforcing this point, if we look at the ACM term premium model, there has been a market return in term premium, particularly further out the curve. And in such an environment, if we still can't get 10-year yields to 2%, I think that that is very telling, especially given what now marks a decided shift in policy objectives out of Washington. Specifically, we have gone from Biden's initial push at another round of fiscal stimulus to longer-term reforms that include not only corporate tax increases, but also increases on the individual level and that's ultimately going to have ramifications on the pace of consumption, as well as valuations in risk assets, and I worry that that's going to be one of the next key chapters in the macro story of 2021.

Ben Jeffery:

And as well as those headlines on capital gains tax increases, we also saw the GOP introduce an infrastructure bill of their own. Now it was roughly a third in terms of outright size is that suggested by the White House, but nonetheless, it appears that on both sides of the aisle the idea of an infrastructure bill is gaining traction. So far, it seems that the preference is to fund this via corporate tax increases rather than more deficit spending, and while the economic benefits of such a program would follow intuitively, it will not be of the same variety of the fiscal deals we've seen passed within the last 18 months. An infrastructure program is going to be a much longer term endeavor over the next eight to 10 years, which will have a far slower stimulative influence than say three rounds of direct payments.

Ian Lyngen:

Or frankly even a fourth round of direct payments. There has been chatter that once we get to the end of the extended unemployment benefits, which expire on Labor Day, that there will be political will to push through even further fiscal stimulus. Now we're somewhat skeptical of this notion given the fact that we should be as an economy far enough through the inoculation process and close enough to herd immunity, that by providing incentives for workers to stay out of the labor market will ultimately be doing the real economy a disservice. The question will be one of ensuring a short-term base level of consumption or forcing the issue of retooling parts of the labor force to better fit the post-pandemic jobs landscape.

Ben Jeffery:

And I'm a little bit more concerned about the achievement of herd immunity period, not even necessarily by the end of 2021. We've already started to see anecdotal evidence at least that there are certain pockets within the US where vaccine supply is exceeding demand. This inflection point is only going to become more widespread as all the individuals who want to receive the vaccine have done so. It's going to be that final leg of the vaccination process that ultimately is the most difficult. While 27% of the adult population being fully vaccinated is certainly an accomplishment, and versus the rest of the world, a good development, it leaves the US well off of that 75% level that seems to be the consensus for what's required for herd immunity.

Ian Lyngen:

And reasonable concern is the flattening of the vaccination curve. There was a very steep uptake, particularly as more supply came online, but there will be a point where the campaign shifts from queuing for the vaccines to actively advertising to get people to come in and have the vaccine administered. We haven't really seen much of that shift yet, but we are starting to see some indications that that's quickly approaching on the horizon. That coupled with the pause in the Johnson and Johnson vaccine, does if nothing else re-introduced to investors the risk that the path toward herd immunity is not without hurdles and potential pitfalls.

Ben Jeffery:

And the calculus around when this will ultimately happen is-

Ian Lyngen:

Ben, calculus? Really? Are you sure?

Ben Jeffery:

Like I was saying, well outside of our analytical wheelhouse. What remains to be seen is the degree to which COVID mitigating restrictions are rolled back even without achieving that herd immunity threshold.

Ian Lyngen:

The risk there is that the real limiting factor becomes people's willingness to re-engage in in-person commerce, travel, et cetera. If the populace doesn't feel safe in going back and re-engaging in the economy as we did in 2019, that will slow the prospects for a service-driven rebound that have so defined this stage of the recovery.

Ben Jeffery:

So what you're saying is re open it and they might not come?

Ian Lyngen:

But to not re open it would be dumb.

Ben Jeffery:

And we know dumb.

Ian Lyngen:

Do we? Whose that?

Ian Lyngen:

In the week ahead, the Treasury market will have a variety of inputs to help refine expectations going forward. Ostensibly, the highlight should be Wednesday's FOMC rate decision and Powell's press conference that follows. Our expectations however are that the Fed has no incentive or urgency at this point to shift the monetary policy stance. So what we'll see is a reiteration of the lower for longer guidance, as well as some acknowledgement of the stronger start to the year than many had been anticipating, as well as the increase in COVID cases globally. So a balance of risks to be sure, but one that won't have a lingering impact on the Treasury market.

Ian Lyngen:

More importantly, we do see the first quarter real GDP print and with the consensus of 6.5%, we will be watching to see how investors respond to this piece of economic data. If we use the price action thus far in the second quarter as any indication, one should expect that the Treasury market will shrug at a strong GDP print and move on to pricing the risks that, once we get past fiscal stimulus, the economy will struggle to retain the momentum that it's starting the year with.

Ian Lyngen:

It's this degree of apathy toward the realized economic data that has largely defined trading thus far over the course of April, and in this context, a drift toward lower yields wouldn't actually be that surprising. We're maintaining our year-end target for 10 years to end 2021 in a range of 125 to 150 with an acknowledgment that is a reasonably wide range, but it is in contrast to a lot of market expectations who see 2% 10-year yields as a path of least resistance.

Ian Lyngen:

In the very near term, we will be watching the take down of Monday's two-year auction of $60 billion in the morning and Monday's five-year auction of $61 billion in the afternoon. We'll also have the seven-year on Tuesday and as the seven-year has been a focal point for the bond vigilantes, we can't help but acknowledge its importance in defining the rate landscape over the near term. If we see a reasonable tale of note, it will be difficult for 10-year yields to push through the 150 level.

Ian Lyngen:

However, if in keeping with the return of Japanese investors, we see an outsized foreign allocation for this particular benchmark, that would solidify this notion that the earlier struggles of the seven-year were one-off and as coupon size expectations start to fall in the year ahead, we might ultimately have established the peak in yields for the first half of the year. We're operating under the assumption that if 10-year yields are not above 177 by the time the May refunding settles, that that will represent the upper bound for rates as we look for the seasonal influence that favors lower Treasury yields over the course of the summer to take hold with an objective of seeing rates bottom in the middle of September as the true economic performance of the year becomes much more evident and the success in the efforts to reach full reopening and herd immunity become more obvious.

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 as the summer approaches and the COVID-15 conflicts with our beach ready ambitions, we cannot help but wonder if others at the gym are laughing at us or with us. Well, since we're not laughing...

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 FIC 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:

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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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