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Silence of the Hawks - The Week Ahead

FICC Podcasts Podcasts October 21, 2022
FICC Podcasts Podcasts October 21, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of October 24th, 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 194, Silence of the Hawks, 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 October 24th. Given all that's been said by Fed officials directly and through the media, the pre-FOMC moratorium on public speeches will offer an all too welcome Silence of the Hawks. 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 I-A-N.L-Y-N-G-E-N@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 Treasury market came into a relatively low data week with expectations for a benign consolidation around rates that had already been well established. In fact, in the run-up to the early November FOMC meeting, what we saw instead was a sharp sell-off that got 10 year yields above 4.34, and the market's focused on the prospects for another 75 basis point rate hike in December after what is widely expected to be 75 in November.

Now, this has intuitively been accompanied by higher than expected terminal rate assumptions as high as 5%, in fact. This is materially above what the Fed has projected at 4.6%, and when accompanied by a balance sheet runoff program, which is worth roughly an additional 75 basis points, that would bring the aggregate terminal rate assumption for the cycle to 5.75, an impressive transition given where we started the beginning of the year.

Now, we'll be the first to concede that rates are higher in the fourth quarter than we were anticipating given all of the risks facing the global economy. But nonetheless, we do take solace in the fact that we have transitioned from an environment where break evens were driving nominal rates to an environment where forward inflation expectations, while perhaps not as low as the Fed would like to see, remain well below their peaks, and are consistent with investors' assumption that over the medium to long term monetary policy makers will be able to keep inflation contained.

This implies that the underlying move has largely occurred in real terms. Higher real yields are the best reflection of the true borrowing costs throughout the economy, and as a result, as we push toward higher real rates, we become increasingly cautious regarding the prospects for the economy. We've long made the observation that monetary policy actions impact the real economy with a lag. The operating assumption has tended to be six to nine months. So putting in context the time it took to get policy rates and the balance sheet process from extremely accommodative to neutral, which frankly just recently occurred, what's currently driving our baseline anxiety is that the timer of two to three quarters for the fallout from tighter monetary policy truly just started as real yields moved above zero and are continuing to trend above 150 basis points.

As the market braces from real rates that are sustainably higher than prior to the pandemic, we continue to look for signs of weakness in a variety of different quarters, the most obvious being market functioning. Not only do we have the issues that the gilt market has been suffering from, but when we look overseas, the relentless strength of the dollar has clearly had an impact on the yen and other major currencies. Eventually, the US, which is actively engaged in importing deflation, and in effect exporting inflation, will be faced with some of the unforeseen damage afflicted on the global economy.

Ben Jeffery:

Well, coming into this week, frankly, there wasn't a massive expectation that it was going to be a game changer. There wasn't a ton on the economic calendar. Sure, we did have a 20 year auction and a five year tips auction, some Fedspeak dispersed around as well, and that wasn't really a particularly exciting setup for Treasuries. But what ultimately happened was the exact opposite.

We saw the selling pressure that has been evident over the past several weeks take another significant leg higher in yields. Ten year rates touched 4.34%, which is their highest level since 2007. Terminal estimates, at least as reflected in the Fed funds futures market moved well above 5%, and of course, we're in for another change of leadership in terms of the UK's government. All of this added to an already very volatile backdrop in a still very thin liquidity trading environment to really make the unifying theme of this past week that of volatility, and volatility that's likely here to stay, at least until the November FOMC meeting.

Ian Lyngen:

Yes, and as we enter the Fed's pre FOMC meeting moratorium on public speeches, it's notable that the most recent Wall Street Journal article did confirm that 75 in November is a given at this point. However, another 75 in December shouldn't be a foregone conclusion. In fact, the downshifting to 50 basis points in December remains our baseline assumption if for no other reason than there are still another two CPI prints between now and the December meeting. Moreover, the closer that the Fed gets to terminal, the more likely they are to downshift just to add a little bit of flexibility in the pace, if in fact we end up seeing a couple more stronger than expected CPI releases.

Another observation on the market that seems to resonate as we make the rounds and meet with clients is that we are reaching an inflection point from the perspective of the global financial system, not in so much that global monetary policy makers have been successful thus far in their campaign to contain inflation, but rather that we're beginning to see significant signs of strain throughout the system. The gilt market is the easiest example to point at in terms of a well-established and developed market that is showing signs of significant stress at a point when one wouldn't necessarily anticipate that that were the case.

Ben Jeffery:

And market strain is increasingly becoming not just a foreign issue, but a domestic one, as well. Another big theme within US rates this week was what we learned in the refunding questionnaire that was released last week, in that the Treasury Department is seriously considering starting a buyback program. Now, what this program would look like is still very much up in the air, but the fact that Washington has moved so quickly from the early days of entertaining this idea to formally asking the primary dealer community about it suggests that market functioning in Treasuries is rising on the list of concerns, both at the Fed and at the Treasury Department. We did hear from Yellen explicitly that it's something she's worried about. And so as we get to the November refunding announcement, which is on the same day as the Fed, and then into next year towards the February and May announcements, greater clarity on the issue of whether or not the Treasury will start to buy back old debt with new debt is definitely something that will have implications for liquidity.

In terms of what this would look like and how it is crucially different from QE is that unlike QE, in which bonds are purchased with money that is created by the Fed, bonds purchased in a buyback would be funded by increasing actual issuance. So think of it as the Treasury selling more on the runs in order to purchase the comparatively less liquid off the run bonds. Now, in discussions around this topic, one fair point of criticism is that by removing bonds in the off the run sector and reducing the trading flow in those securities, the Treasury would be successful in driving increased trading activity in on the runs, but actually run the risk of exacerbating the situation in off the run Treasuries, which brings up the question whether or not this really needs to be dealt from through the angle of regulatory relief and maybe a reintroduction of the SLR exemption of Treasuries that we saw in place through the beginning of 2021.

Ian Lyngen:

I'd argue that we probably need to see both. I think the SLR regulatory relief to some extent is a foregone conclusion at this point. However, true buybacks we haven't seen in a very long time. I do anticipate that investors will struggle to really differentiate between buybacks and QE, even though the fixed income market and Treasury market participants in particular know that there is a very distinct difference that has broad reaching ramifications for the overall state of monetary policy. But in practical terms, such an operation will look remarkably similar to QE.

And it's also worth noting that while, Ben, you have actually characterized the process as selling more on the runs and buying off the runs, there's also a compositional issue of where the Treasury Department will choose to increase its net borrowing. Said differently, simply because the New York Fed working as an agent for the US Treasury Department might end up buying several billion in the 20 year sector, doesn't necessarily imply that that issue is going to be increased by the same amount. In fact, all else being equal, we continue to assume that the Treasury Department is going to take advantage of the liquidity and the demand in the very front end of the market and utilize bill issuance. The one caveat is that bill issuance is starting to get comparatively expensive when we look at the depth of the inversion in the overall curve.

Ben Jeffery:

Completely agreed on all fronts, Ian. And really, what I think the meltdown in the gilt market has done is served as a warning or reminder to those in charge of other developed countries' debt markets that in the current inflation paradigm and higher interest rate paradigm, that the consequences of sovereign debt issuance are elevated. And clearly the risk that was posed to the UK's pension system by what we saw in the gilt market was enough to make Yellen concerned to probably accelerate the discussion of this issue and ensure that the official sector is ready to act to support Treasury liquidity in the event that that's needed.

For better or worse, a meltdown in the Treasury market has far different implications than a meltdown in the gilt market, simply given the difference in outright size, but also the fact that Treasuries are systemically important to the global financial system in a way that gilts are not. And especially with the dollar as strong as it is, the Treasury Department knows that a well-functioning market is crucial considering just how volatile everything is at the moment.

On the issue of the dollar strength, we also saw the yen sell off through that 150 level this past week, and that intuitively led to some discussion about more Japanese selling in the interest of currency defense. But it also reinforces the fact that Japan is still a large net seller of Treasuries, and it's still too soon to expect Tokyo to step in and buy the dip we've seen so far this year.

Ian Lyngen:

So this begs the question, if one of the reasons that we have seen such a significant backup in gilt yields has to do with liquidity and functioning, if it's made abundantly clear by Yellen and company that there will be buybacks, or at least the potential for buybacks should be on the table, shouldn't that net be a positive for Treasuries, i.e., contain the extent to which the market might back up in rates? All else being equal, the short answer is yes. The flip side, and this is what I suspect has become problematic in evaluating the balance of risks for the rate market as we look between now and the end of the year, is inflation continues to run higher than expected, and as a result, the terminal rate continues to be edged higher and higher.

Now, 10 year yields did get as high as 4.34 in the week just passed, and that's consistent with a pushing higher of the terminal rate expectation. However, it is also reflective of an investor base that's looking at Treasuries as an asset class, and frankly, no one wants to be the hero and jump in and catch the proverbial falling knife. I think that's the dynamic that we anticipate to play out over the course of the next several weeks. Very choppy price action, very volatile moves in sentiment around both monetary policy and the ramifications for other financial markets. This has been the case over the course of the last couple weeks, and there is little on the horizon, macro or otherwise, to suggest that will change between now and the FOMC meeting.

Ben Jeffery:

And this is absolutely consistent with the conversations we've had this week, but also, frankly, throughout the entirety of this year. What I mean by that is there's no shortage of cash in the system. There's ample liquidity, and investors have capital to deploy in financial markets. It's simply that given the uncertainty on the economy and the uncertainty on how the Fed will behave, we're seeing a wholesale unwillingness to reach any further out the yield curve than is absolutely necessary. So what this means is that, depending on the type of investor, they're either remaining as overweight cash as is permitted, or keeping their investment durations as short as they can simply to protect themselves against what's been an undoubtedly impressive move toward higher rates across the curve.

And as this plays into our longer run bullishness on the Treasury market, this introduces the potential for the move toward lower yields to be even more dramatic and more aggressive than would otherwise be expected. Because once it becomes clear that inflation is beginning to moderate, and that the Fed is nearing terminal or has arrived at terminal, investors are going to want to capture as much yield as possible for as long as possible given what it seems is becoming an increasingly likely global hard landing. So at this point, while a move back to a 3.50 10 year yield seems like an extremely aggressive call, if we've learned anything over the course of this year in the Treasury market, it's that very large moves can take place over the course of a very short amount of time.

Ian Lyngen:

And I think that's precisely the issue at hand, Ben. The case for a deeper inversion and lower outright yields further out the curve continues to resonate with the caveat that stubbornly high core inflation does make it difficult to envision a rally of the magnitude that we have been projecting. Now, our conviction to lower rates in the medium term still remains high. The precise timing around that move is ultimately going to be contingent on two factors. The first, Ben, as you pointed out correctly, is the inflation profile. We don't need to see inflation drop below zero on a month over month basis. We simply need to see core return to the prior norm of two to three tenths of a percent month over month for a few months. And once that flows through to the three month annualized rate, both market participants and the Fed will be more confident that inflation expectations have in fact been anchored.

The other aspect that we will most likely see, even potentially before the moderation of inflation, is another meaningful dislocation in a financial market. Whether that ends up being the US equity markets, US credit, European Credit, Latin American Credit, some of the functioning in the markets in Asia, all remains to be seen. From our perspective, we remain very concerned about the prospects for the European economy during the winter. The energy crisis that's looming is going to have immediate ramifications for growth. And while some reports suggest that there's adequate energy stores in the event of a typical winter season, the risk of a colder winter that requires more energy for baseline heating needs remains not only relevant but also underpriced given the balance of risk for the global economy at the moment.

Ben Jeffery:

And if you won't say it, I will. Winter is coming.

Ian Lyngen:

Ben, let's tame one dragon at a time.

In the week ahead, the Treasury won't be hearing from any Fed speakers as the pre-FOMC moratorium on public speeches is in place. And frankly, the Fed has done a very good job of setting the tone for the upcoming meeting. The market is anticipating and well positioned for another 75 basis point rate hike, and then the prospects for another comparable move in December. Now, our base case remains that we'll see a down shift to 50 basis points in December. However, we'll offer the very meaningful caveat that there are still two CPI prints between now and the December decision. And as a result, we wouldn't be surprised if the Fed emphasized flexibility as the market continues to ponder what their final move for 2022 will ultimately be.

Needless to say, they're a high upside risk for short term rates, but as we have seen in recent weeks, the price action in and of itself has been choppy enough to keep investors sidelined. Rates are much more attractive and outright terms than they were at the beginning of this year. Nonetheless, we struggle to see a compelling reason for dip buyers to come in off the sidelines, at least until the Fed delivers on the long anticipated pivot of monetary policy. As we get closer to the terminal rate, the Fed will find it increasingly prudent to push back against the market 75 basis point hike assumptions, and instead embrace a slower pace of hikes.

Nonetheless, the November FOMC a meeting will have a decidedly hawkish tone. After all, they are going 75 and want to embed a reasonable amount of flexibility for further rate hikes. And as a result, we'll also caution against dip buying until there's greater Fed and inflation clarity. On the supply front, we see 42 billion in two year Treasuries auctioned on Tuesday afternoon. This will probably be one of the more challenging issues to underwrite, given the proximity to the upcoming 75 basis point rate hike and all the uncertainty around terminal.

Similarly, the five year on Wednesday afternoon, which is 43 billion, will be faced with policy uncertainty. As the week unfolds the 35 billion at seven year on Thursday is more likely to track dip buying interest. On the macroeconomic data front, Thursday stands out as the most tradable in so far as it includes the first look investors will have at GDP in the third quarter. As it presently stands, the consensus is for an increase on a three month annualized basis of 2.3%. Within that series, however, personal consumption is seen increasing just an eighth of a percent, which begs the question of the trajectory of consumption as the fourth quarter comes into focus.

On Friday, we'll see September's personal spending data, which is anticipated to increase four tenths of a percent. Now, September's data will obviously be embedded in the Q3 real GDP report, but what we won't have is we won't have a sense of the trajectory as the third quarter came to a close. And at its essence, that's what we anticipate will drive the response to the combination of Q3 GDP and Friday's personal income and spending figures.

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 Britain prepares to select its next Prime Minister, the 57th, in fact, we are reminded by the ever-evolving geopolitical landscape that the only true constant in life is the prerecorded Macro Horizons disclaimer.

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 FICC 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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