Summer Swan Song - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 186, Summer Swan Song, 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 August 29th. And as we say adieu to August, we cannot help but recall that Johnny Mercer classic, we'll miss hikes most of all, when autumn yields start to fall. Wait, what?

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 had a meaningful array of fundamental inputs to drive trading direction. That said, at the end of the day, the most influential factor was Friday's Jackson Hole speech by Powell. In fact, that dominated trading throughout the week, whether it was positioning in anticipation of a hawkish takeaway or unwinding those positions as the market continued to chop around in remarkably volatile end of the summer trading conditions. Realized volatility ticked up while volume started to decline. Conviction was thematically light over the course of the week. And as a result, it wasn't particularly surprising to see that the market responded to a well telegraphed hawkish Fed event by flattening. Front end of the curve sold off. Longer into the curve, rallied in outright terms. 10 year yields still are effectively at 3%, while two year yields continue to creep higher and higher as the debate surrounding where terminal in this cycle will reside.

Ian Lyngen:

Our takeaway is that the September meeting will be pivotal in the market's understanding of where the Fed will end this hiking cycle. If we get 75 and an upward revision to the dot plot, then a 3.75 to 3.40 range should be in play by the end of the year. And that will more than likely represent the effective upper bound of how far the Fed believes it needs to push policy rates in the current environment. Now that doesn't bode well for un-inverting the yield curve. And in fact, what we heard from Powell was that the Fed intends to keep policy rates on hold longer than it has previously, which we would characterize as the most practical way for the Fed to be hawkish well into 2023. Let us not forget that the balance sheet unwind continues, and that's going to be a key background factor as reserves are drained from the system.

Ian Lyngen:

In terms of the other economic data, we did see that the University of Michigan survey's final revisions included a downtick in both the one year inflation expectations and the medium five to 10 year inflation expectations. Medium was revised down to 2.8 from 3%. Now that's going to be a net positive from the Fed's perspective, insofar as it does demonstrate that the average survey respondent has a degree of confidence in the Fed's ability to contain forward inflation. Nonetheless, we know that the correlation between that particular series and energy prices, notably gasoline, is very high. And so to say medium term inflation expectations are lower because of the Fed's actions does imply that perhaps the Fed is simply taking the opportunity to normalize rates, given where we are in the overall business cycle.

Ian Lyngen:

Nonetheless, Powell was hawkish. Personal spending, disappointed. Core-PCE, disappointed, and we had a solid bid for the seven-year auction stop through 2.6 basis points, which is an especially strong showing. Now the two- and five-year auctions didn't fare as well. Twos tailed 1.3 basis points and fives tailed 1.1 basis points. Very consistent, however, with the balance of risks in the run up to Jackson Hole, IE. the hawkish expectations brought into the event, made it unattractive to pay up for two- and five-year securities in this particular environment.

Ben Jeffery:

Well, Ian, it was a week that was defined by Powell's Jackson Hole speech. And now that we have the testimony, fair to say, the chair's comments came, the chair's comments went, and generally as expected, the Fed is still committed to tightening and policy rates are going to be higher for a "long time".

Ian Lyngen:

I think that's a fair characterization of Jackson Hole's takeaways. I do think that it is notable that the market does continue to price in the possibility that once the Fed has reached terminal, it ends up staying on hold for a relatively short period. Now, this is precisely the opposite of what the Fed is trying to communicate. I think that explains why on Friday, we saw the curve flattening really start to regain momentum. Even from a technical perspective, we see that the daily stochastics in twos/tens have crossed in favor of an extension into more deeply inverted territory. Now, this is also consistent with Powell's observation that households and businesses are going to see a difficult period as the Fed continues to fight inflation. Now, we did see an increase in the probability of a 75 basis point rate hike following Powell's speech, and that certainly resonates.

Ian Lyngen:

Now Powell noted that the size of September's rate hike will be determined by the totality of the economic data in the interim period. That's Powell simply saying that the Fed isn't going to favor a 50 basis point rate hike simply because July's inflation series was flat on a headline basis. More importantly, we saw core-PCE come in below expectations on Friday. Now admittedly, the market already knew that there was a softening on the inflation front, given the CPI print, but as the Fed's favored measure of inflation, it is a good sign insofar as the Fed's actions thus far have begun to flow through to the realized data.

Ben Jeffery:

And in addition to what we heard from Powell, who was obviously the headliner in terms of Fed rhetoric, we also heard from several other Fed speakers in Wyoming, who all repeated this idea that higher policy rates, AKA in restrictive territory, for a long time is going to be appropriate. Ian, as we've talked about previously, this runs counter to what we're seeing priced in the Fed funds futures market, and given that the recent historical average of the Fed's timeline on hold is right around seven months, it's fair to assume that that average is going to be the minimum amount of time that we see rates on hold. And frankly, the more realistic base case is going to be that we're going to see rates at terminal for a much longer period this time than we have historically. So if one assumes that the final hike of this cycle will be in December of this year or maybe early next year, that means that the very earliest rate cuts should really be entering the discourse is 2024.

Ben Jeffery:

Now, of course, that will ultimately need to be a function of how well the labor market holds up to the tightening that we've already seen executed, but policy easing priced into next year still seems to be a bit too aggressive. There was another thing Powell mentioned related to this in that the Fed does not want to loosen policy prematurely. So in contrast to a policy error argument where the Fed is starting to get worried about tightening too quickly, what we actually heard was the opposite. Their concern is that they don't want to back off too quickly, which again, should keep pressing the curve flatter.

Ian Lyngen:

I think at this point, it's a fair assumption that we will see the twos tens curve invert back to the depths that we've already probed, which was negative 58 basis points, and even push beyond there. I think that there's a strong argument to be made for a negative 60 to 65 range in the run up to the September FOMC mean, if not, between the September and the November meetings. There's still an open question about where the terminal policy rate should be. It is encouraging to see that most Fed speakers have really focused on a range between 3.50 and 4%. Now whether or not we end up at 3.50 to 3.75 or 3.75 to 4% will ultimately be a function of the September move. The logic goes that the Fed will need to decelerate before ending rate hikes, despite the idea that they have been somewhat front loaded.

Ian Lyngen:

More importantly, a rate hike at every meeting this year has been more than adequately priced in. So we suspect that the Fed will be content to take advantage of the market's pricing in that regard. So, if next Friday's non-foreign payrolls report continues to show underlying strength in the labor market and the August CPI data shows a relatively healthy print, then 75 basis points should be on the table. This would clearly bias us toward the upper bound, that 3.75 to 4% range for target Fed funds by the end of the year, but with one major caveat. That being the Fed will issue an updated SEP, as well as the beloved dot plot. So within the dot plot, we'll see exactly what the Fed is thinking for terminal, given all the information that will have come out since June, which was the last update to their forecast that the market has.

Ben Jeffery:

There was another aspect of monetary policy that was defining this past week, and that is what we heard and saw in Europe, namely that there's some discussion on the ECB of delivering a 75 basis point rate hike. These headlines intuitively pushed up front end European yields, which in turn added to the under performance of the two year sector in the US. This brings me to a client question we received this week, which is, how does the situation in Europe, and what I think you and I would both agree, Ian, is a much a dimmer outlook there than in the US, play into the Fed's calculus and just how aggressive they're willing to be if we're already seeing troubling developments in terms of the economy in Europe and the UK, while it seems that peak inflation has passed in the US? Does more aggressive tightening from the ECB, the BOE, the BOC mean that the Fed will be required to do more, or do other central banks moving aggressively take some of the onus off of Powell to tighten financial conditions, simply given that other markets are doing some of that tightening for the Fed?

Ian Lyngen:

I think one of the things that has truly defined this cycle much more so than any of the prior hiking cycles is how focused the Fed has been on the US and primarily the US alone. Now it goes without saying that the Fed is the US central bank and their objective is to keep price stability and maximum employment in place. However, in prior cycles, what we saw was what one might characterize as a mandate creep that led the Fed to become the de facto central bank to the world. So the fact that the ECB might be more aggressive in the near term and the European economy is facing a higher probability of a meaningful recession, really complicates the calculus for the Fed.

Ian Lyngen:

On the one hand, yes, other global central banks doing heavy lifting for the Fed should tighten financial conditions globally, which will add a minimum, put downward pressure on commodity prices, et cetera, but given the Fed's commitment and the subsequent dollar strength, I'd argue that if anything, ultimately the behavior of other central banks in this environment only incrementally limits what the Fed will need to do. But as I pointed out earlier, the conversation is terminal between three and a half and 4%, not terminal between 5 and 6%.

Ben Jeffery:

And we've talked a lot about the renewed flattening of the curve and twos/tens closing back in on negative 40 basis points. But also let's not forget that we saw some pretty significant bearishness in outright yield terms as the market pressed 10 year yields higher to challenge that 3.10, 3.12 level that ultimately served a solid support before dip buying interest emerged and brought rates lower, along with a similar inflection and momentum that you touched on in the curve, Ian, with daily stochastics crossing in favor of a greater rally. And for the time being, it seems that that 3.25 level in 10 year yields is going to remain unchallenged, at least until the September FOMC meeting. Not to mention the fact that 3.50, which we visited in early June, is looking increasingly likely to serve as this cycle's yield peak in tens.

Ben Jeffery:

Particularly after both the PCE data, which we've talked about, but also the revisions to the University of Michigan inflation expectations numbers, this building consensus around peak inflation, combined with what might be a shifting focus back toward recessionary concerns in the US, both point toward a more constructive take on the long end of the curve, as opposed to another period of bearishness that puts, let's say 3.50 back on the table.

Ian Lyngen:

You're right, Ben. We are squarely in the peak inflation and the peak rates camp, at least for 10- and 30-year yields. But as you also noted, this is becoming increasingly consensus. Our biggest takeaway from the Fed's actions this summer is that they've effectively doubled down on reestablishing their credibility as an inflation fighter. And not only does that imply higher policy rates, but as we've discussed, it implies letting the balance sheet run off for a longer period of time and retaining terminal for longer than we've seen in prior cycles. In practical terms, that might translate through to a deeper recession with greater rate cuts if and when they are required. I suspect that that's going to be very top of mind as we navigate the balance of 2022 and we start to ponder what the world will look like next year.

Ian Lyngen:

That is, a central bank that is more stubborn on rates than it has been in many decades and an underlying economy that, while ostensibly strong, is starting to show some signs of softening. Within Friday's data, we also saw a disappointing personal spending print. Now that's meaningful simply because so much of the US economy is driven by consumption, and if we're starting to see consumers pull back, that doesn't bode well for the idea that the third and fourth quarter of this year will see a rebound from the negative GDP prints that we saw in the first and second quarters.

Ben Jeffery:

And we've talked a lot about the fundamentals, monetary policy, but let's not forget we also saw the final coupon auctions of August with twos, fives and sevens this week, the former two requiring tails, while sevens stopped meaningfully through in a strong bid at what was the second highest yielding seven year auction since 2010. Now it's impossible to know with any degree of certainty where exactly the strength of that bid came from, but given what we've seen historically, in terms of Japanese participation in the seven year sector, as well as what we've seen more recently with the Ministry of Finance Data indicating some growing interest from Tokyo and owning foreign notes and bonds, it's not too great of an inference to make that perhaps stronger foreign demand helped account for the strength of the result at the seven year auction that was definitely absent for twos and fives.

Ben Jeffery:

As we get further along through this calendar year and approach the halfway point for Japanese fiscal year, it's going to be very topical to see how that investor base's behavior begins to change. Presumably we get some stabilization in the cross currency volatility that has kept hedging costs so high, and there is the reasonable probability that Japanese investors will start to get involved in Treasuries in a more meaningful way that again, would help contain any further backup in rates. And given the more general trend following nature of that type of investor, once it becomes clear that the path forward is towards significantly lower yields, it's that follow on buying interest that definitely holds the potential to exacerbate a bullish move that would also be fueled by the closing out of what is still a very substantial short base in the Treasury market. And this is a crucial component of what still leaves us comfortable with that 2.50 level for a target in tens at the end of the year.

Ian Lyngen:

Let us not forget that as year end comes into focus, even a portion of the core short positions are going to be covered simply for profit booking reasons, if nothing else. And as expectations for the next leg in the cycle are refined, the Fed has delivered its series of rate hikes, it wouldn't be surprising to see the latter part of the fourth quarter take on a decidedly bullish tone in Treasuries, especially further out the curve. The biggest remaining question from our perspective is, how far will two year yields trade under effective Fed funds and for how long, given that the Fed is clearly signaling their intent to keep policy at terminal longer this cycle?

Ben Jeffery:

Let's not forget, Ian, it is the last week of summer. So, any plans? Taking any time off?

Ian Lyngen:

No, Ben. I'll be working. Thanks, BLS and your payrolls report.

Ian Lyngen:

In the week ahead, the Treasury market will continue to digest the information coming in from Jackson Hole. We'll have the interviews and takeaways from Saturday's event, as well as a variety of Fed speak on the horizon. The week ahead contains comments from Barkin, Williams, Mester and Bostick, all of which we expect will continue to reiterate the Fed's hawkish message. To be fair, there is a point when monetary policy makers will pivot. They'll pull back from the hawkish rhetoric, but it's just not yet, and we struggle to imagine it will occur anytime between now and the midterm elections.

Ian Lyngen:

On the data front, Friday sees the release of payrolls for August. The consensus is for a print of 300,000. In addition, the unemployment rate, which is currently at 3.5%, will be a focal point, and estimates are either for an unchanged or slightly higher unemployment rate at 3.6. Still, when we think about it from a broader context, the unemployment rate is remarkably low. And while the labor force participation rate has lagged where we might have otherwise expected it to be in this cycle, it still isn't at the extreme seen at the beginning of the pandemic. All else being equal, we expect that the takeaway from non-farm payrolls will be confirmation of the Fed's assessment of the underlying strength of the real economy being more than adequate to sustain several more rate hikes between now and the end of the year.

Ian Lyngen:

There are also a couple events midweek that warrant acknowledgement. First, the ADP private employment report is now back after a brief sabbatical. In addition, Wednesday represents month end. And given that August was a refunding month, there should be a reasonable amount of demand either to match the benchmark or to keep a constant short versus target. Now it is notable that the recent positioning data continues to illustrate that real money has retained a significant short versus the duration benchmark. So this, if nothing else, suggests that at some point between now and the end of the year, we could see either a flight to quality episode that triggers duration buying to get back to even with the benchmarks, or simply position squaring as year end comes into focus.

Ian Lyngen:

For the last several weeks, we have been lamenting the typical late summer, low liquidity, low conviction environment for trading US rates. We anticipate that that has at least one more week left, with the exception of payrolls. Although given the timing of NFP, we don't expect that it will be a well-attended event in the traditional sense. Although there could be more sustainable price action that results if for no other reason than given the Fed's data dependent mode for the size of the next rate hike.

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 we watch the pundits in their best professional mountain attire in the Tetons, rest assured that we've recorded this episode in cowboy hats, rope ties and chaps while watching Yellowstone. Chair Dutton has an nice ring to it, although Rip would drop inflation off of the train, as it were.

Ian Lyngen:

Thanks for listening to Macro Horizons. Please visit us at BMOcm.com/Macro Horizons. 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.

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