Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

Short Week, Good Week - The Week Ahead

FICC Podcasts November 05, 2021
FICC Podcasts November 05, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 8th, 2021, and respond to questions submitted by listeners and clients.



Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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.

Podcast Disclaimer

Read more

Ian Lyngen:

This is Macro Horizons, episode 145, Short Week, Good Week, 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 November 8th. As we look forward to Thursday's bond market holiday, we'd like to offer a nod to SIFMA and a thanks for allowing us to not work from home. Sorry, equities.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its 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 past, there were several meaningful developments that helped to contribute to the markets' broader understanding of the macro landscape. Most notably was the FOMCs decision to follow through with a tapering announcement. The market received the widely anticipated information that QE will be cut by $15 billion a month, which makes June the estimated last month for balance sheet expanding bond buying. While this was very consensus, we also saw what we'll characterize as a dovish taper. And by that we simply mean that the Fed chose to emphasize that, while the threshold for winding down QE has been achieved on the employment front, the same cannot be said about the threshold for rate hikes.

Ian Lyngen:

That distinction came at an important time, as we've seen some relatively hawkish pivots from other major central banks, not least of which being the Bank of England, as well as the RBA and the Bank of Canada. All this has brought up the obvious questions about coordinated central banking action. We'll argue that the coordination aspect of it was more relevant when the pandemic hit and all major central banks were actively easing. Now, as we know, the pandemic has impacted different economies in dramatically different ways. And so the notion that there are going to be some economies more highly impacted by higher energy prices and the type of inflation that we've already seen in the cycle certainly resonates.

Ian Lyngen:

And that will lead to the type of divergence that is currently obvious in global central banking at the moment. One of our core tenets for this point in the cycle is that, while market participants might think that policy makers are behind the curve, unlike forcing a central bank to ease, it is very difficult to force a central bank to tighten monetary policy. In fact, the most logical way that one might assume that this could occur would be by pricing in a significantly higher probability of rate hikes in the near to medium term. And that's precisely what we have seen. But in practical terms, effectively what has occurred is that the market is tightening for the Fed, which is entirely different than the market prompting the Fed to tighten. In fact, as front end yields increased, we saw equities begin to wobble, although that's since been rectified, and financial conditions tighten. That is the opposite of the type of environment in which one would expect action from the Fed.

Ian Lyngen:

In fact, thinking the equation through, the most likely way that market participants could have an impact on monetary policy-making, from a pricing perspective at least, would be by continuing to bid up breakevens. Because for a comparable nominal rate, the higher we have breakevens, the lower we will see real yields. And lower real yields have materially contributed to easier financial conditions. So, if the Fed sees financial conditions trending in the wrong direction, I.E. easier, that will provide the Fed with the incentive and/or needed cover to deliver the first rate hike on the cycle. While this is clearly not this week's business, nonetheless it is an important discussion as the market ponders exactly what to expect in 2022.

Ben Jeffery:

Ian, please take a seat. We have a lot to talk about.

Ian Lyngen:

That is very true, Ben. There has been a lot that's occurred in the Treasury market that has really helped to recast the macro narrative as the year has come to an end. Most notably, the Fed finally delivered on the extremely well-telegraphed tapering announcement. We got precisely what the market was looking for, which was 15 billion a month of tapering, 10 billion in Treasuries, and 5 billion in mortgages. This puts the presumed end of QE in the middle of 2022. That's been a very well-telegraphed timeline. And as a result, we were not surprised that the price action which ultimately occurred was relatively limited. The bigger question now becomes whether or not the Fed decides to employ some of the flexibility that it has built into the tapering process and end QE even earlier, and what that might or might not imply for the pace of rate hikes as the cycle gets underway.

Ben Jeffery:

And you said end QE earlier. And I think that's very important, that while the language within the announcement of tapering reflected some flexibility, AKA be adjusted as warranted, really in practical terms at this point in the cycle, what that means is that the Fed could potentially accelerate the pace of bond buying. In our pre-NFP survey this week, we compared market sentiment on the likelihood of an acceleration versus a deceleration. And it wasn't particularly surprising to see that a faster pace of tapering was viewed as more likely. But really, given the distribution of the answers that we saw, at this point I think it's fair to say the consensus is that we're going to be running at that $15 billion a month pace until the end of June, AKA that mid-2022 target that Powell hinted at even before this week's meeting.

Ian Lyngen:

This does bring into question, however, the amount of tightening that's currently priced into the Fed funds futures market. The Fed has made their sequencing intentions very clear. And by that I simply mean that they won't simultaneously hike rates and be buying bonds. So, that implies that it won't be until Q3 when one might consider the first rate hike as a live possibility.

 

Ben Jeffery:

And that Q3 timeline is now very important for another reason. And that's what we heard from Powell at the press conference, in that he expects we'll have a better understanding on the degree to which some of the supply side constraints that we're experiencing now have abated. And this touches on something that you and I have discussed, Ian, which is that while yes, you can't have inflation without the demand side of the equation, at this point the acceleration in consumer prices that we're seeing is probably still more a function of issues on the supply side. And frankly, higher interest rates are not the proper tool to address these supply side issues. There will eventually come a time when the logistical headaches and supply chain bottlenecks that we've been experiencing work themselves out. And Powell went as far to say it's not going to be until we have greater clarity on this topic that the committee will start contemplating raising rates.

Ian Lyngen:

So, this brings up a question that we've heard several times from clients over the course of the week, and that is, how high is the risk that the Fed is either in the midst of committing a policy error, or will eventually commit a policy error in 2022 by tightening monetary policy more quickly? The short answer is that it's still too soon to really know. If in fact the Fed has the transitory characterization of inflation wrong and we see self-perpetuating upward pressure on consumer prices throughout the course of the next two or three quarters, then the Fed would arguably be a bit behind the curve. The flip side is, if in fact the FOMCs assumptions regarding the nature of inflation pan out and we see a steady drift back to pre-pandemic style inflationary pressures, then if the Fed chooses to accelerate tapering and/or bring forward a rate hike, then the risk quickly becomes that the Fed is effectively putting the brakes on the real economy too quickly.

Ian Lyngen:

And that's, to a large extent, what the market seems to be telling us at this point. Any Treasury market weakness inspired by hawkish rhetoric or ambitions has hit the five year sector far more than it has tens and thirties. And in fact, that was the knee-jerk response to the stronger than expected payroll report on Friday. The headline print combined with the revisions and the drop in the unemployment rate painted a very constructive picture for the employment landscape, but rather than a wholesale repricing toward higher rates, what we saw was the front end come under pressure with twos, threes, and fives drifting higher in yields, but still well within the recent range, whereas tens and thirties immediately started to probe the lower bound of their recent range.

Ben Jeffery:

And aside from the jobs numbers themselves and the unemployment rate, the one arguable weak spot in the data was the unchanged participation rate versus the expectation for a 1/10th of a percent increase. And this is, again, something Powell focused on in his press conference, that the reluctance of workers to reenter the labor force has been much more pronounced than what the Fed was anticipating. At 61.6%, the participation rate is hardly in a zone that would be encouraging for the FOMC.

Ben Jeffery:

And there was a very good question posed in the Q&A which is that, given we're seeing what is ostensibly a tight labor market and upward pressure on wages, doesn't that risk the self-perpetuating nature of inflation driven by higher wages, more capacity to consume and higher propensity to consume that would trigger a runaway acceleration in consumer prices? Said differently, the demand side inflation that higher interest rates would be very effective at combating. And what we heard from Powell is, that's not at all what the Fed is thinking. At this point, the low participation rate, distorting the traditional Phillips curve narrative, and this latest increase in wages is a function of temporary or transitory distortions on the supply side of the labor market.

Ian Lyngen:

There's some nuance within the unchanged labor market participation rate that's worth highlighting. Specifically, we did see a decrease in labor market participation for the 55 and older cohort, and a slight increase for the balance of the labor force. So, this is very consistent with the idea that expiring extended unemployment benefits have prompted some workers to reenter the market, while elevated asset prices have brought forward the retirement plans of many in the labor force. All of this does risk a sustainably higher trend in wages. However, when we look at the year-over-year pace of average hourly earnings at 4.9% versus what we have seen in terms of headline CPI gains, what we see is that wages are still struggling to keep up with prices. So, on real terms, consumption might continue to face headwinds into the end of the year. This is particularly troubling when we think about the relevance of the holiday spending season, not only to retailers, but also to the overall pace of the recovery.

Ben Jeffery:

Now, the Fed and NFP were undoubtedly the highlights of this past week, but we also got something of a surprise decision from the Bank of England. They opted to keep their policy rate unchanged at 10 basis points which, judging by the moves in the UK bond market, caught some investors off sides.

Ian Lyngen:

I think that there's a very pivotal dynamic playing out in the global rates market at this point. And that is, we have a subset of investors who are looking at the inflation numbers, the trajectory of inflation expectations, and central bankers who appear, at least ostensibly, content to stay on this sidelines. What we have seen over the course of October is a run up in the implied pricing of rate hikes for the Bank of England, the Bank of Canada, as well as the RBA and the Fed. This brings us to a fundamental question. The classic adage that the market eases and the Fed tightens continues to resonate, even in the Fed's new framework. What we saw with the Bank of England was effectively the market trying to force the issue.

Ian Lyngen:

And while we did ultimately hear more hawkish official commentary coming out of the Bank of England, the fact that they failed to deliver what was priced in with a 92% probability, I.E. a 15 basis point rate hike for the BOE, really speaks to the implicit inability of the market to force monetary policy-makers to tighten. This isn't to say that by pricing in forward rate hikes, that it doesn't allow central bank's sufficient cover to follow through on tightening ambitions. And I suspect that that's really going to define the monetary policy narrative in 2022. Specifically, the market will continue to price in two to three rate hikes in 2022. And the Fed might ultimately only deliver one, but they will have more than enough of a buffer to execute on a rate hike without materially disturbing financial conditions or risk assets.

 

Ben Jeffery:

And it was a week defined by central banking and monetary policy. There's no doubt about that. But on Wednesday, we also did get a very important refunding announcement from the Treasury Department that showed the first cut to coupon auction sizes of this cycle. Twos, threes and fives are all going to be reduced by $2 billion a month in the next quarter. Sevens are going to be coming down by $3 billion a month. Tens and thirties each down by 2 billion for the quarter, and twenties by 4 billion for the quarter. Now, the magnitude of the declines were generally consensus, maybe a bit more on the conservative side. And I would argue that that reflects the large amount of uncertainty in Washington around exactly what form and what size the next round of legislation is going to take. Not to mention the fact that we're once again approaching the new drop-dead date on the debt ceiling issue, with all that implies for the Treasuries cash balance.

Ben Jeffery:

So, from this perspective, it resonates that Yellen would rather risk being overfunded versus underfunded, if only to avoid needless volatility on the issuance front. Given the Feds diminished demand of $10 billion a month in Treasuries is going to becoming along with a decrease on the supply front of $17 billion a month from the Treasury Department, so the resulting price action should be fairly muted. Which once again reiterates one of our core tenets on the supply side dynamics in the Treasury market, which is that the macro fundamentals are far more important in setting the outright level of yields. Sure, it would be reasonable to expect some concession for tens and thirties on Tuesday and Wednesday of this coming week. But at this point, I think it's very fair to say the market's attention is focused squarely on the trajectory of the recovery and just how transitory inflation ultimately proves.

Ian Lyngen:

Another uncertainty that is increasingly topical is who will get the nod as the chair of the FOMC. Our baseline assumption coming into this process was that Powell had a 70 to 80% probability of being renominated. Now, while some of the disclosures in terms of personal trading and the politics associated with oversight at the Fed have made headlines, the fact of the matter is we continue to see those odds as roughly in place. And so as that applies to the market outlook, that assumes continuity for monetary policy going forward, and that keeps the bull flattening trend in play between now and the end of the year. In envisioning who might replace Powell, Brainard is the obvious go-to from a political perspective. In the event that she does get the nomination, that will be a decidedly less hawkish or even outright dovish policy skew.

Ian Lyngen:

Playing that in the Treasury market would imply a dramatically steeper curve, with rate hikes in 2022 being priced out and upward pressure on 10 and 30 year yields on an outright basis as investors demand greater inflation premium to go further out the curve in the event that the perception is that Brainard would allow inflation to run hotter for even longer. So, while a Powell renomination is less the path of least resistance than it might have been prior to the developments of the last few weeks, at the end of the day we expect that he will get the nod.

Ben Jeffery:

Nodding off. Isn't that kind of like signing off?

 

Ian Lyngen:

It certainly is when you're working from home.

Ben Jeffery:

What? What?

Ian Lyngen:

We're still here. We're still here. In the week ahead, the Treasury market will continue to digest a relatively strong October payrolls report. We saw the headline print at 531. The unemployment rate declined to 4.6%. All of which implies that the employment market is on reasonably strong footing. Now, this is meaningful because we saw the dip in the September data which was, at least at that point, attributed to concerns associated with the Delta variant. Also contained within the most recent labor market update were upward revisions to September hiring. So, overall employment growth continues at a reasonably good clip. And with that backdrop, one might have expected the knee-jerk price action in the Treasury market to be a bit more bearish. In fact, interestingly, what we saw were 10-year year yields dip below 150, which has some meaningful technical significance, if for no other reason that it's decidedly through the bottom of the prevailing range and it occurs following the Fed's official tapering announcement.

Ian Lyngen:

We've been advocating leaning bullishly on the Treasury market in the wake of the Fed's official announcement. We did see a small backup in rates on Wednesday that ultimately provided an attractive buying opportunity for 10-year yields. But it's safe to say at this point that 175 to 177 yield peak that we saw in Q1 will represent the upper bound for 10-year yields for the balance of 2021. As we contemplate the year ahead, we become a bit more bearish on Treasuries. We think that there's a compelling case to be made that the bearish narrative that dominated Treasuries during the first quarter of 2021 comes into play during the first half of next year. Unlike this year, however, 2022 finds a real economy that's on stronger footing with demonstrated inflationary pressures. We have the Fed following through with tapering and in doing so, investors are extremely focused on not only the lift off rate hike, but what we expect will eventually evolve into an active debate regarding the terminal rate for this tightening cycle.

Ian Lyngen:

The Fed has penciled in two and a half percent. Although if we look at the cycle that preceded the pandemic, the Fed struggled to keep Fed funds above 2% for any meaningful period of time. So, that implies that there will be an active debate between 175 and 225. At the end of the day, it does ultimately come down to whether or not the Fed's transitory characterization of inflation early in the cycle proved correct, or if wage gains ultimately make inflation more self-perpetuating as we move through 2022. In such a scenario, a higher terminal rate could be warranted.

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 a reminder, this weekend is daylight savings. And while smartphones automatically dial back the clock, that flashing 12 on the VCR ain't going to reset itself.

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 Thick 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. Notwithstanding 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.

Speaker 2:

It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice, or a representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act. BMO is not undertaking to act as a swab advisor to you, or in your best interests in you. To the extent applicable, we will rely solely on advice from your qualified independent representative in making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

Speaker 2:

You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative, if applicable. BMO assumes no responsibility for verification of the information in this podcast. No representation or warranty is made as to the accuracy or completeness of such information, and BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter, and information may be available to BMO and/or its affiliates that is not reflected herein. BMO and its affiliates may have positions, long or short, and affect transactions or make markets in securities mentioned herein, or provide advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMOs trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

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

You might also be interested in