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A Squared Dozen - The Week Ahead

FICC Podcasts October 29, 2021
FICC Podcasts October 29, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 1st, 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 144, A Squared Dozen, 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 November 1st. And as Halloween approaches, there is no ambiguity regarding this year's must have costume among the central banking crowd. Hint, it is not a dove or even a pigeon.

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, the Treasury market received a great deal of new information, particularly in the form of a slightly disappointing real GDP print, which offered a glimpse of some of the stagflation light concerns that have been pervading the markets. Specifically the higher than expected personal consumption numbers were offset by a higher than expected headline price deflater. As a result, we saw a 2% increase in real GDP during the third quarter. Now recall at the beginning of 2021, most market participants were assuming that the second half would be characterized by an acceleration of growth as the real economy came back online. And while the upside from stimulus seen in the first half started to fade, built up savings and pent up demand would continue the real economy's positive momentum into the end of the year. Now, the fact that the Delta variant came into play during the third quarter certainly complicates matters, but one thing is certain and that's that there is nothing between now and Wednesday's FOMC meeting that would keep the Fed from delivering on the well telegraphed official announcement of QE tapering.

Ian Lyngen:

The price action itself also told a very specific story in terms of market expectations for the year ahead. We saw the two, three and five year sectors continue to come under pressure, and the broader shape of the curve was decidedly flatter. This brings up the question of how much of this has been overpriced and will there be a correction at some point? So to some extent, yes, we are starting to get to extremes in terms of what's priced in for rate hikes next year. However, the fact of the matter is that historically the market has been more eager to price in rate hikes than what is ultimately delivered by the Fed. So the notion that they are two rate hikes solidly priced into the market at this point, and our take is that the Fed is only likely to deliver one, is not without historical precedence. In fact, we expect that on a rolling basis, the market will air on the side of pricing in a more dramatic tightening series than what will ultimately be realized.

 

 

Ian Lyngen:

Now, to be fair, such a bias is consistent with the balance of risks at the moment, especially when inflation continues to spread higher than expected. And the supply chain and logistic concerns do not appear to be easing any time soon as we head into the holiday shopping season. So in short, we're at an important inflection point for monetary policy as the real economy continues to work its way out of the pandemic and investors focus on the year ahead.

Ben Jeffery:

Well, Ian, the November Fed meeting is coming at a very pivotal time in the monetary policy cycle. This past week, the trend in Treasuries was undoubtedly one of flattening, as assumptions on rate hikes in the US and, frankly, globally continue to be brought forward.

Ian Lyngen:

There has been a remarkable shift in the broader global central banking narrative as we approach the end of the year. Yes, we know that the Fed is poised to taper its QE program, but what we've heard from the Bank of England and the Bank of Canada is that rate hikes in those countries are a lot closer than what we'd been assuming here for the Fed. And as a quick glance at the Fed funds futures market reveals, we're currently pricing in two full rate hikes for 2022 with better than even odds that the Fed actually moves in June. My interpretation of that is that the market has gotten somewhat over exuberant in assuming how aggressively the Fed will hike rates to combat inflation, especially given that a fair amount of the inflation is going to be headline and function more as a tax on consumption than it will be reflective of a stronger underlying economy

Ben Jeffery:

And looking at 10 and 30-year yields in outright terms, I think it's exactly that dynamic that you highlight, Ian, that helps explain why we saw 10-year yields move fairly significantly lower, despite what's becoming the increasing expectation of higher policy rates. Now this gets at the different drivers at different points on the yield curve. And what I mean by that is that the front end and belly are going to continue to be beholden to the path of policy rates while moving out to sevens, 10s, 30s and 30s, the long end is far more responsive to the longer term implications on growth and inflation.

Ben Jeffery:

I also think it's worth touching on what we heard from Christine Lagarde at the ECB meeting. And she went far as to explicitly say that current market pricing is not in line with the guidance that's being provided by the ECB. Now, granted that's in Europe not the US, and the ECB has a track record of airing on the more accommodative side of the policy spectrum. But nonetheless, in the event we hear something similar from Powell on Wednesday that could offer a fairly meaningful reversal of the price action we've seen this week.

Ian Lyngen:

And to your point, Ben, the ECB has a tendency to air on the side of being more accommodative, but that's not to imply that the Fed doesn't also have a similar tendency, or at least during the last few cycles. What's different this time is that there has been a clear acceleration of inflation. We're seeing that in wages with more implied by the elevated quits rate, and the fact that the labor force participation rate remains remarkably low, particularly for the under 55-year-old cohort. So that implies that the current episode of labor scarcity might not be transitory in the way we had been previously assuming.

Ben Jeffery:

And that's a really good segue to what was probably the most important fundamental update this week in the advanced look at Q3 real GDP. We saw just a 2.0% expense expansion versus expectations for 2.6% during the third quarter. Now, yes, there's certainly an argument to be made that some of the drag was a result of the Delta variant and factors that will likely not be as pronounced in the fourth quarter, but nonetheless, a quarterly expansion at just 2% hardly points to a significantly optimistic trajectory on the path of the expansion from here. Related to in no small part by exactly that labor market dynamic you highlight Ian, we still have a stubbornly low participation rate. And the sub-sector of the labor market most adversely affected by the pandemic, the lower wage earnings service sector jobs, are going to be the ones that continue to be the slowest to be brought back online, which will leave sustainable wage pressures somewhat elusive, at least over the medium term.

Ben Jeffery:

And it's this dynamic that I think is probably going to define trading in US rates and likely markets more broadly over 2022. And that is the precarious position of central banks, the Fed included, of endeavoring to offset runaway inflation and the expectations thereof, while at the same time not prematurely offsetting what would otherwise be an ongoing turn of the jobs lost to the pandemic.

Ian Lyngen:

Within the details of the third quarter GDP print, it is notable that we saw higher than expected consumption, which during a period of heightened concerns associated with the Delta variant was somewhat surprising. But what was more meaningful when it came to the overall real GDP numbers was the higher than anticipated increase in headline prices. This remind us that for the same amount of nominal growth, the more inflation that there is in the system, the lower real GDP ultimately is. Diving a bit deeper into the details of the report, we saw a drop in goods spending and an increase in service spending. This is very consistent with the rotation that many in the market had been anticipating would characterize the second half of the year. What is striking, however, is it is occurring with real GDP at 2%, rather than 6% or 8%.

Ian Lyngen:

A question that we've been receiving quite a bit over the course of this bull flattening move has been, "How far does the flattening extend and when would we consider it overdone?" So on one hand, the technicals imply that the move is overdone and there should, if nothing else, be a period of consolidation in the near term. But more fundamentally when we think about the degree to which the market is expecting rate hikes next year, more than 50 basis points of tightening seems to be more than a little bit ambitious given where the Fed has signaled that it is in its own cycle. So putting this all together, we do expect there to be a steady grind toward a flatter curve with 10-year yields continuing to decline in an outright basis. But there will be moments for tactical re-steepenings with the emphasis on the front end of the curve.

Ben Jeffery:

And in addition to the number of rate hikes, I also think timing is a critical component here. On Wednesday, the path of least resistance for what to expect in terms of the details of tapering is going to be a $15 billion a month pace. We saw that figure cited explicitly in the FOMC minutes. And assuming that that cadence is maintained all the way through the process, this would leave tapering to conclude in June. Now, Ian, I think you and I are on the same page that the language around tapering is likely going to incorporate a degree of flexibility, something along the lines of assuming the economy performs in line with expectations. So while yes, that could mean an acceleration of the trimming of bond buying, I think all the risks that we've discussed thus far skew the probability in favor of a slower taper rather than a faster one.

Ian Lyngen:

While that might be our base case scenario, I would argue that in the event that the Fed emphasizes the flexibility that they'll need around the pace of tapering, the market will interpret that as hawkish and presumably increase the odds of a June rate hike, which will ultimately exaggerate the flattening in the curve, particularly fives, 30s.

Ben Jeffery:

So in contemplating when tapering will ultimately end, at this point I think it's fair to say this cycle is going to be far different than last cycle. Remember the last round of QE ended in 2014 and we didn't get the first rate hike until over a year later. The fact that our conversation is centering on just a matter of months between the end of tapering and the liftoff rate hike speaks to the unique nature of the economic shock brought on by the pandemic and the concern that the Fed has on rising prices. New framework or not, clearly the communication thus far indicates that the Fed is not willing to let the proverbial inflation genie out of the bottle just yet.

Ian Lyngen:

It also speaks the idea that the current interpretation in the market is that Fed got it wrong on transitory. We've long maintained that the Fed owns the definition of transitory. So while the market might be eager to get in front of any shift on the part of the Fed in terms of how they're characterizing inflation, at the end of the day, it's a shift in the official characterization of inflation that matters in terms of justifying some of the rate hikes that we see priced in for 2222. It's this dynamic which will make the FOMC meeting all of the more interesting, particularly Powell's press conference.

Ben Jeffery:

And another question we've received several times this week is, "Can the market force the Fed to tighten?" The distinction worth drawing here is that while the market can tighten for the Fed, investors can't force the Fed to tighten in the same way that they can to ease. And as an example, in a world where we're starting to see higher front end yields, higher borrowing costs and more hawkish pricing, that's going to have the same effect on financial conditions, i.e. a tightening, as actual tighter monetary policy would. So in a way, drawing out the current market dynamic to its conclusion would actually lead to tighter financial conditions as a function of the market, which somewhat counterintuitively would give the Fed a bit more flexibility in actually delivering on rate hikes. If financial conditions are tightening, even without the Fed being forced to act, the FOMC is not going to feel compelled to add to that tightening pressure by actually delivering on rate hikes.

Ian Lyngen:

While I generally agree with that take, the one exception is a scenario in which the market is so concerned about inflation that we run up breakevens, comparable with what we have been seeing, and that forces down real rates. And with 10-year real yields below negative 100 basis points, that has reinforced the base of easy financial conditions. And so in effect, by repricing break even significantly higher, we see real rates press lower, that makes financial conditions easier. And if the Fed's objective is to stabilize financial conditions or even potentially tighten them, then such a dynamic could actually compel the Fed to act.

Ben Jeffery:

And in the discussion of financial conditions, we can't ignore the role that equity volatility plays in the Feds measure of financial conditions. And given it was a week with another round of record high stocks, the subdued volatility landscape and risk assets simply reinforces this very easy financial conditions paradigm that we still find ourselves in.

Ian Lyngen:

And as year-end approaches, it reminds us that not all vol is good vol.

Ian Lyngen:

In the week ahead, the primary event will be the FOMC meeting on Wednesday, which includes Powell's press conference after the fact. Now, as we've already outlined, our expectations are for a 15 billion a month pace of QE tapering that will end balance sheet bond buying in the middle of 2022, all else being equal. Let us not forget, however, that we also see the October non-farm payrolls print. Now with the current trajectory of initial jobless claims trending lower, especially as the enhanced unemployment benefits have come off, there is no question that the pace of jobs growth will be closely followed once we have the Fed's official tapering announcement in hand.

Ian Lyngen:

As to the question of whether one should expect a hawkish tapering or a dovish tapering, we're somewhat of two minds on this topic. At its core, the Fed needs to deliver an optimistic view on the pace of growth, as well as expectations for inflationary pressures to be transitory. So that would imply a neutral to hawkish tapering. On the flip side, we know that the Fed had previously emphasized the difference between the lower threshold for tapering versus the higher threshold for actual rate hikes. Now, in the event that the committee or Powell chooses to focus on the difference between these two triggers, it stands to reason that the overall Fed event will have a bit more of a dovish undertone.

Ian Lyngen:

What's far less obvious is the extent to which the Treasury market quickly moves beyond trading the tapering once it's been realized and focuses on the fallout from a less accommodative monetary policy stance. If the recent price action is any guide, that's going to be net constructive for 10s and 30s, while the perceived removal of a hurdle to the first rate hike will continue to weigh on the front end of the market. The trend toward a flatter yield curve into year-end continues to resonate as does leaning more bullishly further out the curve, given the strong tendency of prior tapering announcements to be net bond bullish for 10s and 30s. It's certainly well within the set of conceivable outcomes that the Fed delivers a tapering, it's a relatively balanced stance in terms of forward monetary policy expectations, the market simply chops around ahead of non-farm payrolls and the knee jerk response to NFP sets the tone for the coming week into the November 10th core CPI print of course.

 

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. As the days get shorter, and Tim Cook prepares to set our clocks back for us, we're reminded of just how much time we actually spend in the dark.

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 the 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 Inc. 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:

Not withstanding 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. 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 representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you.

Speaker 2:

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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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