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Terminal Volatility - Monthly Roundtable

FICC Podcasts Podcasts October 31, 2022
FICC Podcasts Podcasts October 31, 2022

 

Margaret Kerins along with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton and Ben Jeffery from BMO Capital Markets’ FICC Macro Strategy team discuss the upcoming FOMC meeting and whether or not the Fed can actually be credible about forward guidance for upcoming meetings and holding terminal after messaging back in May that 50 bp rate hikes should be on the table for the next few meetings and then actually raising rates by 75 bp at each meeting since then coupled with the huge revisions to the dot plot from June to September. The team discusses economic uncertainty and geopolitical risks and how these factors impact our outlook for US and Canadian Rates, IG credit, and foreign exchange.


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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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Margaret Kerins:

This is Macro Horizons monthly episode 46, Terminal Volatility presented by BMO Capital Markets. I'm your host, Margaret Kerins. Here with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton, and Ben Jeffrey from our FICC Macro Strategy team to bring you our debate on the upcoming FOMC meeting and whether or not the Fed can actually be credible about forward guidance for upcoming meetings and holding terminal after mismessaging back in May. The 50 basis point hikes should be on the table for the next few meetings and then actually raising rates by 75 basis points at each meeting since then. Coupled with the huge revisions to the DOT plot from June to September, we discussed economic uncertainty, geopolitical risks, and the upcoming midterm elections and how these factors impact our outlook for US and Canadian rates, IG credit and foreign exchange.

Each month, members from BMO's FICC Macro strategy team join me for a round table focusing on relevant and timely topics that impact our markets. Please feel free to reach out on Bloomberg or email me at margaret.kerins@bmo.com with questions, comments, or topics you would like to hear more about on future episodes. We value your input and appreciate your ideas and suggestions. Thanks for joining us.

Volatility remains the name of the game across markets with large daily swings in market pricing. This reflects decreased liquidity and heightened uncertainty surrounding the impact of tightening monetary policy on global economies. The Fed remains hawkish and Fed Funds futures are pricing a terminal rate near 5% and a high probability of the higher for longer narrative being achieved. Of course, this is today's pricing and pricing has been nothing other than volatile. So let's kick it off with Ian. Ian, a 75 basis point move this week is widely anticipated, so all eyes will be on Powell's messaging at the press conference. How will the market trade a 75 basis point hike and more importantly, the messaging surrounding slowing to 50 basis points in December?

Ian Lyngen:

Well, Margaret, I think that Powell's biggest challenge at the moment is that the Fed needs to effectively communicate to the market that we are nearing terminal. And whether terminal is the corridor between 4.75 and 5% or slightly higher, is almost a moot point at this stage in the cycle. The Fed is going to deliver 75, the statement will be hawkish. After all, they're moving 75 basis points. And the only nuance that we expect that could be delivered, is in the form of the press conference. And the most practical way that Powell can suggest that we're due for a downshift, is by emphasizing that this far into truly tightening territory, the bar becomes higher for each incremental hike. And I think there'll be some version of that narrative outlined at the press conference itself.

Ben Jeffery:

And Ian, I would also add that the November Fed meeting is going to mark something of a transition point in the way that the Fed is removing accommodation. And what I mean by that is, Powell has given the Fed the flexibility to continue tightening by 50 basis points in December in this case, and maybe 25 thereafter in March. And moves such as that are still acknowledging the potential negative fallout on the real economy. And once we get into 2023, the messaging is going to shift from actively tightening, to a longer period on hold this cycle than we've seen previously. Even as some of the benchmark economic data will likely start to deteriorate, we're expecting that core inflation will moderate and that what has been an unquestionably strong jobs market will start to come under pressure. So no longer will NFP gains north of 200,000 a month become widely assumed and instead a more measured pace of hiring and concerns on a true recession will start to bring more significant buying interest into the long end of the treasury curve.

Margaret Kerins:

So what do you think that means for the two year rate, 10s, and 2s/10s in general?

Ian Lyngen:

So I would say that that means we're going to see upward pressure on the front end of the curve in terms of rates with effective Fed Funds ostensibly acting as a floor for 2 year yields. Further out the curve however, with the 2/10 curve currently inverted by 44 basis points, we see the path of least resistance towards deeper inversion. Now eventually, there will be an inflection point, after all 2023’s big macro trade was always going to be the bull steeper, it’s just a matter of timing that move. But the Fed's commitment to keeping terminal in place for longer during this cycle than it has in previous cycles, really does change the game somewhat for the very front end of the curve. If we think of 2 year yields as effectively a rolling 24 month window of monetary policy expectations, the stronger Powell signals that the Fed is committed to a higher terminal for longer, the weaker one would expect the 2 year sector to be. There's no question that we're entering a very challenging period for monetary policy makers and their messaging of what comes next once we've reached terminal.

Margaret Kerins:

So the bottom line there, is that we're going to have continued volatility in treasury market pricing as the market grapples with exactly how high the terminal rate will get and how long the Fed will hold it in addition to the possibility of some sort of a premium priced in on Fed credibility. So Ian and Ben mentioned the impact of tighter monetary policy on expectations for the economy into 2023. So Dan Krieter, is any of the slowing showing up in earnings and your expectation for IG earnings and what does that mean for spreads in the near term and the long term?

Dan Krieter:

Yeah, Q3 earnings really kind of summarizes the dichotomy that Fed is facing here. Earnings season starts as it does every year with the big bank earnings and the banks came out with pretty impressive earnings highlighting the strength of the consumer, which was potentially a sign that inflation could stay elevated in the near term. But as the season has rolled on, earnings have become decidedly less optimistic, particularly regarding guidance for future earnings. Obviously, big tech sector earnings have garnered the most attention and it's worth bearing in mind that those disappointing earnings have come compared to already significantly lowered expectations. Over the course of Q3, we saw 6.5% drop in analyst earnings expectations, which was the largest since the pandemic and actual earnings are coming in even below those lowered expectations for some of the major tech companies. So clearly here these earnings are starting to provide further indication that Fed restriction is beginning to be felt in the real economy, which arguably justifies the need for a downshift in the pace of Fed restriction beginning in December.

Margaret Kerins:

So we're seeing this downshift in earnings expectations and the effective Fed Funds rate right now is about 3.08 and expected to go higher over the course of the next few months. So how does that impact your view for credit spreads?

Dan Krieter:

Well, I think Danny and I have been pretty bearish credit in 2022, which has proven to be a good strategy. But I think looking at the very near term, slowing corporate earnings may actually represent a near term bullish sign for credit, because I think the market's first impulse will be to trade a more dovish Fed. And there's evidence of this notion in recent primary IG markets where last week we had issuance in IGs exceed expectations for the first time since mid August and concessions on those deals averaged single digits for the first time since Labor Day. So we're seeing a thawing in primary IG markets, more issuance getting done at better execution levels, which has been a technical drag on credit spreads for weeks if not months at this point. So I think you're starting to see a window here for credit to continue outperforming. However, longer term slowing earnings and increasing pressure on corporations can only be a negative for credit and I don't think we've yet seen the peak for credit in the current cycle, it's just going to come further down the road.

Margaret Kerins:

So speaking of the peak in credit spreads in this cycle, how should we think about the timing of reaching Fed Funds terminal and the peak in credit spreads?

Dan Belton:

Margaret, it's interesting because when we look back at recent peaks in credit spreads, we find that credit spreads typically peak around the same time as a peak in fundamental stress and we measure fundamental stress typically using net rating changes. And so, it's important to note that while rating actions remain supportive right now, there's considerable room for those to worsen. And that's when we're thinking that credit spreads are going to peak. Likely, in the second quarter of 2023. In terms of the level for the peak in credit spreads, if we look back at recent periods of growth slowdowns excluding 2008 and 2020, which each brought very acute credit fears that we’re not expecting to be repeated, spreads typically peak around the 225 to 260 basis point range. And we've seen these peaks both in recessionary periods of the early 2000s and non-recessionary slowdowns in growth in 2011 and 2016.

So whether credit spreads ultimately fall in the upper end or lower end of that range, I think it's going to come down to the fundamental strength which is broadly supportive right now. We're only just now beginning to see the first broad indications of fundamental deterioration as these third quarter earnings are rolling in, we're seeing interest coverage falling, liquidity ratios are down, profit margins are compressing, but fundamentals were starting from a very healthy place. So high grade leverage is contained, interest coverage ratios were near their highest on record as of the second quarter of this year. And so, we're looking for spreads to stay in the narrow end of that 225 to 260 basis point range because of the fundamental strength heading into this likely downturn. And we're targeting about 225 basis points for cycle peaks and creditor on the second quarter of next year.

Margaret Kerins:

So as monetary policy makers globally continue to tighten, the tightening will continue to have an impact across all markets. Let's shift a little bit to the Bank of Canada. So Ben Reitzes, what prompted the Bank of Canada to shift its tone and implement a smaller than expected rate hike?

Ben Reitzes:

Simply put, a weaker economy. And the Bank of Canada is much more concerned about the economic backdrop than they showed even a couple weeks ago. Things appear to have changed from the Bank of Canada's perspective in that they are far more concerned about the growth outlook than they were a quarter ago. They look for the economy to effectively tither on recession in the first half of the year in Canada and they have US growth at close to 0% for next year. So weakness there as well. And that's really a big shift from concern and drum beating consistently about inflation and upsides to inflation and the fear of doing too little versus doing too much. And that appears to have changed for now. And the bigger question, is whether other global central banks follow suit. We kind of saw something maybe a little bit similar from the ECB last week and we'll hear from the Fed this week.

And the bank has tended to be among the leaders from a policy perspective globally. And so again, we'll see if others follow suit, but for now, we still do look for the Bank of Canada to continue tightening policy, but at a slower pace, 25 basis points at a time now. Reflecting that increased concern about growth, about the economy, about the fact that Canadian households and the Canadian economy in general is much more levered than the US and so we're just much more sensitive to interest rates than the US economy is. What was particularly interesting is that Governor Macklem sounded concerned about the currency, about the Canadian Dollar and the weakness there just a couple weeks before the meeting, but in the policy statement and in the press conference, no concern at all. And I guess the recent strength in the Canadian Dollar held off their concern. But I guess going forward that, that's still an area that could cause more inflation pressure. So we will have to watch that space very closely.

Stephen Gallo:

Yes, Margaret, the European Central Bank policy announcement is very much in focus right now. As Ben noted, we got the ECB out of the way last week. We get two additional G10 monetary policy announcements in Europe out later this week in the form of the Bank of England and the Norges Bank. My angle on all things currency related in Europe right now, my key angle anyway, is that central banks are getting less and less traction on this issue of currency defense purely with interest rate hikes and monetary tightening. And the Euro and Sterling both have negative core flows fundamentals and rate hikes can't fully offset those fundamentals anyway. I think we also have to add into the mix the fact that central banks in Europe are now very aware of how the toxic combination of monetary tightening, massive government borrowing and very high inflation can seriously erode the value of a currency given what happened to the UK.

So what did we see from the ECB last week? In my opinion, and I agree with what Ben said earlier, despite seriously high inflation pressure in the Euro area, we saw a clear indication from Lagarde that the ECB shrinking its balance sheet is a non-issue for 2022. And for the week as a whole, financial conditions didn't tighten aggressively in Europe. That would be one of my key takeaways. Peripheral spreads narrowed, rates generally fell and overall versus the Dollar, the Euros seem to benefit from this dynamic throughout the week. So where does that leave us? Well, the suggestion is that looser domestic financial conditions or a less severe tightening of financial conditions are probably net positives for the major European currencies versus the Dollar and vice versa, and I think the BOE is going to very much take that into account at its upcoming policy announcement later this week.

Margaret Kerins:

So Stephen mentioned potential dovish shifts in Europe, Greg, what's going on in Japan?

Greg Anderson:

So no shifts in monetary policy from the BOJ last week, with markets maybe a few participants looking for, hoping for the BOJ to raise the yield curve control ceiling rate on 10 year JGBs, which they did not do. Rather, the Japanese policy response to their situation just continues to be one of using FX intervention to control the most out of control variable for them, which is the weakness of the Yen. And to talk about how that is impacting other markets for a second, I'll just start off by saying, as an FX guy, we normally think of it as when US interest rates move that has a spill through effect to Dollar Yen, we don't tend to think of it as going in a reverse direction.

However, over the last month or so, I've had a lot of conversations with fixed income investors who are seeing feedback running in both directions from US Treasury yields to Dollar Yen and from Dollar Yen to US Treasury yields. Just to explain the linkages quickly, Japanese real money investors have huge US Treasury portfolios, both the BOJ whose holdings are un-hedged, as well as private sector investors whose holdings tend to be hedged at something like about an 80% hedge ratio. So for those Japanese institutional investors, they've seen the value of their portfolio. If it was a hundred billion Dollars worth of bonds at the beginning of the year, now they're worth 85 billion.

So if they were running an 80% hedge ratio at the start of the year, that meant that they needed in aggregate an 80 billion short Dollar Yen hedge book, but now they only need a 73 billion short Dollar Yen hedge book. So the system has to buy $12 billion Yen because US bonds have lost so much value. So there's the feedback from Treasuries to Dollar Yen, but as we have seen MOF intervene in the FX market, fear has entered the system that hey, they're going to have to sell Treasuries, and if they sell Treasuries, then Treasuries are going to fall further and it becomes this perverse doom loop with both variables working together. That's where the MOF intervention I think has been important and I'll argue that it's reasonably successful. Over the past five weeks it appears, and they've released the data this morning, they've spent about 63 billion USD to prop up the Yen.

And I would argue they probably have accomplished enough to where we have reached an equilibrium and they'll be able to park it between 145 and 150. I think through the end of the year and yes, they may need to spend a little bit more, but I don't think that they'll end up running out of money and needing to liquidate Treasuries through the end of the year. If they pull it off, I think that can help calm US Treasury markets, but we do have to watch for this next year, because Japan in addition to this hedge ratio problem also has a core flows deficit that it's a smaller issue, but something in the order of 80 to a $100 billion a year of a flow deficit that Japan has to plug. So I would look for the pair to hold 145 to 150, but have more upside pressure in 2023.

Margaret Kerins:

Well, and that could certainly add to the impact of QT on Treasury yields in 2023. Definitely something to watch. So we've covered a lot of territory. Let's conclude with our rapid fire round table kicking it off with Ian.

Ian Lyngen:

We're expecting that the next week will be definitive in terms of policy, but not so much in terms of rates. So we'll continue to look for a deeper inversion with a nod to the fact that the Fed will be slowing the pace of rate hikes.

Margaret Kerins:

Ben Jeffrey.

Ben Jeffery:

And we've now reached the point in the cycle when the Fed's tightening is going to transition from actively raising rates to communicating a stronger commitment to holding on hold in restrictive territory this cycle than what we've tended to see historically.

Margaret Kerins:

Dan Krieter.

Dan Krieter:

I think there's a window for outperformance in credit spreads in the near term as optimism for a soft landing once again increases, but ultimately I think that optimism will fade.

Margaret Kerins:

Dan Belton.

Dan Belton:

We're looking for credit spreads to peak in the second quarter of next year, around 225 basis points as the economic fundamentals deteriorate.

Margaret Kerins:

Ben Reitzes.

Ben Reitzes:

The Bank of Canada has slowed their pace of tightening, but more rate hikes are still ahead. The question now, is whether inflation slows sufficiently next year to keep them from continuing to push through their rate hikes in 2023.

Margaret Kerins:

Stephen Gallo.

Stephen Gallo:

I think the pace of tightening and financial conditions is very much in play as a driver of the major European currencies versus the Dollar right now. The consensus are for the Bank of England to go by 75 basis points this week, but the risk in my opinion is that the bank goes by less or that any sort of interest rate hike is relatively dovish. And I'd probably argue that if financial conditions don't tighten significantly in Europe this week, a dovish outcome from the Bank of England is not necessarily super bearish for Cable. It might be net bearish for Sterling versus commodity block currencies, but not necessarily for Sterling against the Dollar. We're not hugely bullish here on Sterling, broadly speaking, but we're sticking with our view for now that the low in Cable is probably in for the cycle.

Margaret Kerins:

Greg Anderson.

Greg Anderson:

If you see an opportunity to buy Dollar Yen on a 145 handle or to get long CAD Yen on a 107 handle, take it, but don't force the issue and don't be greedy, because we're likely talking about a move of a few percent through the end of the year as opposed to the massive moves that we have seen, the bulk of those moves has probably already occurred.

Margaret Kerins:

Okay, and that's a wrap. Thank you to all of our BMO experts, and thank you for listening. This concludes Macro Horizons monthly episode 46, Terminal Volatility. As always, please reach out to us with feedback and any ideas on topics you'd like us to tackle. Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. We'd like to hear what you thought of today's episode. You can send us an email at margaret.kerins@bmo.com. You can listen to the show and subscribe on Apple Podcasts or your favorite podcast provider. And we'd appreciate it if you could take a moment to leave us a rating and a review. 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 is produced and edited by Puddle Creative.

Speaker 9:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Margaret Kerins, CFA Head of FICC Macro Strategy
Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist
Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy
Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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