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Squid Bonds - The Week Ahead

FICC Podcasts October 22, 2021
FICC Podcasts October 22, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of October 25th, 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 143, squid bonds 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 October 25th. And after watching the latest binge-worthy Netflix series, all we can say is please hold the Calamari.

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 to 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 passed, the most interesting aspect of the Treasury market was the price action itself, as opposed to any incremental new information on the fundamental side. We started out the week with an aggressive pricing in of rate hikes in 2022. Now it does follow intuitively that if the Fed is poised to announce the tapering of QE at the November meeting, the market's attention will shift toward the next policy transition, which will be toward rate normalization.

Ian Lyngen:

What was most striking was the aggressiveness with which the market has been pricing in rate hikes. We had a 50 50 chance priced in for a June rate hike, and then a subsequent rate hike in September, and one more by the end of the year. That implies not only a much more aggressive path than the Fed has laid out in its projections, but also a truncated or accelerated tapering period, as opposed to the official guidance that we have seen thus far.

Ian Lyngen:

I will note the caveat that if we look historically, the market has a strong tendency of pricing in whatever the status quo is at the moment. So at this point being against the effective, lower bound for policy rates for the foreseeable future which let's call it six to eight months, and then we price in what is presumed to be the next shift, in this case rate hikes. What we have seen in the past is this window of expectations will simply be extended with the passage of time.

Ian Lyngen:

So if we assume that that's the case, that means that when we have two hikes fully priced in for 2022, and that reflected in the two and three year sector, that those bonds look comparatively cheap. And that was precisely the market's logic behind the recent re-steepening of the yield curve. This steepening, unlike what we saw in Q1 was driven by a bullish move in the very front end of the market. So effectively, taking out some of the more aggressive rate hike pricing.

Ian Lyngen:

Concurrent, and perhaps as a result of this move, we saw 10 and 30 year yields edge higher with tens reaching levels not seen since Q1. We've been very much on board with the bearish period for Treasuries during the month of October. It's been consistent with the seasonal patterns and it also reflects a pricing in of the risks associated with the November tapering announcement. While the price action would suggest otherwise, anecdotes reflect that there is a reasonable amount of buying interest in the market at the moment, particularly in the front end.

Ian Lyngen:

Which again, has contributed to the incremental re-steepening. What remains to be seen is the extent to which 10 and 30 year yields can back up before there is sufficient buying interest to stop the sell off and establish a new upper bound for the trading range further out the curve. Our expectations are that the zone between 170 10 year yields and 177 is going to represent a key battleground for the market, as it were. And we would expect an acceleration of the dip buying interest already evident in the Treasure market.

Ben Jeffery:

Looking at the calendar this week, frankly, I would have expected something of a placeholder in terms of what to expect in the Treasury market. But what we saw was early in the week, an impressive amount of hawkishness priced into the curve that ultimately resolved in a sell off toward meaningful higher long end rates.

Ian Lyngen:

Yeah, we did see tens set some of the highest levels since the first quarter. So that was an impressive move. I will note however, it's very consistent with the notion that we were expecting a run up in yields into the November FOMC meeting as the market tries to get ahead of the policy shift.

Ian Lyngen:

Now, when we look historically, what we see is previously tapering announcements have been dip buying events. And that's our base case scenario for the balance of the fourth quarter. That's not to say there's no potential for 10 and 30 year yields to edge higher from here, but rather there will be an inflection point, presumably some time after the Fed meets.

Ben Jeffery:

And looking at the breakdown of the price action, what struck me was the impressive rally in breakevens and what that ultimately translated to in terms of nominal yields. We saw five year breakevens reach their highest level on record and 10 year breakevens trade through the peaks we saw established in May of this year.

Ben Jeffery:

Now this came after the early week flattening trend, which was a reflection of liftoff being priced entirely in, in September of next year with even a small chance of a June, 2022 liftoff. So the reversal of that dynamic and accompanying increase in inflation expectations resonates with the idea that more accommodative monetary policy will flow through to higher inflation expectations while sooner or more aggressive rate hikes will have the opposite effect.

Ian Lyngen:

Well, intuitively that makes sense, Ben, but one of the interesting nuances of the recent price action was that we did see as you point out, a reasonable amount of rate hikes brought forward into 2022 and still we have breakevens up against or through some of the recent peaks.

Ian Lyngen:

So there's one of two things going on. Either the market is saying that the Fed simply has no control over inflation or rather would be unwilling to hike to the degree needed to offset what we're going to see in terms of realized inflation. Or given the increasing amount of inflation that the market is expecting, the new equilibrium involved both a more hawkish Fed and higher breakevens.

Ben Jeffery:

And the path forward for the Fed is especially topical. Given a very interesting question we recently fielded. On Thursday of the week ahead, we do get the first look at Q3 GDP and with estimates, most notably the Atlanta Fed's GDP now tracking sub 1%, the question was would a negative GDP print in the third quarter lead the Fed to postpone tapering, which remember at this point is expected to be announced just five trading days after GDP hits the tape?

Ian Lyngen:

Well, I'd say definitely maybe on that one, Ben. Because the Fed is expecting a pretty solid year's worth of growth in 2021. And if the second half underperforms expectations to such an extent that we're risking a technical recession by the end of the year, I think that that would in and of itself give the Fed pause.

Ian Lyngen:

Now that isn't to suggest that in such a hypothetical, they wouldn't eventually follow through with tapering. However, from the market's perspective, tapering immediately in the wake of a negative real GDP print would send conflicting messages and add greater uncertainty to the forward path of policy rates.

Ben Jeffery:

And to emphasize a point that you've made previously, Ian, even the risk of this, I think suggests that Powell is likely preparing to deliver a quote unquote "Dovish taper." And while what specific form that will ultimately take, won't be known until the November meeting. It's not unreasonable to assume that the committee will introduce language that emphasizes that QE tapering is a flexible process. It can be slowed or suspended if needed. And while at this point, that seems more likely than speeding the process up. Within the formal language of the release, that will definitely be something to be mindful of.

Ian Lyngen:

Another aspect to the price action in the week just passed that's worth highlighting is the fact that Fed funds futures priced in roughly a 50, 50 chance of a June rate hike in addition to fully pricing September and December. So in keeping with the flexibility of tapering theme, that runs up against a sequencing issue for the Fed. The Fed has made it abundantly clear that they're not going to hike rates as long as they're still expanding the balance sheet.

Ian Lyngen:

So that means if in fact, we were to see a June rate hike that the Fed would need to accelerate tapering so it ended sometime in the early second quarter. And frankly, given the lag impact of monetary policy actions are generally thought to be in the six to 12 month range, and then immediately follow through with the rate hike would introduce some very significant risks to the real economy, ie, a classic policy error.

Ben Jeffery:

And in discussing this, what jumps to my mind is how would financial conditions respond in such an environment? What would the equity market do? While following some of the weakness in stocks that we saw earlier this month, Dow traded at record highs once again this week. And using the current paradigm of equity volatility that remains very low and in turn financial conditions that remain very easy, at this point, the Fed has to be taking solace in the fact that we now have a second half 2022 rate hike priced in, tapering broadly assumed and still financial conditions remain very benign. So to me, rocking that proverbial boat at such a precarious point in the recovery seems like an unneeded risk for the Fed to take.

Ian Lyngen:

I tend to agree. And I would argue that the vulnerability of financial conditions might become much more evident in the latter half of the fourth quarter. It's very difficult for me to envision a straight line of 10 year yields above 2%, given everything we know about the headwinds facing the global economy.

Ian Lyngen:

Especially at a moment where not only is the Fed pulling back from an extremely accommodated monetary policy stance, but so are several other global central banks. All of which creates an environment in which sentiment towards risk assets will be closely followed for any potential ramifications from the removal of the stimulus punchbowl as it were.

Ben Jeffery:

And I also think it's fair to draw at least a rough comparison between the current repricing and what we saw in the first quarter. But I would add two critical differences are the stimulative influence coming out of not only the Fed, but also Washington. At this point, it seems fairly unlikely that we're going to get any sweeping spending bill out of Congress. And the Fed is clearly committed to begin pulling back on their own accommodation.

Ben Jeffery:

So while it feels like a long time ago now, remember in the first quarter we got another round of direct payments and enhanced unemployment benefits. We're still introducing a meaningful amount of upside to the growth landscape in the first half of the year. That's no longer the case. And I think Ian, to your point, adds to this notion that it's going to be difficult to see 10 year yields move two, or through that 2% level in the near to medium term.

Ian Lyngen:

Recall that the September and October period was supposed to be an important litmus test for workers willingness to reengage with the frontline service sector opportunities as the enhanced unemployment benefits rolled off. Now, we can finally see after several weeks of a slow drawdown in enhanced unemployment benefits that we're starting to stabilize at what I would characterize as the new normal for continuing and initial jobless claims.

Ben Jeffery:

On that topic, there's two nuances to flag. The first is that while yes, jobless claims have been declining, remember in the September payrolls report so too did the participation rate. So the fact that the labor force participation rate, especially in that younger than 55 year old category is now trending downward, and it's hardly an encouraging signal for that big wave of rehiring that was broadly expected to take place this autumn.

Ben Jeffery:

And secondly, and much to your surprise I'm sure, Ian, was a detail we saw in the beige book this week, which was at across districts many surveyed firms said that as the pandemic has begun to wane, they can actually get by with fewer workers as a function of increased automation. Now automation in the service sector is hardly a new phenomenon, but certainly a trend that was accelerated by COVID just given the health concerns surrounding in-person interactions.

Ben Jeffery:

So the fact that companies have now come out and explicitly said, "We don't need as many people doing these jobs as we did before the pandemic" implies a slower pace of hiring and ultimately sustainable wage gains in an environment when prices are already moving higher. Not exactly an ideal outcome at this point.

Ian Lyngen:

As we think about the economic landscape over the course of the next several years, it's very difficult to ignore the relevance of the accelerated speed of automation in the service sector. I suspect that that will be very thematic and continue too, as you point out, Ben, undermine the pace with which the workers who were hit the hardest at the beginning of the pandemic are ultimately reintegrated into the labor force.

Ian Lyngen:

Now, when we think about pockets of labor scarcity and how will ultimately contribute through to the overall economy. At this point, we're less concerned about those particular wage gains leading to true demand driven inflation, but rather the costs associated with those wages from the producer's side, leading to something akin to a supply shock. So pushing higher costs of labor through to the real economy has different implications than if we were seeing organically created free range, grass fed, demand driven inflation.

Ben Jeffery:

How much will that cost?

Ian Lyngen:

Well, how much you got?

Ben Jeffery:

It's headline anyway.

Ian Lyngen:

In the week ahead, the Treasury market will have several key fundamental inputs to help guide trading direction. Although ultimately, we're going to continue to focus on the bearish seasonals in the run up to the November 3rd FOMC meeting. The Fed will be in its radio silent period, and so we don't anticipate any material changes to fed expectations over the course of the week. As previously noted, the most important data point is going to be the first look at third quarter real GDP.

Ian Lyngen:

The consensus is for roughly 3%, although some tracking estimates do suggest a sub 1% par, most notably the Atlanta Fed's GDP now tracker. Setting aside the immediate implications from an outlier negative GDP print on Thursday, we're looking to the release to help level set expectations for the balance of the year with an emphasis on the quarters core PCE figures. Recall that for the same amount of nominal growth, a higher rate of inflation undermines real GDP.

Ian Lyngen:

This speaks to this stag inflation light scenario in which higher prices simply function as tax on consumption. Now, this is very consistent with the way that the Fed has historically characterized run ups in energy prices, for example. And given the recent moves in both natural gas and oil, it's unsurprising to see investors focused on such a scenario. Admittedly, that was no one's base case as we came into 2021, nonetheless, as the inflation complex has continued to edge higher and the transitory or not transitory debate remains an open one, one would be remiss not to at least acknowledge the stag inflation light risks in the year ahead, even if such would be a low probability event.

Ian Lyngen:

As it presently stands, we expect that the second half of Q4 will have a bullish tone in the Treasury market. Not to the extent that we are looking for a complete reversal of the selloff that has occurred since rates hit their lows at the end of the summer, but rather a steady recalibration of expectations once we see the response of risk assets to the reality of the Fed scaling back from the QE program.

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 we prepare for Halloween, it was truly disappointing, but came as no surprise that our Jack Skellington costume needed a trip to the tailors. Guess it's Jack Roundington this year. Thanks, COVID.

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 thick Macro strategy group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

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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