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Spring Breakout? - The Week Ahead

FICC Podcasts March 18, 2022
FICC Podcasts March 18, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of March 21st, 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 163, Spring Breakout, 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 March 21st. And a quick note, the Senate passed a bill making daylight savings time permanent starting in 2023. The vote was unanimous. Amazing. Of all the things that could bring the political parties together, clearly it's an idea whose time has come, even if it's an hour late. And the House still needs to pass the bill.

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 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 with our musings on the week ahead. Please feel free to reach out on Bloomberg or email me at I-A-N, dot, L-Y-N-G-E-N at B-M-O dot 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 great deal of fundamental inputs to drive trading direction, the most relevant of which was of course the FOMC decision. The Fed increased policy rates by 25 basis points in keeping with the broad expectations for the liftoff. The Fed also signaled that it would increase at 25 basis points during each of the remaining meetings in 2022.

Ian Lyngen:

This was on the upper end of expectations and as a result, the curve flattening trend accelerated with twos, 10s and below 19 basis points. This is very consistent with the notion that the front end of the curve is going to continue to follow monetary policy expectations with twos, threes, and fives buys toward higher rates while 10s and 30s will continue to respond to the broader global macro back drop.

Ian Lyngen:

Now, we are on board with an inversion of the twos, tens curve, sometime between now and the run up to the May FOMC meeting. Now, Powell did signal that the balance sheet runoff announcement could come as early as the May meeting. We're interpreting this to be a clear sign that May will be the timing of the runoff announcement. Now there might be some clarification between now and then, but all else being equal, anticipate some type of further clarity at the next meeting.

Ian Lyngen:

The April 6th release of the FOMC minutes will provide an ideal forum for the Fed to outline the discussion around balance sheet runoff. So, whether or not we see a 60 billion or 80 billion cap on Treasury runoff or a 30 billion or higher cap on mortgage runoff is frankly the final normalization question. To be fair, we've been very impressed with how hawkish the Fed has been thus far. And given that understanding of Powell's reaction function to the risk of higher consumer prices, we'll air on the side of suggesting that the caps will be higher and the notion of outright sales from Soma at some point does need to be on the table. The bigger question as we ponder the implications for US rates is whether or not this leads to a steeper curve, a flatter curve, or has zero net impact.

Ian Lyngen:

In the run up to the announcement, we anticipate that there will be a subset of the market that pushes the steepening notion. I.E., as the balanced sheet is reduced, investors will demand more term premium to go further out the curve and as a result, 10 and 30 year yields will be higher. We're certainly sympathetic to this notion, but until we have greater clarity from the Treasury department on any intention of changing the average maturity of the Treasury's debt outstanding, we expect that any steepening impulse will be limited.

Ian Lyngen:

What will prove more influential is the upward pressure on yields in the front end of the curve. As we near the May rate hike, it almost goes without saying that there will be some subset in the market who expect a 50 basis point move as opposed to 25 and this in and of itself will lead to underperformance of the front end, regardless of what the FOMC ultimately delivers.

Ian Lyngen:

In addition, during the week just past, we saw a disappointing retail sales number, especially within the control group, which backs out food, energy, building materials, and auto parts and best maps with GDP. This was concerning given how strong the underlying labor market is. And while the decline was off of upwardly revised figures for January, nonetheless the trajectory as Q1 develops is troubling and something worth keeping an eye on.

Ben Jeffery:

So, it was always going to be an exciting week in the Treasury market, if only because we got the first rate hike of the cycle. But even before that, coming in from the weekend we saw 10 year yields trade through that 206 level that had held several times driven in large part by 10 year break evens touching 3% for the first time ever.

Ian Lyngen:

It was actually an extremely volatile week in the Treasury market, very consistent with the beginning of a hiking cycle, but also with the backdrop of geopolitical uncertainty that continues to provide two dueling narratives. First, the Fed and the ECB have made it abundantly clear that they're viewing the risks associated with Russia's invasion of Ukraine as inflationary. The flip side is that there have been clearly demonstrated safe haven flows as a result. Speculation that Putin might increase the threat of using the Kremlin's nuclear arsenal has added to the uncertainty as we consider the next phase of trading in the Treasury market.

Ian Lyngen:

Quickly to recap what we did learn from the Fed, the liftoff hike was 25 basis points. However, it was executed in a way that was particularly hawkish. Specifically, the dot plot indicates that there will be a total of 725 basis point rate hikes in 2022. Now this is a market increase from the three that had been previously signaled by the Fed.

Ian Lyngen:

During the press conference, Powell made a couple points worth noting. First was that he characterized the dot plot as indicating 725 basis point moves as opposed to a different combination of hikes. This doesn't mean that 50 basis points should be off the table at one meeting at some point, but the base case scenario is now a 25 basis point hike at every medium.

Ian Lyngen:

Powell also noted that the balance sheet runoff announcement could be, "As soon as May." We are interpreting this as a very strong signal that it will be May. Because the Fed is signaled they're moving at every meeting, this deemphasizes to some extent the relevance of the balance sheet runoff announcement. If for no other reason than it won't replace a rate hike in the same way that it did during the last cycle.

Ben Jeffery:

And that's a really important point, I think, going off of what you mentioned on the likelihood of a 50 basis point move, Ian. If in fact like the last cycle, the Fed is going to assign some rate hike equivalent to X amount of dollars running off the balance sheet, then if in fact the balance sheet rundown begins in May, that could be in monetary policy tightening terms equated to a 50 basis point move, or at least that's probably how the committee will aim to frame the decision.

Ben Jeffery:

And let's not forget, we will start to get message refining Fed speak once again, now that the meeting is behind us, which should help set the stage for both the scale and timing of the rundown even before we get the minute of this last meeting, which will be released on the afternoon of April 6th. And furthermore, I think the dot plot also did something very relevant in terms of what will be the driving force behind the moves in the rates market over the rest of this year.

Ben Jeffery:

Powell has now laid out what the Fed's game plan is going to be over the course of 2022. And while the first quarter has been largely defined by evaluating the Fed's reaction function to the inflation data, to Russia's invasion of Ukraine, to the dimming growth outlook, we now know that given all these factors, the Fed would like to raise rates at by 25 basis points at every meeting between now and the end of the year. Looking at the 2023 and 2024 dots, there's an additional three or four rate hikes penciled in on top of the seven that they hope to deliver in 2022.

Ben Jeffery:

So, putting that another way: The roadmap is to reach terminal some point in the middle part of next year. And that terminal rate is expected to be higher than the central banks longer run estimate, which fell from 250 basis points at the December SEP to 242.5 basis points at the latest revision. That's the first downward adjustment to that number since June 2019.

Ian Lyngen:

Also within the updated projections, we saw a notable decline in the Fed's expectations for real GDP in 2022. In December, the forecast was for a 4% growth rate. In light of everything that's happened, not least of which being the increase in realized inflation, now the Fed is projecting growth of 2.8% this year. That's a notable shift and one that's worth pondering as we consider the balance of risks for the rest of the year. If in fact, the Fed is unsuccessful in containing upward pressure on consumer prices, then for the same amount of nominal growth, one would assume that real GDP will suffer even further. It's that version of stagflation light that I think presents the biggest risk as we look beyond 2022 and into next year.

Ben Jeffery:

And as we move further along through the economic recovery, that gets at something that right now is not all that relevant, but maybe over Q2 and Q3 could become increasingly so, and that is the potential divergence between headline and core inflation. As the war in Ukraine has continued, it's become clear that energy and food prices are going to continue to be distorted by the disruptions associated with the conflict, which by definition will asymmetrically boost headline inflation.

Ben Jeffery:

Now the stable prices side of the Fed's mandate is focused on core prices. So, as we reach the point when the base effects and presumably some of the supply side issues, excluding the war ,start to resolve themselves, in the event we start to see core inflation moderate while headlines still remains elevated, probably principally as a function of oil prices, if the Fed chooses to emphasize core over headline inflation, that could be a potential inflection in the trajectory of how the committee is thinking about the path of monetary policy.

Ben Jeffery:

Now, Ian, that doesn't take negative, real growth off the table. But exactly as you point out, it's not true stagflation, if only given how tight the labor market is.

Ian Lyngen:

And Ben, I think you highlight one of the key risks for the next stage of the recovery and that's the labor market. We have seen consistently strong payrolls reports. The unemployment rate continues to decline. And while there are some pockets of labor force participation that are a bit lower than we might have otherwise liked to have seen, the reality is that the jobs market is still very strong.

Ian Lyngen:

However, it's a lagging indicator. And if we look at what is occurring in terms of consumer confidence, specifically the University of Michigan survey, we see the lowest level since 2011, with higher prices of both energy and goods being cited as weighing on sentiment.

Ben Jeffery:

And we got a very good question from a client this week that focused on what the market reaction would be. If we see other Western countries take the same tact that the US and the UK have in banning the import of Russian oil. Obviously that would put significant upward pressure on crude as a whole. So, what would the response function be in US rates and how would that change the thinking at the Fed?

Ian Lyngen:

I think to some extent we've already seen the Fed's willingness to address higher energy prices. If we were to see an even more significant bounce in oil, I think that the concern coming out of the Fed would be far more focused on the potential impact to real growth, and we'd anticipate that officials would recharacterize the impact of inflation as a significant tax on consumption across a variety of wage earners, not just those who are in the lower quartile.

Ian Lyngen:

And to be fair, what we're watching now is we're watching a market that has effectively priced in the bulk of the cycle already. And in conversations with clients, the big question is what's next? We know what the Fed is going to do to a large extent. We have a much better sense of their reaction function. And now with the last big decision being the caps for balance sheet runoff, or the lack of caps for balance sheet runoff, beyond that are we actually going to go back to trading the data as we had previously? It's notable that questions regarding the pandemic and COVID case counts have ceased.

Ben Jeffery:

And that may very well be the case. It's been over two years since the economic data has really mattered from a trading perspective. But now that the pandemic's influence, at least domestically, seems to be more or less negligible from an economic perspective, we could very well be reentering the paradigm that defined the 2017, 2018 period, where the long end of the curve is going to be far more beholden to the realized performance of inflation and growth, while the front end will be very anchored to the Fed's commitment to continue raising rates.

Ben Jeffery:

Ian, you touch on something very important, which is that as with much of this cycle has played out so quickly, a lot of the increase in front end rates that are reflecting a higher Fed funds target band has already played out. Two year yields reached levels that we didn't see until the Fed had already executed 125 basis points in rate hikes last cycle. So, from that perspective, I think it's reasonable to assume that the data is going to need to validate the current state of the market, which to me continues to point toward a flatter curve, maybe to inversion?

Ian Lyngen:

The case for curve inversion is very strong at this point. With each in incremental rate hike and/or stronger economic data, the market will continue to price in further rate hikes in 2023. Now whether or not the Fed ultimately gets to a terminal rate close to 3% is going to be a function of a variety of things, not least of which being how risk assets perform in that environment. Nonetheless, a flatter curve as the Fed marches towards rate normalization is our baseline expectation.

Ben Jeffery:

I'm happy you touched on the performance of risk assets. Given the fact that we've seen stocks put in something of a bounce from the local lows, but more relevant from the Fed's perspective is what that has meant for financial conditions. Intuitively we've seen financial conditions tighten meaningfully from the easy extremes we got to a couple months ago, but in outright level terms, the FCI is still easier than it has been at any point, excluding the last two years.

Ben Jeffery:

We had a client ask this week where the pain point lies in terms of the financial conditions index and while the level is certainly relevant. I think what Powell is probably more concerned with is the speed with which we get there. A slow grinding tightening of financial conditions that slowly demonstrates the removal of monetary policy accommodation would be an ideal outcome for the FOMC. Something that they've been able to pull off thus far, and the ability for the fed to continue doing this is going to be paramount as they endeavor to bring the economy to a soft landing.

Ian Lyngen:

And if we've learned anything throughout the years, it's that a soft landing is a difficult landing.

Ben Jeffery:

Keep that runway phoned.

Ian Lyngen:

In the week ahead, the economic data calendar is light by anyone's calculations. We see new home sales on Wednesday, as well as the durable goods figures for February on Thursday. Overall, our expectations are that the Treasury market will continue to trade off of the geopolitical headlines and the situation in Ukraine. With the blueprint in hand from the Fed, expectations for monetary policy normalization are going to take a backseat to trading the macro fundamentals.

Ian Lyngen:

Now, the uncertainty in this regard is what fundamentals will be in focus. Higher energy prices are a given at this stage, and we are concerned that elevated energy prices will continue to erode real purchasing power. And as a result, growth will trend lower in 2022 than otherwise anticipated. Now, this isn't to suggest that the US economy is on the precipice of a recession, but rather even the Fed's downwardly revised 2.8% GDP forecast for this year will start to look a bit ambitious in the event that the second quarter doesn't represent an acceleration from some of the softness in growth we're anticipating in Q1. To be fair, Q1 is still tracking above 1%, but with the disappointing retail sales figures in hand, the idea that the consumer might be losing momentum certainly does resonate.

Ian Lyngen:

The week ahead also offers two distinct supply events. The $16 billion 20 year auction on wins day, as well as the $14 billion tips reopening auction on Thursday. The nominal 20 year should require some type of concession. That concession will either occur in the run up to the auction itself or in the form of a tail at the auction. The tips auction will be more interesting. Given that 10 year break evens reach 300 basis points and the upward pressure that persists in the energy complex, it's difficult to imagine that there won't be a renewed amount of interest in inflation protection.

Ian Lyngen:

The flip side to that would be there's little question that what the Fed delivered in terms of its hawk-ishness was a Fed credibility enhancing event, insofar as it made clear to market participants that the Fed is not only able, but also willing to do what it takes to keep inflation expectations anchored. It's these crosswinds that we expect will lead to a reason amount of uncertainty for the 10 year reopening auction. All else being equal, we'll be watching oil prices as an indicator of how far break evens can run and if the market will put additional pressure on the fed to increase the pace of rate hikes.

Ian Lyngen:

We've reached the point in this week's episode, where we'd like to our sincere thanks and condolences to anyone who has managed to make it this far. And with the first day of Spring upon us and college basketball top of mind, we'll be the first to concede that at least our madness isn't limited to March.

Ben Jeffery:

Are their upsets in a dot plot?

Ian Lyngen:

Clearly, yes.

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 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.

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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