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Shelter Caused the Storm - The Week Ahead

FICC Podcasts Podcasts October 14, 2022
FICC Podcasts Podcasts October 14, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of October 17th, 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 193 Shelter Caused the Storm 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 October 17th. And on the topic of things that end too quickly, we have celebrity marriages, the Macro Horizons disclaimer, 4% 10-year yields, and the UK exchequer post. It was an eventful and memorable 38 days. Thanks for your service.

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.

In the week just past the majority of the selling pressure early in the week was triggered by the situation in London. On the fiscal side, the potential for tax cuts led to a very significant selloff in the longer end of the gilt curve. However, the Bank of England had established a new program to intervene to buy longer dated gilts.

Now, initially that program was 5 billion pounds a day, but on Monday when the US market was closed, that amount was increased to 10 billion pounds a day and on Tuesday the program was expanded to include linkers or British TIPS as we call them. What we then saw was some stabilization in the gilt market. However, the upward pressure on 30-year gilt brought the benchmark as high as 5% and it has contributed to the upward pressure in U.S rates. We also saw headline and core PPI as well as headline and core CPI print higher than anticipated and this has focused the market on the outlook for the November and December rate hikes. Our baseline expectation had been 75 in November, 50 in December, and then 25 in February bringing the effective Fed funds rate to 4.6%. This was consistent with what the Fed's projections indicated and frankly pretty consensus.

At the beginning of the week just past however, there was chatter about a dovish pivot to address the strains in the overall financial system that have emerged. However, the September CPI print has effectively taken that off of the table. So 75 basis points in November remains our base case. We expect it to be a definitively hawkish hike and since we'll still have two more inflation reports between now and the December hike, we're holding the 50 basis point assumption for the time being with a nod to the fact that what might ultimately lead to a dovish pivot won't be the data, but it could be related to market functioning and asset valuations. The FOMC has been content with the sell-off in equities that we have seen thus far in 2022, which has brought the S&P 500 down 25% year to date. And to a large part, monetary policy makers have been content to see this repricing because it's occurred in a relatively orderly fashion.

In the event that the selloff picks up momentum and the repricing becomes even more dramatic, we'd look for an increase in realized volatility to tighten financial conditions even further. And depending on the trajectory of the move and whether or not there's contagion into credit markets or other markets more broadly, that could lay the groundwork for a less hawkish skew in December. But for the time being, our baseline assumption is that in three weeks’ time we will get another 75 basis point move and an official statement and press conference that reinforces there is more work to be done.

Ben Jeffery:

So it was the CPI print we've all been waiting for and once again, consumer prices rose more than expectations in September. The reaction in treasuries got us quickly through that 4% level in 10 year yields and the benchmark of all benchmarks got to as high as 4.075 before a large round of dip buying ultimately brought yields back below 3.90.

Ian Lyngen:

That 4% level was always going to be an inflection point for investors and as we move forward with more rate hikes, it will be interesting to see if in fact 4% is defended. Our baseline assumption is that it'll be difficult to sustainably trade above 4% in tens as long as the FOMC is actively battling inflation and the more inflation that we get, the more rate hikes or the greater certainty around the rate hikes already signaled by the S&P that will develop. As a result it was unsurprising to see the twos tens curve flatten back to negative 54 basis points. We're continuing to watch a negative 58 basis point level, a breach of which would show very little resistance between negative 58 and negative 75. A space to watch if nothing else.

Ben Jeffery:

And helping to explain the price action were some of the compositional factors of the actual CPI figures and what we saw both in rents and owner's equivalent rents both climbing an impressive eight tenths of a percent month over month. Just those two categories accounted for nearly 60% of the overall increase in core inflation. And given what we know about A, the lagged impact of mortgage rates on real estate prices and B, the additional lag of actual real estate prices into the OER series, this means that it's not particularly surprising that OER is continuing to accelerate but more topical for the path of inflation over the course of the next year, we're reaching the point when one should expect that OER is going to start to moderate. Now this certainly doesn't mean we're going to be in for negative month over month prints on the housing front. It also means we're not going to keep climbing at eight tenths of a percent month over month and what that means for the overall level of core inflation that reached its highest level on a year over year basis since August 1982.

Ian Lyngen:

One question that we've received from clients this week was what happens if the Fed is unable to control the type of inflation that appears to be working its way through the system? Ben, as you pointed out, shelter really is causing the storm as it were on the inflation front and we know that there's a lag impact not only of monetary policy but also of the moves in housing prices.

Moreover, as affordability starts to become an issue and potential home buyers are priced out rolling into the rental market, we've seen rents start to increase as well. So contemplating a situation where the Fed continues to hike but shelter as a pillar of inflation doesn't moderate the Fed will be faced with some very hard choices frankly. The Fed can get inflation down by destroying enough demand that other prices come under pressure. That's clearly a non-ideal situation for Powell, but nonetheless, if the FOMC is going to continue to hold that 2% inflation target and wants to keep forward inflation expectations well anchored, it might prove to be a much bumpier ride between now and the point in which the Fed is satisfied with the progress made in the battle against inflation.

Ben Jeffery:

And as we continue to think about what size December's hike will ultimately end up being, at this point 75 in November is all but guaranteed. And a conversation we had this week, the hypothetical was offered what if we are in for a repeat of what we saw at the end of the last hiking cycle and that the December rate raise was viewed as a hike too far by equity markets and December was defined by plunging stocks in this case from an already troublingly low level surging tighter financial conditions and the risk that the market narrative shifts to the concern that the Fed is overdoing it.

Now, Ian, as you and I have talked about before, unlike in 2018 when a 20% correction from the highs in the S&P 500 was what it took to get the Fed to blink, that potential pivot point is much further from the all-time highs than 20%. The S&P is already off 25% year to date and frankly I would argue it wouldn't be until we see another 10 or even 15% down trade in stocks that the surge in volatility would become severe enough for the Fed to think about changing course. And in this context changing course wouldn't be introducing rate cuts, it would maybe just be not delivering that final 25 basis point hike or two in the early part of next year.

Ian Lyngen:

I for one certainly do have my S&P 500, 3000 cap on. I think that the move that we have seen thus far in equities hasn't been sufficient for the Fed to change course and as you point out Ben, it's a reasonable concern that December might be a very difficult month for the equity markets. In fact, to some extent that's almost our base case scenario. Not so much that we have a massive repricing lower in US equities, but rather that as we move forward in the cycle, the ramifications for the global economy become much more relevant and flight to quality drives the 10 year yield lower. Now our conviction on that particular dynamic is relatively high, although the precise timing into yearend is going to be a much bigger uncertainty. Another client question we received this week was, given the upward surprise in CPI and the ongoing strength in the labor market, is it even possible for the Fed to pivot between now and the end of this year and how could this environment not see higher rather than lower 10 year yields?

While that is certainly a valid concern, it's worth highlighting a particularly unique aspect of this cycle. Prior to the pandemic, the Fed was considered and rightfully so, the de facto central bank to the world. Since the pandemic and the massive amount of inflation that the U.S has seen, the Fed's focus has shifted from the global economy to the U.S and in that process not only from a dual mandate but for all intents and purposes to a single mandate, and that is the Fed is fighting U.S. inflation at all costs. And what we have seen is that as the dollar strength has persisted, the other central banks have needed to at least attempt to catch up with the moves from the Fed and that is going to have longer term ramifications for Europe, for example, for the UK comes to mind and it's that uncertainty that we ultimately anticipate will drive a bid for duration.

The caveat is that we're all too aware that it's very tempting to look at 10 year yields as nothing more than a combination of growth and inflation expectations in the US. Now, had we been doing this podcast 20 years ago, we'd probably be shipping it out on vinyl, but we'd also be making the argument that two year yields are a function of near term monetary policy expectations and 10- and 30-year yields are set by U.S growth and inflation expectations. Fast forward to 2022, what's driving the longer end of the curve is not in fact solely the US economy as ownership of treasuries has become more globalized and the economy itself has tinted toward globalization certainly over the last 20 years. But the reality is that 10- and 30-year yields are primarily dictated by global growth and inflation expectations. And as the Fed effectively hikes the rest of the world into a recession, a bid for duration will ultimately emerge.

Ben Jeffery:

And so why then don't we expect tens are going to rally to 2% even through 2% back to a one handle? What I would say is what makes this cycle definitely different than what we've seen over the past several monetary policy cycles is that along with the Fed aggressively raising rates, almost universally other developed markets, central banks are also raising rates. The Bank of England, the Bank of Canada, and even the ECB have all lifted their policy rates, which in turn has buoyed their own sovereign debt market yields. And that's why unlike a historical flight to quality episode when rates were still effectively at zero in Europe now the fact that there is some yield to be offered and bunds, OATS, gilts and Canadas the outright level that 10 yields will be able to reach in the most bullish example is a bit higher than one would have otherwise expected had we not seen such widespread global hawkishness.

Now of course, the one exception to this is the Bank of Japan and based off everything we've heard from policymakers in Tokyo, there is very little appetite to lessen the accommodative stance from the BOJ. We've seen what that's done to the yen and more importantly for the treasury market. The weekly Ministry of Finance data over this past week showed another impressive week of net selling of foreign notes and bonds of $11.8 billion. That's the fifth consecutive week of outflows. And in terms of a single week's worth of selling pressure, the largest we've seen since the end of June, clearly a large driver of the bearishness we're seeing in treasuries remains the absence of Japanese buyers and actual selling pressure of Japanese investors as well. And as we approach the end of this tightening cycle and presumably some of the dollar strength and overall volatility moderates, we expect that Japanese investors but also foreign investors generally will start to become more active dip buyers and treasuries.

Ian Lyngen:

Let us not forget that another key investor base in treasuries have been missing this year and that's domestic banks. We haven't seen banks buying treasuries in any meaningful size, and part of that has to do with the SLR regulations and the reserve capital that's required to own treasuries. But part of it is also the fact that there's been so much uncertainty associated with inflation and where the Fed is ultimately going to need to hike rates. And as a result, domestic banks have also been absent in the mortgage market. So in short, there's capital on the sidelines that has yet to be deployed. And when there is a sufficient flight to quality impulse, we expect that that capital will ultimately be employed and that treasuries will be the beneficiary.

Ben Jeffery:

And related to that line of thinking is also what we heard from Secretary Yellen this week about her concern around sufficient liquidity in the treasury market. At this point, it's still too soon to expect the Fed to do anything similar to what the Bank of England did in terms of supporting treasury liquidity. However, the fact that Yellen went as far as to address the issue in a speech this past week suggests that there could be some regulatory changes that allows banks to provide more ample liquidity or as we saw in the August refunding documents, an ongoing study on the potential for treasury to buy back some off the run securities as a means to reduce the deficit but also improve market functioning. This certainly isn't something that's going to be resolved in the very near term, but particularly as liquidity remains poor is definitely something to keep in mind as a background factor as we continue to watch the volatile price action play out.

Ian Lyngen:

Speaking of liquidity concerns, I suppose, Kwasi’s at the pub

In the week ahead, the treasury market will have very little supply with which to contend. We have the 20-year nominal auction at $12 billion and $21 billion in five-year TIPS. Beyond that, the data calendar is comparatively light, certainly given last week's inflation update. We do see the Empire manufacturing figures on Monday as well as Cap U and IP on Tuesday. Ultimately, however, we expect that the bulk of investor attention will be focused on at least initially, the situation in London and the prospects for a more dramatic selloff in gilts as the Bank of England's emergency bond buying program further out the curve winds down. Now there's an argument to be made that since they could so easily re-implement the 10 billion pound a day purchase program, that there will develop a sense of calm in the gilt market. For the time being. However, the verdict is very much still out in this regard.

We do have a few fed speakers of relevance in the week ahead, Bostic, Kashkari on Tuesday followed by Kashkari, Evans, and Bullard on Wednesday, and then Williams to round out the week on Friday. Of those, the two voters are Bullard and Williams and given investors willingness to trade off of comments from both of those monetary policy makers will be attuned for any additional information that would help the market skew the possibility of another 75 basis point hike in December, as well as the November 75 that we're already anticipating. While the upside surprise in core CPI was appropriately traded as a flattener in the treasury market, we'll caution against assuming that a hundred basis point rate hike should be on the table for November. That surely won't stop the market from attempting to price that in. Nonetheless, the Fed has made it very clear that they're defining a jumbo rate hike as 75, and perhaps that's jumbo enough.

We're certainly cognizant of the potential need for more 75 basis point moves, especially given these stubbornly high core CPI numbers. It is notable that within the CPI series, the majority of the monthly gain has been a function of housing, whether it's OER or rents, and that's relevant given the delay with which home prices and rent costs flow through to realized CPI, the Fed was surely somewhat concerned to see the increase in the University of Michigan's inflation expectation numbers. The trend had been convincingly lower up until the October print, and as a result, it goes without saying it is going to be a very tense period in the treasury market between now and the November 2nd FOMC meeting.

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 we struggle to find a compelling explanation for the post CPI stock market rally, we are reminded of the time tested adage, if you don't know who the sucker at the table is, it's time to change tables.

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:

The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

 

Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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