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Return to the Home Office - The Week Ahead

FICC Podcasts August 27, 2021
FICC Podcasts August 27, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of August 30th, 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 135, Return to the Home Office, 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 August 30th. And with in-person working delayed by Delta, we're reminded that whether it's work-life, hawk-dove, or the checkbook, balance is the key.

Announcer:

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, Powell's Jackson Hole presentation was unquestionably the highlight. The Chair made a very clear distinction between tapering and the liftoff rate hike and that was really the primary driver behind much of the post Jackson Hole decline in Treasury rates that materialized. Yes, the Fed is on track to taper. Yes, the announcement will occur sometime this year, but it appears that both the Fed and the market have moved on to the implications from less monetary policy stimulus, as well as beginning the process of re-evaluating estimates of when the Fed will follow through with the normalization of policy rates.

Ian Lyngen:

As it currently stands, the market is pricing in a rate hike by the end of 2022, if not the beginning of 2023. There's an active debate surrounding whether or not the inflation environment will lead to the Fed pulling forward the liftoff rate hike, or if the Fed's transitory assumption comes to fruition and the peaks of inflation are behind us, then that will allow the Fed more flexibility in the process of raising rates.

Ian Lyngen:

One of the defining aspects of the price action surrounding Jackson Hole, and the fact that the Fed has made it abundantly clear that tapering is on the horizon, is the fact that the market continues to hold such a notably narrow and lower rates range than many in the market were anticipating at the beginning of the year. One of our major concerns is that the cheaper and steeper narrative from here seems to imply that after the market returns from the long Labor Day weekend, that a renewed bearishness will emerge simply because we're that closer to tapering and, presumably, the first rate hike, to say nothing of the ongoing risk of inflation.

Ian Lyngen:

We struggle with that narrative because it's effectively re trading all of the same information that drove 10-year yields to 177 in the first quarter. The fact of the matter is the timeline out of the pandemic has been increased because of the Delta variant, as well as the market focusing on the potential for a series of rolling variants going forward. This recalibration occurred at a pivotal time for forward market expectations as well and, at the end of the day, we do expect to see some attempts to re price the market toward higher yields. However, we'd view those efforts as a buy-in opportunity with the primary theme for the balance of 2021 being that of the range trade.

Ben Jeffery:

Well, we got Powell's Jackson Hole speech and it was bullish, it was bearish, it was a flattener, and it was a steepener.

Ian Lyngen:

It was also live and virtual, which added a bit of a twist, but I think the biggest takeaway from Powell's presentation at Jackson Hole was that the Fed is going forward with the tapering timeline that's generally in the market and that implies that we get something by the end of this year. Whether that's a combination of the announcement and the implementation of tapering, or we simply get an announcement in December to be implemented in January is ultimately going to come down to the next few key pieces of domestic data, specifically jobs and inflation. What's no longer an open question is whether or not the Fed will taper.

Ben Jeffery:

And in addition to that, Powell was very explicit about separating the tapering conversation from the liftoff one. And in looking at the price action immediately following his speech, the fact that we saw the belly of the curve outperform and five sturdy steepen, to me suggests that this is the Chair's attempt to push out liftoff timeline assumptions even while remaining committed to pulling back on bond buying. We've been discussing about how Q4 and likely Q1 of next year is really going to be a story about the price action in the belly of the curve just given that sector's sensitivity to liftoff timing assumptions.

Ian Lyngen:

And further to your point, Ben, not only did the five-year sector outperform thirties, but it did so with an outright move lower in rates. So this wasn't a situation where the market traded tapering bearishly. In fact, it was the exact opposite.

Ben Jeffery:

And what this points to, admittedly somewhat counterintuitively, is that it's the monetary policy impulsive tapering that's more consequential in terms of the price action than the actual $80 billion a month in treasuries that the Fed is delivering. And what I mean by that is while yes, in a vacuum, less demand from the Fed should translate to cheaper bonds and higher yields, the fact that pulling back on QE is going to act as an offset to both higher growth and inflation, less accommodative policy, is being read at this stage as bullish for bonds. So even though directionally the opposite of less Fed demand, it does demonstrate the importance of the calibration of monetary policy, whether that be extremely accommodative, less accommodative, neutral, or restrictive.

Ian Lyngen:

Powell also made it very clear that the Fed is committed to the new maximum employment framework. Not only was that language specifically used, but in separating tapering from the liftoff rate hike, what the Chair is attempting to do is dissuade the market from assuming that there will be a known window of nine to 12 months between the last bond purchase and the first rate hike. That's an assumption that the market has been holding on to simply because that was the timeline during the last cycle.

Ben Jeffery:

And this was an idea we saw discussed in the July FOMC minutes as well. And that is that while generally speaking, the committee is of the mind that substantial further progress has been made in achieving their inflation mandate, on the jobs front, there's still more work to be done. The US economy is still short, roughly six million jobs versus pre-pandemic levels, and it's going to be further progress on that front that's going to serve as the barometer for liftoff.

Ben Jeffery:

Now, Ian, I want to pose a quick question to you on liftoff timing and what that implies for the terminal rate. Does an earlier timeline in term of the cycles first rate hike to you suggest that the level to which the Fed will ultimately be able to raise rates will be lower?

Ian Lyngen:

That is about to become the pivotal question of 2022. If inflation performs in a way that the Fed needs to bring forward the liftoff rate hike, does that imply a higher terminal Fed funds rate, a lower terminal Fed funds rate, or can we simply assume that it's two and a half percent, which is what the Fed has been projecting for quite some time? My read is that if in fact the first hike comes sooner than the market is anticipating that it's ultimately the nature of inflation that will dictate the terminal rate of this cycle.

Ian Lyngen:

Now in that observation, what I mean is that if we continue to see supply driven inflation that is a result of dislocations that occurred during the pandemic that ultimately get the Fed so worried about inflation expectations drifting higher that they deliver the first rate hike sooner rather than later, that would lead to a slower growth profile going forward and ultimately imply that perhaps they don't need to tighten as much as they would have otherwise.

Ian Lyngen:

The flip side is if we find that core inflation continues to outperform expectations with a broadening of categories that is accompanied by higher wage gains and what the Fed would characterize as good demand side inflation, that's an indicator of an economy that is heating up. If such a situation occurs, then the transitory definition comes into question and that suggests that the Fed will need to respond more quickly and ultimately they might need to hike to a higher terminal funds level given the strength of the overall economy.

Ben Jeffery:

So to sort of summarize, another way to put that might be, well it's going to be up to the labor market to inform when liftoff is. How high policy rates ultimately reach are going to be a function of inflation over the longer term. Fair to say?

 

Ian Lyngen:

Yes, I would say that's a fair characterization, again with the nuance that not all inflationary pressures will be treated the same by the Fed. And that's really going to be the defining characteristic of the year ahead.

Ben Jeffery:

But let us not forget, more immediately relevant will probably be Friday's jobs numbers. We do have the August employment report and given the fact that hiring likely was starting to be impacted by the rise of the Delta variant, just how many workers were brought back online in August is going to be especially informative for the trajectory of the labor market going into the autumn when enhanced unemployment benefits have rolled off and childcare considerations surrounding in-person learning, et cetera, will likely be a bit more normalized than we've seen for the past 18 months.

Ian Lyngen:

Well, we are coming off of a series of very impressive improvement in the jobless claims figures, and that implies, if nothing else, we should be in a good spot for a strong August NFP number. Recall that July's print was disproportionately influenced by the education sector. And so to assume that we're going to get another blockbuster one million plus print, including revisions, seems to be a bit ambitious. Nonetheless, the consensus is for 750,000 jobs to have been added in the month of August and that's more than sufficient to keep the Fed on track for tapering by the end of the year, while at the same time reducing any urgency to bring forward a liftoff rate hike.

Ben Jeffery:

Which in terms of the moves in the market should still leave this range that we've seen in 10-year yields well intact. Over the week just passed, we did get back up to challenge that 135, 136 level, but in the wake of Powell's speech, we once again saw that via dip that was considered buyable. So in addition to that 142 level that we've been highlighting as the top of the range, it's now clear that the bar to retest that level has been raised and especially during the unofficial last week of summer and presumably limited conviction over the next few sessions, at least into NFP. The most likely scenario is more of a drift in yields than the outset of any new trend. I do think it will be especially interesting to see the degree to which the strength in five-year yields extends if only as an indication of how different geographies trade the information offered by Powell on Friday.

Ian Lyngen:

I'd take it a step further and say that we'll actually probably be in a range for 10-year yields that can be roughly represented as 112 to 142 between now and the September 22nd FOMC meeting. Now we have very clear technical support and resistance within that range and a prolonged period of consolidation as the market and the Fed continues to debate whether or not they'll taper in September is the path of least resistance. Our stance remains that they'll take a pass at September and focus on the November and December timeline, but an unexpectedly strong payrolls print or higher than anticipated CPI data might provide a compelling reason to pivot.

Ben Jeffery:

And of course, this is all taking place with the backdrop of a domestic equity market that continues to set record highs and in turn keep financial conditions at their easiest levels on record. Now remember during the prior cycle, it was episodes when financial conditions that tightened sharply that drove an accommodative reaction from the FOMC. So the fact that Powell and company have now been able to meaningfully embark down the road of removing accommodation without inspiring really any reaction other than further easing of financial conditions must be encouraging for the FOMC and really affords them a great deal of flexibility going forward.

Ian Lyngen:

So the only real takeaway here Ben is it's all taper, no tantrum.

Ian Lyngen:

In the week ahead, the highlight will be the August non-farm payroll sprint. The current consensus is for 750,000 with the unemployment rate at 5.2%. In terms of wages, we'll be focused on average hourly earnings. The current consensus calls for a three-tenths of a percent gain in that category. And as we contemplate the inflation complex going forward, the one key component for inflation to become self-perpetuating will be ongoing wage gains.

Ian Lyngen:

Suffice it to say the debate between whether or not the Fed announces in September, November, or December will be ongoing until the next meeting. The more hawkish Fed speakers have advocated for a September taper, while the bulk of the committee appears content with sometime during 2021. We're not anticipating any grand revelations from the Fed over the course of the next couple of weeks, if for no other reason than the week ahead is the last on official week of summer. And if the Fed's tapering announcement isn't enough of an incentive to break the range, we struggle to imagine a great deal of net price action between now and the Tuesday after Labor Day.

Ian Lyngen:

Recent auction performance suggests that there continues to be sufficient underwriting demand for primary issuance in a Treasury market. This fact was reiterated by the 1.1 basis point stop through at the recent two-year auction, while fives and sevens tailed modestly. The strong support for the very front end of the curve does reflect the reality that there remains a great deal of cash in the front end of the market and with the ongoing potential for the debt ceiling to come into play, we struggle to see a scenario in which the post Labor Day auctions are not well received even if they occur at the current or a lower rate plateau.

Ian Lyngen:

The price action that followed Jackson Hole reinforces the idea that responses to bond bullish and bond bearish inputs are going to be expressed differently along the curve than we had seen prior to the June FOMC meeting. This is simply an observation that we've transitioned to the point in the cycle where the belly will lead the price action. So in a bearer scenario, we would expect five-year yields to increase more than tens and thirties, and in a bullish, we would expect larger declines in fives than further out the curve. Now this is a departure from what we saw in the beginning of the year, where the curve was primarily a directional trade with tens and thirties affectively leading the way. This shift is simply a function of the market moving beyond trading tapering to focus on tapering the liftoff hike.

 

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 there appears to be a dash for clever ETF tickers, we're thankful to have secured the rights to PUN.

Ben Jeffery:

Is that a pun?

Ian Lyngen:

Are you having pun yet?

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.

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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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