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Spring Inflection - The Week Ahead

FICC Podcasts April 16, 2021
FICC Podcasts April 16, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of April 19th, 2021, 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 116: Spring Inflection. 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 April 19th.

Ian Lyngen:

As we ponder the difference between a me-me and a then-them, it strikes us that being out of touch with technology could in fact be symptomatic of an underlying issue that results from one being confined at home for more than a year, with only close family and friends to appreciate the struggles of trying to find the files inside the computer. Huh.

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 U.S. 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 past, the Treasury market put in a fascinating performance in terms of the divergence between incoming economic data, supply, and the actual price action. By way of a quick recap, we saw a strong core CPI print at three-tenths of a percent, month over month. We saw retail sales come in at nearly 10% for the month of March, as well as strong showings from Empire and Philly Fed on the manufacturing side. We also saw a $38 billion, 10-year auction that tailed just four-tenths of a basis point, as well as a $24 billion, 30-year reopening. All of this would suggest that there should have been a consistent, upward pressure on Treasury yields. In fact, what was realized was the exact opposite. Over the course of April, we had seen 10-year yields rally from effectively 175 to 153. This comes in contrast to the broader economic outlook, and it also puts into context just how far investors have gotten ahead of the reflation and reopening narrative.

Ian Lyngen:

Powell has recently said that, for monetary policy to change, we need to see the actual economic data improve, as opposed to simply elevated market-based indicators of inflation expectations and sentiment more broadly. All of this with the backdrop of continued record-high equity prices, left the market to ponder exactly what was going on. Now, part of this is going to be a positional skew. The market did come into the second quarter leaning notably short, particularly for real money investors. So it follows intuitively that there would be a round of short-covering that emerged when the Treasury market failed to sell-off even further, on what is arguably some of the strongest economic data that we are going to see for some time.

Ian Lyngen:

One of our primary concerns remains that because Washington concentrated so much of the fiscal stimulus during the first quarter with fiscal bailout 2.0 hitting households in January, and then 3.0 hitting households in March and the beginning part of April, that in effect we have brought forward not only a fair amount of consumption and retail spending, but also the associated hiring needs. So by effectively compressing the reopening into the first quarter with a little bit of follow-through in the second quarter, the risk is that investors would have taken that trajectory of growth and assume that it carries through, throughout all of 2021. So in this context, we're reasonably encouraged to see the market pull back off the yield highs if for no other reason than it makes 2%, 10-year yields a very difficult target from the current position.

Ben Jeffery:

Well, Ian, it looks like Dogecoin wasn't the only thing that rallied this week.

Ian Lyngen:

Treasury markets certainly rallied. And what I find fascinating about the price action in Treasuries, was the fact that it came despite a series of very bond bearish developments over the course of the last two weeks. Recall at the beginning of April, we had a strong employment report with more than a million jobs on net added to non-farm payrolls. We then saw a decade's high ISM Services print, as well as higher than expected core CPI this week, to say nothing of the blowout retail sales print for the month of March. And still, we managed to see 10-year yields retrace to 153 after peaking at 177 in late March. This does beg the question, how has investor sentiment turned over the course of just two weeks? And what does it imply for the path of rates going forward?

Ben Jeffery:

In addition to that string of data, I would also add the latest development on the vaccine front to the list of factors that are influencing sentiment at this stage. We've seen the FDA come out and recommend that the Johnson & Johnson vaccine be paused, which was originally expected to last a few days, but now seems like it could be more on the order of weeks. And this is notable given what has thus far been a pretty seamless ramp-up in the inoculation process, at least in the US. So the fact that the path toward herd immunity suffered something of a setback, even at a time when the data has come in stronger than expected, really reinforces this idea that expectations may have gotten a bit stretched in regards to optimism on the recovery, even if the Q1 data has been very strong. No doubt about that.

Ian Lyngen:

I would also add that, this does reflect what Powell said at the beginning of the recovery, and that was effectively, "As goes the pandemic, so goes the US economy." And what we have seen is investors willing to scale back optimism based on some of the struggles of rolling out the vaccine. And I would argue that's not inconsistent with the risks that the US economy now faces.

Ben Jeffery:

And while this news is no question significant, it is worth emphasizing the share of Johnson & Johnson vaccines that make up the overall vaccination picture in the US. Pfizer and Moderna by far make up most of the vaccines administered. And in terms of individuals who are now fully vaccinated, two shots in the case of Pfizer and Moderna, one in the case of Johnson and Johnson, only roughly a tenth of those people who are fully vaccinated were given the Johnson and Johnson vaccine. So going forward, while this is a headwind on the margin, the fact that Pfizer and Moderna continue to represent such a large share of the overall doses is encouraging that herd immunity will probably be achieved, even if it takes a bit longer. Assuming this pause is more than just a few days.

Ian Lyngen:

The estimates currently stand that we will get to 75% inoculation by September, rather than July, as a result of this Johnson & Johnson pause. I'll argue, however, that there might be a bigger risk at play. And that is people's willingness to embrace the vaccine. Now, while there has always been a subset of the US population that has expressed openly in the polls that they are unwilling to be vaccinated, the headlines associated with some of the Johnson & Johnson side effects are pretty dramatic, even if the outcomes are extremely rare. In the context of what one might ultimately anticipate in terms of, what percentage of the US population that ultimately embraces the vaccine, I can't help but think of all the polling risks and inaccuracies, frankly, that we have seen revealed over the course of the last five years.

Ben Jeffery:

And what this all boils down to is a theme that I think you and I have discussed quite frequently, in which is that it's going to be the latter parts of the path out of the pandemic, and frankly, the economic recovery that are going to become the most difficult. The initial surge in hiring as lockdowns were rolled back was always going to be the simplest part of that process. The pickup in spending as a function of in-person commerce now being available, that was always going to be relatively straightforward. But now that we've reached this point, we're starting to hit the time period when not only are firms going to need to retool to whatever the new normal ultimately looks like, but the influence of the massive amount of fiscal stimulus that's been put into the system, which certainly contributed to March's retail sales data, is beginning to fade. So from that perspective, while a strong Q1 and even a strong Q2 are almost a foregone conclusion, it's once we move beyond that, that at least has me a bit more concerned.

Ian Lyngen:

Then you made a great observation about how quickly firms are going to be willing to, or even able to adjust to the new norm. Unlike when we entered the pandemic, where frankly, there was a great deal of implied and explicit urgency and haste, the transition out of the pandemic, there's a bit more flexibility as we think about hiring needs, reopening needs, even restocking needs, particularly in the context of the frontline service sector providers. Restaurants, bars, entertainment, and all the firms that really benefit from the in-person experience won't necessarily find it advantageous to ramp up to 2019 levels immediately. In fact, it makes a lot more sense to take slow and measured steps and scale-up staffing levels, and scale-up inventories until there's a better sense of the amount of demand that can actually be realized post-pandemic.

Ian Lyngen:

It won't be as dramatic as turning the lights back on, in a way that turning the lights off in March of 2020 hit the US economy. This is also complicated by the work from home revolution and the fact that a lot of people, roughly 25% of the labor market, is in a position to slowly scale-up going back into the office. That's one of the biggest risks and unknowns as we think about the path out of the pandemic.

Ben Jeffery:

Do you think this move we've seen from 177, 10-year yields down to 153 has been a function of the market coming to grips with that realization? Or more of a reflection of a positional skew, maybe some flows-driven moves by a market that was decidedly short when 10-year yields were at 170?

Ian Lyngen:

I would say without question, it was a combination. What we had to start the second quarter was the return of Japanese investors. We have seen that via the MOF data, as well as anecdotally, and that led to an initial stabilizing bid. That stabilizing bid then ran up against those stronger than expected data points that we highlighted earlier. And the fact that the sell-off failed to extend when faced with such strong numbers, led investors to stop out shorts, which then took on a life of its own and became self-fulfilling in so far as it triggered several key technical levels. The question now becomes how flat is the market versus their benchmark, and what will it take to either see 10-year yields back at 140 or take another shot at 175?

Ben Jeffery:

I'm glad you brought up that point of the Japanese buying, because the MOF data we got this past week revealed significant inflows to Japan of foreign bonds. $15.6 billion, while short not all Treasuries, is well above average for the first week of the Japanese fiscal year. Over the past 10 years, we've seen average buying of just $1.9 billion. So it's fair to say that the willingness of not just Japanese investors, but the foreign market as a whole to add duration, exposure, and chase this latest bullishness will be very important in answering that question of whether we get to 140 or back up to 175 first.

Ian Lyngen:

There are a couple of things I would note. First, the fact that Japanese buying out of the gate was as strong as it was, does bode well for the next several months as investment strategies are typically not implemented day one. Rather, they are scaled in over time. So we'll be closely watching the incoming weekly MOFF data for further evidence of a buildup in this demand. In addition, if you look at the timing of the price action, a lot of these moves occurred during the US session. So it's unlike in the first quarter where a great deal of the repricing occurred overnight. What we're seeing is some of the dip buy-in emerge domestically. Moreover, if we look historically, overseas real money accounts has a specific set of incentives that leave them more likely to follow price action, rather than attempt to time the inflection point.

Ben Jeffery:

And focusing on both this and next week, I would argue we saw some of that dynamic play out in the primary market. Despite all three of this week's auctions coming in just two days on Monday and Tuesday, a decent tenure and very strong 30-year set a constructive auction stage going into this week's 20-year reopening, and next month's refunding auctions. For all the concern that was offered around the seven-year auctions in February and March, we're reaching the point when strong sponsorship for Treasuries at auctions is once again becoming thematic. So this week, while on the margin, we may see a bit of a concession for twenties. Generally speaking, if the most recent price action is any indication, it should come and go with solid demand.

Ian Lyngen:

Further, to your point, Ben, this was supposed to be the year in which increased auction sizes ultimately broke the Treasury market. It doesn't seem to be occurring in a timeline consistent with what the bond vigilantes might have otherwise assumed. Nonetheless, it does warrant keeping a watchful eye on auction performance.

Ben Jeffery:

So, we've sort of reached the point when we need to put the emphasis on the economic data, primary market, foreign flows, maybe a little bit of the positional skew in terms of a short base.

Ian Lyngen:

Yeah, I would agree. And it's very much like the closing joke of a podcast. You don't want to put the wrong emphasis on the wrong syllable.

Ian Lyngen:

In the week ahead, the Treasury market has effectively no economic information to help guide trading. As a result, we expect that the emphasis will be split between the Johnson & Johnson news, combined with the process towards vaccinations more broadly, not only in the US, but also overseas, and the price action itself. The pullback of 10-yields from 177 to 153 has been accompanied with a collective rethink of the overall trajectory of the market. We've long maintained that the first and second quarter would serve to define the upper bound for the trading range in longer-dated yields that will persist over the course of the year. This conflicts with the consensus expectation for the market to be characterized by repricings of 10 to 15 basis points, followed by a period of consolidation, and then subsequently another repricing. Up until the point that 10-year yields are sustainably above 2%.

Ian Lyngen:

The fact that the market has rallied so early in the year speaks to the idea that investors are looking past the short-term upside from fiscal and monetary policy stimulus, and beginning to look with a more critical eye at the prospects for a post-pandemic economy to be anything like it was pre-pandemic. To be fair, shops will reopen and schools will transition back to in-person learning. The travel industry will rebound, although perhaps not as quickly as the airlines would like to see. There really is very little debate on whether or not the world returns to normal. After all, while this might be our first pandemic, it is not the first pandemic. And as a result, we can all say with a straight face that by 2025, the world will look an awful lot like it did in 2019. The bigger debate really does come down to how long that process will take.

Ian Lyngen:

The market was pricing in a remarkable amount of optimism earlier this year. We can see that in break-evens, as well as the increase in real yields. What we're transitioning to now, however, is more active debate of just how justified that backup in rates actually was. And at least from our perspective, if there is any rationale to get 10-year yields above the range that persisted throughout the latter part of 2019, long before the Coronavirus was on the market's collective radar. For context, that range in 10-year yields was 143 to 197. This means that we have taken a great deal of solace in the roughly 25 basis point retracement in tens, as it does conform well with our broader expectations that we end 2021 with 10-year yields in a range of 125 to 150.

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 with pandemic lockdowns remaining in place throughout many regions, as we scroll through the array of streamable films on offer, we're reminded of the timeless wisdom of the late Patches O'Houlihan. Said, "If you can Doge a wrench, you can Doge a coin."

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 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. 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:

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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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