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Thanksgiving Special - The Week Ahead

FICC Podcasts November 24, 2021
FICC Podcasts November 24, 2021



Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 29th, 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 148, Thanksgiving special. 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 29th. And as another Turkey day quickly approaches on top of this year's thankful list resides the fact that management has yet to insist Macro Horizons becomes a video cast. No one needs that.

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 U.S. 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. In the week just past, the Treasury market had a couple key inputs to help define forward expectations, not least of which was to renominate Powell as the chair of the FOMC and Brainard as the vice chair.

Ian Lyngen:

Now, this was very much in keeping with the market consensus, although it did trigger a reasonable amount of bearish price action, if for no other reason, then the decision, remove the risk that Brainard was nominated as the head of the FOMC. Now in the context of what this implies for forward monetary policy expectations, if anything, it simply serves as an official endorsement on the part of the administration of Powell's recent hawkish pivot. Not to be fair, the Fed is anything but super hawkish at the moment, but some of the recent transition, including the tapering of QE does translate to a less dovish stance.

Ian Lyngen:

We continue to anticipate that this less dovish stance will flow through into 2022 and eventually lead to the first rate hike. All else being equal, one rate hike next year is a reasonable departure point for a conversation about the Fed. Powell has made it abundantly clear that he is retaining the transitory narrative. This point was reiterated following the November FOMC meeting when he commented that he expects inflation to moderate in the second and third quarter of 2022. Now recall that in Q2 2021, there were some very significant base effects at play, which led to relatively dramatic increases in the year over year pace of inflation.

Ian Lyngen:

Fast forward to the second quarter of 2022, and we will have a reversal of those influences, albeit on a more modest scale. Given that the monthly increases of core CPI in the months of April, May and June were between seven and nine tenths of a percent. It's safe to say that there is a relatively high inflationary bar as we think about the timeframe for the Fed's evaluation of transitory. To be fair, if we find ourselves in June of next year and the Fed hasn't seen the anticipated reversal of inflationary pressures, one should anticipate a relatively swift policy response.

Ian Lyngen:

Relatively swift in the context of the Fed, however, should be measured in meetings in quarters, not days or weeks. This implies that the second most likely outcome for rate hikes next year will be two quarter point hikes in the second half. The market consensus currently stands at a 25 basis point move per quarter cadence. And that is simply derived by looking at the last tightening cycle. There is an argument to be made that if the Fed feels that they're far enough behind the curve on inflation, that quarter point moves might not be considered sufficient. So one would be remiss not to at least keep the probability of a half point move on the table should the Feds transitory assumption ultimately be proven incorrect.

Ben Jeffery:

While it was a short week, there was certainly no dearth of information that offered some pretty meaningful direction to the Treasury market. Probably most notable was Monday's announcement that chair Powell has now been renominated and her Governor Brainard will be taking the vice chair seat. The one that will be vacated by Clarida on January 31st of next year.

Ian Lyngen:

What's interesting from my perspective about the price response to this was it was decidedly bearish. We saw the front in sell off the five year sector as well. Now that's notable because it was a largely consensus result. Although to be fair on the margin, there was the risk that Brainard got the chair seat. One of the biggest takeaways from the renomination is policy continuity. Now to some extent that goes without saying, but the fact of the matter is there has been a lot of disagreement within the market as well was in Washington on the best response to higher inflation. This eventually will bring us back to the transitory or not transitory debate before the time being. I think the key takeaway is that the Biden administration via renominating Powell has offered an implicit endorsement in the chairs' current plan to continue tapering a pace unless the data dictates and eventually deliver a liftoff rate hike sometime in 2022.

Ben Jeffery:

And that's a fairly notable divergence from what we've seen from presidential administrations past. President Trump frequently expressed his opinion that he wanted lower interest rates, and even looking back historically, there is an abundance of evidence that the executive branch has consistently pushed for easier monetary policy. After all, a president with aims on re-election would naturally like the economy to be running as hot as possible. Bring that to the current paradigm, and the fact that the current administration gave its sort of tacit endorsement of a more hawkish slant exactly as you point out in, speaks to the importance of inflation. And the reality is that at this point, higher consumer prices have made their way into being a political issue. So it's not unreasonable to think that maybe one of the motivating factors behind this decision was in order to be viewed as "taking inflation seriously."

Ian Lyngen:

Well, when coupled with Biden's decision to release oil from the strategic petroleum reserve in coordination with other major nations, it does speak to the fact that Washington is taking inflation very seriously. It certainly resonates that higher oil prices leading to higher cost at the pumps ahead of the holiday shopping season is something that policy makers should be worried about.

 

Ben Jeffery:

And while we received an answer on the chair and vice chair nominations, that still leaves three vacancies on the board of governors that Biden will soon need to nominate, including the Vice Chair for Supervision, a role that was formally held by Quarles, and at least based on our conversations with clients, a job that many thought Brainard would get the nod for. So with the White House slated to announce those nominations at some point in early December, that will be something of an event risk, at least from a financial regulation perspective.

Ian Lyngen:

And it follows intuitively that the Democrats would want to leave their mark on the Fed via a presumably somewhat more restrictive regulatory environment. While this isn't an immediately tradable event for the Treasury market, it is something to keep in mind as we hear of future initiatives from the board of governors.

Ben Jeffery:

And keeping with the theme of politics, let's not forget that 2022 is a midterm year. I would argue that makes the Powell nomination all the more noteworthy especially what we saw in the Virginia governor's race and what that ultimately might suggest about the Democrats prospects at the midterms. Now, Republican or Democrat aside, what we've tended to see historically is that, in the midterm elections, at least one of the houses of Congress has tended to change control, whether that be from Republican to Democrat or Democrat to Republican. So in practical terms, this implies that while we now have the infrastructure bill in hand, if in fact we're going to be returning to a more gridlocked situation in DC in 2022, it certainly doesn't bode well for any new sweeping legislation that increases spending and ultimately Treasury issuance.

Ian Lyngen:

And in the very near term, let us not forget that we still haven't made it through the debt ceiling debate. Between now and the end of the year, one should expect increased headlines regarding the potential for the U.S. to default. Now, we're reminded that unlike most debentures, there is actually not a cross default provision for Treasuries. So said differently, we could have delayed payments on one or two bills comparable to what we saw in 1979, and that will not trigger a mass default of Treasury debt. Nonetheless, it will make for interesting headlines from the Financial Media and something that will surely lead to price dislocations in parts of the bill market.

Ben Jeffery:

And on the issue of governmental borrowing, and Treasury supply specifically, we've now seen the entirety of November's coupon auctions come and go. And frankly, it was something of an uninspired month in terms of supply. The only two stop throughs we saw were for 10 year tips, an endorsement of the value of inflation protection at this point in the cycle, and this past week, seven year auction. And what makes this so noteworthy is that, this was the first month we saw smaller auction sizes since they were revealed at the refunding announcement earlier this month. And all else equal, one would think that smaller auctions would translate to more robust results. The fact that we saw the opposite, highlights that it's the monetary policy in macro backdrop that are far more consequential in determining these auction results.

 

Ian Lyngen:

And I think that that's important context when we contemplate 2022. We're very much on board with a Q1 selloff that attempts to reprice the U.S. rates market at a higher plateau in terms of yields. Now, we do anticipate that the brunt of the bearish impulse will play out in the five years sector. And that implies a further flattening of the 5/30 and 5/10 curve. Now we've been cautious in how we frame this potential selloff. It's not that we're not anticipating a re-trade of the dynamic that was at play during Q1 of 2021, but rather this round will have more fundamental support and therefore be somewhat more sustainable. The flip side is that once the market reprices and the Fed, which we assume will be the case, retains the transitory narrative, at least until the second if not the third quarter, then we'll find ourselves in a situation where risk assets start to look increasingly vulnerable.

Ian Lyngen:

It's easy to envision a situation where, not only are nominal yields higher at the beginning of 2022, but also real yields, particularly in the 10 year sector, start to drift higher, perhaps above -50 basis points, and that ultimately will have ramifications for the equity market and other risk assets eventually leading through to tighter financial conditions. Such a situation would effectively be the market tightening for the Fed. And if the market tightens for the Fed that will lessen the urgency, bind monetary policymakers to either accelerate tapering or bring forward the liftoff rate hike.

Ben Jeffery:

But it's not just a question of the market's pricing of normalization, the departure point, both from a yield perspective but also an economic fundamental one, matters. And in this regard, the next three weeks are going to be very pivotal, given the fact that this week we get November's payrolls print. The following week we get the November CPI data. And then, of course, is the Fed meeting, which while at one point was largely expected to be a placeholder, now contains the event risk associated with either a more aggressive dot plot and/or the prospect for the Fed to hint that maybe the debate around accelerating tapering is picking up a bit of steam.

Ian Lyngen:

I think it's fair to say that at the December FOMC meeting, there will be a discussion about accelerating tapering. And while my baseline assumption is that they don't follow through with that in December, one would be remiss not to look at the November non-farm payrolls data, and arguably more importantly, the November CPI print as a gauge for any additional urgency on the part of policy makers to wind down QE more quickly and thereby provide a greater deal of flexibility regarding the first rate hike if and when they decide to bring it forward.

Ben Jeffery:

And we've heard from several members of the committee that they are in the camp advocating for a faster pace of winding down bond buying, specifically, [inaudible 00:13:02] come to mind. But given the fact that they're more hawkish tendencies over the course of 2021 are well known Clarida's comments that he might think about starting the conversation on accelerating tapering, really reiterates this notion that while, yes, every vote counts on the committee, really it's the chair, the vice chair and the president of the New York Fed who contribute most meaningfully to the overall policy discourse. So Williams, Clarida and Powell, not yet suggesting their advocacy for a faster pace of tapering, should leave the issue firmly in the discussion category in December.

Ian Lyngen:

And given Clarida's looming departure, one should be a bit more assertive in discounting those headlines.

Ben Jeffery:

I'm just glad he's going to have time to work on that next album.

Ian Lyngen:

Truly looking forward to that. In the week ahead, the Treasury market will be returning from the long holiday weekend to meet a series of important data releases. First up, will be Wednesday's ADP figures, as well as ISM manufacturing. Now these will help set the tone ahead of Friday's all important November payrolls report. As it presently stands, the consensus for Friday's number is a half million increase in non-farm payrolls with an unemployment rate at 4.5%. We've been focused and will continue to emphasize the relevance of the labor market participation rate, particularly the below 55 year old cohort.

Ian Lyngen:

We know that the pandemic has led to a wide variety of changes in U.S. labor, not least of which it has brought forward retirement for many baby boomers. So it doesn't resonate that the 55 and older cohort will be especially relevant for the next stage in the cycle. What is more important are the low wage earners and the frontline service sector. There's no question that we're seeing pockets of labor scarcity, particularly in the low wage and low skill sector. What is uncertain, is how long that persists now that the enhanced unemployment benefits have expired. And we're now seeing shockingly low initial jobless claims.

Ian Lyngen:

It will be very informative for the macro outlook to have the update from the November employment report. One would typically anticipate that December would be relatively quiet in terms of macro inputs, and more importantly, anything that would occur which would truly recast expectations for the year ahead. At last this December is atypical certainly in this regard. If for no other reason, then the mid-December FOMC meeting will allow the market to receive another input as investors attempt to further refine a collective understanding of the Fed's reaction function to the higher than expected realized inflation prints.

Ian Lyngen:

Needless to say, the potential for an accelerated tapering is on the table. Although, we expect that that will not ultimately come to fruition. Nonetheless, a focus on the payroll's report, including the labor market participation, as well as the composition of the CPI data that will be released on the 9th of December are warranted and could potentially turn the tide in terms of the Fed's thinking. That said, all the early indications suggest that Q4's inflation profile will be notably more subdued than that of Q2, which should, all else being equal, take any pressure or urgency off the Fed to respond with a quicker pace of tapering.

 

Ian Lyngen:

We've reached the point of 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 holiday travel at hand, we've never been so excited to quickly fail a rapid test. Didn't even study. 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 podcast 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 Nasdaq Bank 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. 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.

Speaker 2:

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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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