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Returning to Work - The Week Ahead

FICC Podcasts April 30, 2021
FICC Podcasts April 30, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of May 3rd, 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 118, Returning to Work. 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 May 3rd. With vaccines now widely available, and the next big decision being what to wear on the first day back in the office, we find ourselves simultaneously cursing the overzealous dryer for shrinking our collars and praising the life's work of Thomas Hancock, the inventor of elastic. It's just fantastic.

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 U.S. 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 market had a lot of fundamental inputs to choose from in terms of trading direction. However, once again, and to a large extent as has become thematic throughout the month of April, we saw the market willing to ignore a particularly strong GDP print, as well as a Fed that did demonstrate some optimism while at the same time reinforcing the notion that any uptick in realized inflation will be characterized as transitory for the time being. Now, the implications for monetary policy from that are relatively straightforward. If the Fed believes that inflation is temporary in nature, it won't respond to the spikes that the market is generally anticipating will materialize in the coming months. Fast forward to the end of this year, however, if the market finds itself in a situation where inflation is consistently running hotter than expected, whether the Fed acknowledges it or not, that will become even more topical.

Ian Lyngen:

As it currently stands, we expect that there will be an increased debate around what transitory actually means and how it should or should not be defined. We'll sidestep that debate for the time being with a nod to the fact that transitory is, for all intents and purposes, defined the way the Fed would like to define it. Said differently, inflationary influences will remain transitory until the Fed concedes that they are not. As we ponder what it would take to bring inflation back into the system on a sustainable basis, the first thing that comes to mind is average hourly earnings and the associated increase in non-farm employment. That would be a clear precursor. One thing that's worth a side note is that there's going to be a compositional issue that begins to come into play in the average hourly earnings data. At the beginning of the pandemic, what we saw was an unexpected increase in average hourly earnings as lower wage, front-end service sector workers were the first to be stopped out during the pandemic.

Ian Lyngen:

As the real economy continues to open and vaccines become increasingly available, what we'll see is the re-introduction of a low wage earners into the aggregate figures. This will, for a reversal of the same compositional reasons, drag average hourly earnings lower. So that will present a bit of a challenge for the Fed as monetary policy makers attempt to time the next transition, which would be tapering of QE purchases. We're relying on the comments from the Fed during the first quarter, when the market was selling off rather dramatically, that the pace and composition of bond buying will remain constant throughout 2021.

Ian Lyngen:

Now, we're certainly sympathetic to the idea that as the facts change, the Fed can change its opinion or its outlook. However, there's also something to be said for Fed credibility. So to actually taper before the beginning of 2022, the Fed would need to start laying the groundwork relatively quickly. A transition from Powell saying QE's going to stay in place to the end of the year, to perhaps, we should scale it down sooner, isn't something that would take place over the course of three or four months. What we would need to see is a continued out performance of the economic data as the U.S. reopens for in-person commerce and the service sector comes back online.

Ben Jeffery:

Ian, I just have to ask, why are we not at 2%?

Ian Lyngen:

Oh, because prices aren't that low. In all seriousness, that has been the question that we've received most frequently over the course of the last week. And frankly, it's a very legitimate question. Given everything that's transpired over the course of the last four months, we still have Treasury yields stubbornly in a range that suggests, quite frankly, that 177 is going to be the upper bound for 10-year yields for the foreseeable future.

Ian Lyngen:

Now, this certainly contrasts with the more bearish camp that was expecting that step function that we've referenced in the past, where 10-year yields sell off 10 to 15 basis points, consolidate for a period of time and then take another step higher until we're well beyond 2%. Instead, what we have seen is a more traditional repricing early in the year, as we bring forward all of the optimism. In this case, it pertained to reopening, reflation, as well as bringing the sidelined workers back into the market. And now the market finds itself in the uncomfortable situation of continuing to look toward the economic data, not for the next trading impetus, but rather to justify the repricing that we saw in the first quarter. And frankly, that's a high bar.

Ben Jeffery:

I would actually argue, following the string of data we've seen, higher than expected CPI, a million plus NFP report, the highest ISM services read on record, all of those factors kept 10-year yields above 150. Had we seen a meaningful disappointment on several, or maybe even one of those figures, the optimism that got 10s to 175 would have come under even greater scrutiny. So to me, the first quarter, the GDP print included, has really offered the hard evidence that investors were looking for during the first quarter when we got that impressive sell off. And I completely agree with you, Ian, that means that the bar is definitively raised for the next leg of the sell-off, now that the impulse of not only the initial wave of reopenings, but also fiscal stimulus has played out to a degree.

Ian Lyngen:

The next important stage that the market is poised to embark on right now is that of a further refinement of the understanding that we have of the Fed's reaction function at this particular point in the cycle. That seems somewhat glib. But the fact of the matter is investors continue to trade the new Fed the same as the old Fed, and that's eventually going to become problematic. So simply looking at the most recent FOMC meeting and Powell's comments about, "We're not even close to the conversation about tapering," that conflicts with a lot of the market chatter in the run-up to the April meeting.

Ian Lyngen:

We continue to see the path of least resistance as the Fed implementing a taper of QE purchases in the first quarter of 2022, with the second half of this year containing the initial trial balloon signaling and then the official announcement that the change will commence with the new year. There's a reasonable amount of disagreement in terms of the precise timing. What I will say, however, is most people generally agree on the sequencing. Specifically, early hints, then the official announcement followed by tapering, and then after balance sheet expanding QE has ceased, there'll be a few months, whether that's three or six remains to be seen, until the liftoff rate hike.

Ben Jeffery:

I have to give you credit for a point you made this week after the FOMC, that was less dumb than usual.

Ian Lyngen:

Wait, wait, wait. Less dumb? Don't worry, bonus season isn't for awhile.

Ben Jeffery:

Thank goodness. The point you made was on Powell's language surrounding what he defines as "substantial, further progress". The chair went as far as to explicitly say, "That since the December meeting, what we've seen in terms of the real economic rebound does not even come close to what they define as substantial, further progress, and we remain a great distance from achieving the Fed's goals." Now, you aptly and not too glibly pointed out that, for better or worse, substantial, further progress is defined by the Fed. So the notion that we'll know it when we get there as defined by the FOMC really gives monetary policy makers the flexibility to keep the backdrop extremely accommodative for a very long time. In a way, because they're kind of making the rules.

Ian Lyngen:

Well, I would say that they're definitively making the rules and that also applies to their characterization of some of the pockets of inflation that we are starting to see and we'll continue to see as the second quarter plays out. The age old riddle, "When is transitory no longer transitory?" When Powell says it's not. I think it's really apropos at this moment because the Fed is at the helm of the proverbial economic ship at this moment, and is making that transition that I continue to reference from the old framework into one of average inflation targeting. And by definition, when a central bank focuses on an average for the inflation target, that implies a degree of comfort with being behind the curve. And that's what investors are grappling with at this moment.

Ben Jeffery:

Turning away from what we learned from this week's FOMC meeting, we also did get the first look at Q1 GDP, which somewhat unsurprisingly was driven in large part by what's been a vestige of the pandemic and that is an impressive performance by goods consumption. In the first quarter, a great deal of that gain can be attributed to stimulus checks, but it's going to be very relevant to see how the balance between goods and services spending plays out as we get further into the new normal.

Ian Lyngen:

Ben, you highlight one of the important risks as we see the year playing out, that's that a lot of the spending patterns that were established during the pandemic end up being a lot more permanent than investors are expecting. So specifically, favoring goods over services will make it difficult for the service sector to rebound. It will make it challenging to find service sector inflation. And more importantly, it will keep the sidelined workers who are initially displaced by the pandemic out of the labor force for the time being.

Ben Jeffery:

On something of a related note to fiscal stimulus and the Treasury Department's ongoing endeavors to fund the deficit, we do also have the May refunding this week. Wednesday morning, Yellen's Treasury Department will update investors on how they're approaching the issuance landscape, and while coupon auction sizes are broadly expected to remain unchanged for the next quarter, we are reaching a point when estimates are being refined on when coupon sizes will need to be coming down, as spending on the part of Washington is shifting away from growing the deficit and toward raising taxes.

Ben Jeffery:

Outside of coup sizes, specifically, it's also going to be very relevant to see how the Treasury Department is thinking about the situation in the front end. There remains a very heavy supply of cash, which has pushed funding costs below zero and triggered a meaningful spike in uptake at the Fed's reverse repo facility. We saw 174 billion in one day usage during this past week and a four week bill auction that stopped at 0.000 for the first time since March of last year. So clearly, whether it be the administered rates or bill supply, there's a lot of moving parts in the very front end of the curve that need to be addressed. That will be a space that's closely watched, in addition to outright Treasury note and bond auction sizes.

Ian Lyngen:

It also puts into an important context, what we have seen in terms of demand for Treasury supply over the course of the year. We're coming off of six consecutive weeks of net Japanese buying of overseas notes and bonds, when frankly, Treasury yields were towards the upper end of the range. The question then becomes, if we continue to see Treasuries on a hedged back to yen basis, you being over 150 basis points, will the shifting economic sentiment lead to even more aggressive buying from overseas, or where will we find ourselves in a situation where pockets of high local savings end up going into local bond markets? That's one of the uncertainties that we're pondering as the year plays out.

Ian Lyngen:

Another key dynamic in the Treasury market, that if nothing else this last week has certainly reinforced, and that is that U.S. Treasury yields are not set by the domestic growth and inflation fundamentals. If we were having this podcast 30 years ago, A, it would be called a conference call, and B, we would be talking about how supply and demand doesn't influence the outright level of Treasuries as much as the domestic growth and inflation outlook. Fast forward to 2021 and what we see is because of the globalization of financial markets and the Fed and the dollar's role in the global economy, the U.S. risk-free rate relies more heavily on the global outlook for growth and inflation than any one country or region in particular. That's something that goes a long way to explaining, for example, why the Taylor rule doesn't work in this current environment, and you can have real GDP at roughly 6.5%, inflation above 2%, and 10-year yields stubbornly below 2%.

Ben Jeffery:

This ties in well to another question that we've been getting a lot, which is, while yes, there still remains a lot of slack in the labor market, another impact of the pandemic has been meaningfully elevated household savings, not just in the U.S. but Europe, Japan as well. So, from an inflationary perspective, does this introduce the risk that once households are able to deploy these pent up savings, they will, and that will translate to even further upside in consumption-driven price pressures?

Ian Lyngen:

Well, if we look at the composition of spending in the U.S., roughly 66% of it is on services and 34% of it is on goods. Now, this breakdown has been skewed toward the goods side during the pandemic, but the composition does speak to the importance of seeing service side inflation come back into the system. So envisioning a situation where we see a spike in the savings rate, as we did with the March data, one should expect that rate to decrease over time while some of that savings is deployed and the income numbers come back in line with historic standards, i.e., not impacted by government stimulus.

Ian Lyngen:

I'd also like to make the point that we've transitioned to a large extent from a situation where Washington's efforts were directly additive to real GDP. We saw that in the case of fiscal bailout, 1.0, 2.0, and 3.0, but now as we move toward infrastructure, education and taxation debates, it becomes less obvious that there's any near-term upside for real growth coming out of Washington. In fact, the tax aspects of it will be more troubling and potentially make firms more reluctant to quickly add back workers as we transition into a post pandemic world.

Ben Jeffery:

All of this really serves to reinforce our more constructive take on Treasuries over the balance of the year, more near-term over the next several weeks, maybe month. There's also something I'd like to highlight that also reinforces 177 as the top of the trading range in 10-year yields, that is the persistent short base we've seen in several of the top tier survey measures that shows real money accounts are still bearish on duration. So in practical terms, what that suggests is that in the event we do get back to 175 10-year yields, or even maybe slightly beyond, there's going to be profit taking along the way that impedes a truly substantial move. Conversely, should we see a meaningful drop in yields, any forced closure of those positions would only add a tailwind to a rally, which I'm content to call a brief positional skew that's a bit bullishly asymmetric.

Ian Lyngen:

My takeaway from that entire analysis is that we're at home, home on a range.

Ben Jeffery:

Where the bulls and inflationists trade.

Ian Lyngen:

And seldom is heard a hawkish word.

Ben Jeffery:

And Powell keeps policy easy all day.

Ian Lyngen:

So bad, it's good.

Ian Lyngen:

In the week ahead, the marquee data will be Friday's non-farm payrolls print for the month of April. The consensus is for 950,000 jobs on the headline number, with the unemployment rate dropping to 5.8% and average hourly earnings increasing one-tenth of a percent. There will be other data to trade in the run-up to NFP, but to a large extent, they're contributors to estimates for NFP. For example, ADP or the challenger data, or even the ISM series will help the market get a better gauge for what hiring looked like as the second quarter got underway.

Ian Lyngen:

In terms of the near-term direction of Treasury yields, the fact that the market was unable to break the 160 to 170 range in 10-year yields, despite the strong GDP print as well as the three-tenths of a percent core PCE number for March, speaks to this notion that the upper bound for 10-year yields has been set for the time being and that comes in at 177. It's not inconceivable to imagine a series of economic data that challenges the upper bound, but it won't be a million in FP print. It would have to start with a two handle and be associated with a much more impressive decline in the unemployment rate. That isn't to negate how impressive the numbers most likely will be, but rather, it's simply an acknowledgement of what's currently priced into the market.

Ian Lyngen:

And as we progress through the balance of 2021, it's important to keep in mind that the debate of what is versus what is not priced in, or omnipresent throughout the history of markets, is particularly meaningful at this moment because we're in uncharted territory. We're coming out of the pandemic and the market as a whole simply lacks context for the magnitude of the numbers that we are going to see. A million non-farm payrolls print is a staggering number by historic standards, if you back out what we saw at the beginning of the pandemic when all the jobs were lost.

Ian Lyngen:

This is also very consistent with the market's apparent indifference toward numbers of this magnitude as they hit the tapes. We have, as a market, transitioned to a stage where stronger than expected data is almost expected. That creates a symmetry of risks as we think about the rest of the second quarter. Said differently, the market will be happy to dismiss higher than expected prints as long as they're within a reasonable range as forecasting error, whereas any under-performance of node will bring into question the reopening reflationary narrative. As that pertains to the direction of rates, this is consistent with the 177 mark in the upper bound for rates for the time being, and also fits well with the traditional seasonal patterns that tend to favor a grind lower in rates in the wake of the May refunding, up until roughly the middle of September. We expect that this will, once again, provide a rough approximation for the directionality, if not the magnitude of the moves that we'll see over the summer months.

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. Not only do we remain impressed that our producers have yet to pull the plug on Macro Horizons, but we recently received an invitation to audition for the Treasury Department's ad campaign. Fear not, radio only. As the world's least interesting man, our agents say that we were born for the role.

Ian Lyngen:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macro horizons. 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 Podcasts or your favorite podcast provider. 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.

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 a suggestion that any investment or strategy referenced herein may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients.

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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