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Running of the Bears - The Week Ahead

FICC Podcasts June 24, 2022
FICC Podcasts June 24, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of June 27th, 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 177, running of the bears 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 June 27. The pendulum of sentiment has swung from the hawkishness that got tens to 3.50 to the latest pit as the benchmark grinds back toward a two handle. Even Poe would be scared of these markets. Now, where did Ben and Powell go with that Amatiato?

Ben Jeffery:

Just a few more bricks.

Speaker 3:

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, this 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 was once again the star of the show. Following last week's FOMC rate decision in which the chair came out with a decidedly hawkish stance to say nothing to the fact that the Fed moved 75 as opposed to the 50 basis points, that at one point prior to the last CPI print had been the consensus. The Fed also emphasized the importance of normalizing rates, both from the perspective of longer term price stability, but also to encourage the correct level of demand in the labor market.

Ian Lyngen:

Powell then subsequently followed up with a congressional testimony that introduced the idea that a recession certainly is a possibility and engineering a soft landing is "very challenging". The resulting price action was initially a selloff that brought 10 year yields as high as 3.50 and subsequently a rally that saw 10 year yields as low as 3%, putting two handle tens decidedly on the radar. In the interim, we had several auctions, including the $14 billion 20 year, which was taken down with relative ease, certainly all things considered.

Ian Lyngen:

There's no question that the primary driver of all financial markets at this moment is calculating the appropriate level of risk to assume that the US is slipping into a recession, or more accurately, the probability that one occurs over the course of the next 12 months. There have been several estimates bantered around anywhere between 35 and 75% in terms of a probability. All else being equal, the Fed would not like to be responsible for the next recession. Although Powell has made it very clear that the Fed is down to one mandate of relevance, and that is lowering inflation expectations and returning inflation to the 2% target.

Ian Lyngen:

It's certainly striking that while a hawkish monetary policy stance would intuitively push rates higher. The acknowledgement of the risks associated with said hawkishness were ultimately responsible for pushing rates lower. So the Fed didn't necessarily change its stance. Rather, a more thorough explanation of the risks such as that given by Powell to Congress was ultimately responsible for shifting sentiment in financial markets. The shape of the yield curve responded accordingly flattening in the run up to the FOMC, re-steepening a bit as Treasuries sold off and then subsequently re-flattening in the week just passed.

Ian Lyngen:

We remain on board with a longer term flattening and a deeper curve inversion, and also take a reasonable amount of solace in the fact that rates appear to be converging closer to a two handle than they did in the middle of June. The extent to which the curve can ultimately invert, and more importantly, the duration of that inversion will be very topical in the weeks ahead, especially in the run up to the next FOMC meeting. In this context, we're biased for 2s/10s to drop below zero with an initial target of 9.7 basis points and for such a move to be sustained in the run up to, and even through the July FOMC meeting. After all, the Fed has committed to at least delivering 50 basis points next month, if not putting another 75 basis point hike on the table.

Ben Jeffery:

So the week of the Fed was an unequivocally hawkish one. We got 10 year yields up to 3.50, twos not far behind that. But this week it was the reverse. Powell's semi-annual testimony to Congress was interpreted as much more cautious than what we heard at the meeting itself. And now there's growing questions on if the Fed is actually going to deliver on what it's promised, given all the worries about a recession. And now tens have fallen back to effectively 3%, a 50 bp round trip.

Ian Lyngen:

Yes, it has been a remarkably choppy period in terms of price action in the Treasury market. If nothing else, our call does find a bit of solace in the notion that at least for the moment, all yields appear to be converging at a level that is below 3%. Now, time will tell. And so far as it relates to the performance of risk assets and whether or not that will ultimately serve as a deterrent for the Fed to deliver on its full tightening cycle.

Ian Lyngen:

I'd add a nuance to your observation, Ben, regarding the hawkishness around the FOMC. And then the subsequent tone of the chair's testimony in front of the Senate Banking Committee. Specifically, Powell was unquestionably hawkish with the 75 basis point hike and subsequent press conference, but I'll argue that he was not any less hawkish when he spoke in front of Congress, rather that he took the time to articulate the downside risks associated with the degree of hawkishness that the Fed is now engaged in. Said differently, he acknowledged the fact that the Fed might inadvertently hike so far that it tips the US economy into a recession. And implicitly, and this is I think, where the real nuance comes in, Powell's okay with that.

Ben Jeffery:

And a big reason why Powell and presumably the Fed more broadly is okay with that is the current state of the labor market, and more importantly, from an inflationary perspective, nominal wages that continue to climb at an impressive rate. By many measures, the jobs market is too tight. And Powell has gone as far to say that he would be comfortable with a modestly higher unemployment rate. Something, I think the argument could be made that we're starting to see within the initial jobless claims figures. This past week, initial filers rose again to their highest level since January of this year. And that inflection has been gradual thus far. And presumably, it's that type of modest increase in unemployment that the Fed is pursuing if only to prevent a wage inflation spiral.

Ben Jeffery:

So with this backdrop, while yes, back to back quarters of negative real growth would technically be a recession, in the current environment nominal output is still very strong. The fact that real growth is negative is simply a result of the deflator. This combined with the state of the jobs market is the main reason why the Fed optically doesn't seem to care that we're going into a recession.

Ian Lyngen:

On the topic of deflator, have you seen the equity market?

Ben Jeffery:

I try not to look.

Ian Lyngen:

And at this point you're not alone. The reality is that equities continue to come off the highs. And the Fed, consistent with the notion that they're willing to accept the slowdown in the real economy, appears content to see asset valuations drift lower. Now, Ben, you made a great point about the Fed, wanting to see a higher unemployment rate in this environment. My concern, and I think it's one that is shared by investors in the Treasury market, is what we are seeing is the beginning of the fallout from monetary policy tightening that has occurred thus far or rather the removal of accommodation. And the open question is, has the FOMC calibrated the removal of accommodation appropriately? I'm very confident in the Fed's ability to increase the unemployment rate from 3.5 to 4.5. I'm far less confident in their ability to stop the increase at 4.5.

Ben Jeffery:

And that's really been something that's dominated the conversations we've had with clients this week. Whereas not all that long ago, the criticisms pointed at the Fed were more of the behind the curve variety, not doing enough to fight inflation, they should go by 50, they should go by 75. Now, the narrative has swung sharply in the other direction. Maybe they're being too aggressive. After all, none of the tightening they've executed so far has flowed through with any material impact on the inflation data. And so the notion that the Fed should be more patient and giving the data the opportunity to respond without over tightening resonates, but the difference between should and will, I think is very important in this context, and is why we still have the curve back in positive territory, but still very, very flat.

Ian Lyngen:

And we would expect that curve flattening bias to continue a dip below zero on 2s/10s once again, for a more sustainable inversion remains our baseline assumption for the period between now and the July FOMC meeting. In terms of this particular rate hiking cycle, there are two things to keep in mind that might help inform expectations going forward. First, Ben, as you point out, there is a significant lag between monetary policy action and when the fallout is evident in the economic data. Second, the type of inflation that is currently making its way through the US economy, and to some extent, the global economy is not the type of inflation that resulted directly from an accommodative monetary policy stance. Instead, it can be attributed to dislocations created by the pandemic as well as very large fiscal efforts on the part of Washington.

Ian Lyngen:

So with this backdrop, we continue to think that the Fed looked at the inflation environment, looked at what the market was pricing in in terms of how aggressive they needed to be to offset inflation and said, "Oh, we don't want to be in the business of buying bonds, we don't want to keep rates at zero, so we're going to opportunistically take this window to begin the process of normalizing rates." Now, our baseline assumption remains that the Fed is going to continue to hike rates until something breaks. The biggest unknown at this moment isn't what's going to break, but rather how broken does it need to get the Fed to change course?

Ben Jeffery:

And the way you characterize the Fed is taking the opportunity the market presented in delivering that 75 basis point hike is important to consider in the other direction as well, especially now that we've seen the Euro dollar in Fed funds futures markets move to reflect the expectation that policy rates are going to be coming down in the later part of 2023, early 2024. It was only last week that we saw some forward contracts in the 1-year/1-year space reach 4%. Now, those are back down to 3.50, 3.60.

Ben Jeffery:

So the moderation of assumptions of how high terminal will ultimately be, given all this recessionary worry, opens the door to the inverse of the reaction function that we talked about when the Fed was getting ready to hike, which is that while the market can allow the Fed to hike and hike for the Fed, the market can also force the Fed to ease by pricing in rate cuts further out the curve that if aren't ultimately delivered, would push financial conditions even tighter. And in the current environment with the S&P 500 in a bear market, that's coming from a particularly troubling departure point.

Ian Lyngen:

Well, Ben, as the classic adage goes, the Fed hikes, the market eases. I think that this particular episode is somewhat complicated, given the relevance of inflation, not only to the Fed, but also given the outright amount of consumer price inflation there is in the system, it has become very politicized. So in that context, the period between now and the midterm elections, I think will be very challenging for the FOMC. They're going to need to continue to deliver something in terms of rate hikes and a moderation of the pace of the increases could be seen as politically unattractive.

Ben Jeffery:

And I just want to reiterate something, Ian, that you and I have emphasized previously about this hiking cycle in particular. And that is, given the aggressiveness that the Fed has set out in raising rates, we've gotten a half point hike, a 75 basis point hike at consecutive meetings following the initial liftoff. Powell has now afforded the FOMC the flexibility to be "dovish" while still raising rates. So even a slower pace of hikes at 50 basis points every meeting would be interpreted as acknowledging the market's response to the rate hikes and offering a less aggressive stance in the slower removal of accommodation. 50 basis points every meeting, 25 basis points every meeting are still multiples of the pace that we saw rates rise from 2016 through 2018, not to mention the fact that the balance sheet rundown is only just beginning and all of those factors will have an accretive impact on the overall economy.

Ben Jeffery:

So before the Fed will pause, they will move to 25 basis points every meeting or even 25 basis points every quarter. It's that transition that I suspect will be the most relevant inflection point that we see start to be communicated toward the end of this year.

Ian Lyngen:

So the question then becomes, what does that do to the curve? Is that just a bull steepener or does it imply a lower terminal rate as well, which would suggest parallel shift lowering rates?

Ben Jeffery:

Certainly.

Ian Lyngen:

One or the other. One thing that it doesn't suggest is that we're going to see a straight shot in 10-year yields to the land of the four handle. In fact, what we have seen in terms of price action and the behavior of market participants over the course of the last week implies to us at least that the 3.5% level should function as the effective upper bound for 10-year yields for the bulk of the cycle. Now, in our efforts to be intellectually honest, I'll be the first to acknowledge that I said the same thing at 3.20.

Ben Jeffery:

And in terms of the timing about when we might see 3.20 revisited, 3.50 re-challenged or even maybe broken before the end of the year, we've gotten a lot of questions on now that we've gotten this rally, what's the next catalyst going to be for the next big selloff? And for better or worse, investors are probably going to have to wait till July 13 when we get June's inflation data. And clearly, any strength there that was reminiscent of what we saw for the last CPI print would be traded as a green light for the Fed to deliver 75 basis points in July. And I would argue maybe even the probability of pricing in the 100 basis points. After all, Powell refused to take that off the table in front of the Senate Banking Committee. And given what we saw in the lead up to the last hike, the market is clearly willing to price more than the Fed has communicated, granted that was a lot higher in the S&P 500, but still something to think about.

Ian Lyngen:

Not only was it a lot higher in equity evaluations, but it was also a lot easier in terms of overall financial conditions. And I think that, that's what the Fed is running up against and will ultimately limit their hiking ambitions. What will be more interesting to see is how quickly it all takes to play out. The eagerness with which they communicated via the financial media, that the last CPI print was enough to put 75 basis points on the table, certainly brought with it a sense of angst in terms of the perception that the Fed acknowledges they might be even further behind the curve than previously assumed. We'll be watching very closely for incoming Fed commentary, not just from the chair, but also from other Fed speakers as monetary policy makers try to re-craft the message, at least on the margin to allow for the amount of flexibility they might want to have embedded in the rate outlook between now and the end of the year.

Ben Jeffery:

Dare I say some good old fashioned data dependence?

Ian Lyngen:

Do I get a write off for that?

Ben Jeffery:

No, but we'll give you a credit.

Ian Lyngen:

I see what you did there. In the week ahead, we anticipate the price action itself will be the big story. We do have several rounds of economic data of relevance, not least of which being durable goods for May, that prints on Monday, followed by consumer confidence and Case-Shiller on Tuesday. We do have the third revisions to the first quarter's GDP unlikely to be market moving. But the highlight in terms of data will be Thursday's core PCE numbers. As it currently stands, inflation is expected to increase half a percent in the month of May consistent with the upside surprise realized in the May CPI data.

Ian Lyngen:

We'll be attuned to any information coming out of the Fed as it relates to an attempt to dial back the Fed's hawkishness. Now, given that Powell has doubled down on the relevance of continuing to normalize rates, we struggle to imagine that the Fed will deliver anything more than a very, very subtle shift as it relates to the pace of rate hikes. But nonetheless, given how topical the issue is at the moment, we anticipate that any nuance offered by the Fed could be potentially market moving.

Ian Lyngen:

In terms of flows, dip buyers have been conspicuously absent throughout much of 2022. Now, the recent 50 basis point rally in tens not withstanding, we continue to look for evidence that the core buyers from Japan, for example, have re-engaged in an attempt to join the rally in Treasuries. Hedging costs have made participation from many Tokyo accounts prohibitively expensive. And given the run in the yen, we don't see that changing anytime soon. If we did see an extended period of stabilization in the yen, that could shift this dynamic, at least on the margin and encourage some dip buying.

Ian Lyngen:

The first leg of the recent rally off the lows has a lot more to do with short covering than it does with accounts actively getting long duration. It's a process of accounts actively going long that we anticipate will bring 10 year yields through 3% and closer to the target of 2.5 that we expect will be realized at some point over the summer months. We'll be the first to acknowledge that this is somewhat off consensus, but not inconsistent with where we are in the cycle, nor inconsistent with the Fed's recessionary warnings.

Ian Lyngen:

It's tempting to suggest that the holiday shortened week ahead will limit participation and create a lower volume profile overall. That said, recent summer trading months certainly have not followed that more traditional dynamic. So we're reluctant to anticipate that the week ahead won't be fully staffed nor have full participation, and therefore, commitment behind any price action that ultimately occurs.

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. While the cadence of the long weekends to kick off the summer has been a welcome development in the bond market, we'll take it one step further and suggest mandatory gray dots between Memorial Day and Labor Day. Yellow was never our color anyway, and blue, well, just made us blue.

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 podcasts 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.

Speaker 3:

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.

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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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