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Trading Through Heightened Geopolitical Risks - Monthly Roundtable

FICC Podcasts February 25, 2022
FICC Podcasts February 25, 2022

 

Margaret Kerins along with Ian Lyngen, Ben Reitzes, Stephen Gallo, Dan Krieter, and Ben Jeffery from BMO Capital Market’s FICC Macro Strategy team to bring their debate on how the recent geopolitical developments impact their outlook for monetary policy liftoff, US & Canadian rates, high quality spreads and foreign exchange and the main risks to these outlooks as discussed in today’s client call.


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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.

Podcast Disclaimer


It’s only been a few days since Russia invaded Ukraine, but markets strategists are already thinking about how this clash could impact global markets over the long term.

“It depends on how long the turmoil persists, it’s ultimate outcome and whether the invasion of Ukraine represents a global geopolitical paradigm shift to something resembling the Cold War,” said Margaret Kerins, Head of FICC Macro Strategy at BMO Capital Markets, on a February 25th panel discussing the implications of the invasion. 

She was joined by the BMO Capital Markets FICC Macro Strategy team, including:

  • Ian Lyngen, Managing Director, Head of U.S. Rates Strategy

  • Ben Reitzes, Managing Director, Canadian Rates & Macro Strategist

  • Stephen Gallo, European Head of FX Strategy

  • Dan Krieter, Director, Fixed Income Strategy

  • Dan Belton, Vice President, Fixed Income Strategy

  • Ben Jeffery, U.S. Rates Strategist, Fixed Income Strategy

While there’s never a good time for countries to engage in conflict, this battle comes at a particularly precarious time. Central banks are on the verge of raising interest rates, while the global economy is still recovering from the pandemic. “Markets were already contending with heightened uncertainty surrounding the economy as the Fed prepares to lift off and normalize its balance sheet,” said Kerins. “This crisis certainly adds another element of uncertainty.”

Rates Still Rising

One of the key questions many are asking is whether the Federal Reserve will increase rates in March. Kerins noted that the BMO team is still expecting rates to rise by 25 basis points, with additional hikes to follow. Rising energy prices, which have climbed higher over the last few days, will also incentivize the Fed to hike rates. “That has only reinforced the Feds’ inflationary fighting urgency point,” said Lyngen.

Still, there’s some worry that a rate increase and a reduction in Fed bond buying, could come back to haunt the central bank. “We’re asking ourselves what are the long-term implications of the current conflict on the U.S. and global economy and does it increase the chance of Fed monetary policy error, which could result in inflation?” said Kerins.

Lyngen isn’t anticipating an error, but more of a policy trade-off, with the Fed potentially slowing growth too quickly to combat rising inflation. “The Fed is doing everything it can to retain and re-establish credibility as an inflation fighter,” he said. “They know the risks they're taking in potentially undermining demand and causing a slowdown.”

The Bank of Canada, which meets on March 2nd, two weeks before the Fed, will likely raise rates by 25 basis points, too, said Reitzes. If anything, the conflict and uncertainty will put an end to any speculation of a 50 basis point rate hike, he noted.

With Canada’s economy so focused on energy, there was some worry that soaring oil and gas prices would ultimately result in higher inflation. But while prices are elevated, they did fall on Friday, with Brent crude trading at $95 a barrel, down from $101 at the start of the invasion.

Still, he’s keeping a close eye on how things may unfold. “The conflict really just highlights the uncertainty that can crop up at any time,” Reitzes noted. “And it doesn't really change the near-term path for policy, but it could bring down the endpoint if the conflict persists.”

Widening Credit Spreads

Dan Krieter, Director of Fixed Income Strategy discussed how the current geopolitical situation might impact credit spreads. Over the last seven weeks, investment grade credit spreads had been widening and are now around 125 basis points, which, he said, is fair value.

It’s possible some of the upward pressure on spreads will start to fade now that the invasion has happened, but a risk premium will likely continue to be priced into risk assets for at least the next couple of months, until the world has a better understanding of Russia’s plan. 

It’s impossible to predict that that risk premium may be, but “it will certainly take us past our initial target,” he explained. “We're going to wind up past the 125 or 130 basis point range, but once we see the spread stabilize and demand start to materialize at higher spread levels, we’re going to enter into something of a range bound environment.”

Higher oil prices could also impact credit spreads, he noted. Typically, rising oil costs cause spreads to narrow, in part because companies have tended to pass price increases onto consumers. But because of rising inflation, the potential for rapidly climbing oil prices and geopolitical uncertainty, businesses may not do that this time around.

“We’re going to have to wait to see what happens as the next leg of credit spreads is going to depend upon the path of inflation and how successful corporations are in passing along the higher input prices along to the consumer,” he said. “We're not going to know that for months.”

A Falling Euro

The BMO FICC team is also paying attention to how currency markets might react to an ongoing conflict.

One thing worth considering is that in retaliation for financial attacks on Russia from the West, the Russian Central Bank could destabilize the euro potentially by liquidating it for selling it from its reserve, said Gallo. “That's something we should ponder, because the euro share of the central bank's reserves is probably around 35% or 40% – potentially higher than the US dollar share,” he explained.

Supply chain disruptions, which could result in even higher inflation, would also impact the euro’s price, said Gallo.  “Importers may start to shift suppliers, which would result in capacity constraints and higher demand forcing up prices,” he explained.

Given all of this, it’s likely the ECB will have to taper its bond purchases at a faster rate than expected, said Gallo, but it could start hiking rates later than expected, which increases the risk of a divergence with the Fed. “That would cause the euro to weaken, too,” he said.

It’s still too early to know exactly how all of this will play out, but while the fighting could end sooner than later, the conflict may last much longer. “I expect the tension related to this shift in geopolitics will linger for months,” said Gallo. “Possibly even years.”

Read more

Margaret Kerins:

This is Macro Horizons Monthly Episode 38: Trading through Heightened Geopolitical Risks, presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Ben Reitzes, Stephen Gallo, Dan Krieter and Ben Jeffery from our FICC Macro Strategy team to bring you our debate on how the recent geopolitical developments impact our outlook for monetary policy liftoff, U.S. and Canadian rates, high quality spreads and foreign exchange, and the main risks to these outlooks as discussed in today's client call.

Margaret Kerins:

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.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries.

Margaret Kerins:

The markets were already contending with heightened uncertainties surrounding the economy as the Fed prepares to lift off and normalize its balance sheet. The crisis in Ukraine certainly adds another element of uncertainty as evidenced by elevated intraday volatility and rates and risk assets. However, tenure yields remain about 50 basis points higher on the year and only about seven basis points off the recent highs.

Margaret Kerins:

As we navigate these uncertainties, we remain confident that the state of the current geopolitical risks will not derail the Fed's mid-March liftoff. And we continue to expect an initial rate hike of 25 basis points. Also, in terms of the Fed's balance sheet, we continue to expect the Fed to maintain its desire to roll it down in the background and not use it as an active tool of monetary policy. Therefore, the bigger questions for us are what are the longer term implications of the current conflict on the U.S. and global economies? Does this increase the chance of a Fed monetary policy error resulting in possibly stagflation?

Margaret Kerins:

Much of this of course depends on how long the turmoil persists, its ultimate outcome, and whether the invasion of Ukraine represents a global geopolitical paradigm shift back to something resembling the Cold War. So Ian, we began the year with the expectation for 10-year yields to push up through 2% between the January and March FOMC meetings. This was achieved six times intraday and held for three closing sessions over the past few weeks and 10s remain within a stones throw of 2%. Absent this heightened geopolitical backdrop, 10-year yields would likely be higher, but are you surprised that they're not lower?

Ian Lyngen:

Well, Margaret, I think it has been a fascinating start to the year without question. And when we think about whether 10-year yield should be lower given the introduction of the geopolitical risks, I think it's important to look at the way in which the market has been trading the headlines over the course of the last two weeks. We had been, as a market, assuming that the most material impact on the global stage from the situation in Ukraine would be that there were a net increase in energy prices that then subsequently flowed through to the U.S. economy and only further reinforced the Fed's inflationary, fighting urgency.

Ian Lyngen:

Point in fact, there were a few episodes in which the geopolitical concerns got to the point of undermining risk assets and then there was a flight to quality in Treasuries. And if anything, the events of the last two weeks have reinforced the idea that the longer into the curve is going to remain in a trading range. And while the Fed is certainly going to follow through with its efforts to normalize both monetary policy rates and the balance sheet, it's going to be tightening or removing accommodation into a very precarious point of the overall cycle, which to your earlier question, implies that there is a degree of policy error risk.

Ian Lyngen:

However, I would reframe that in saying that the Fed is at this moment doing everything that they can to retain and reestablish credibility as an inflation fighter. And the Fed knows exactly the risks that they're taking in so far as potentially undermining demand and causing a slowdown or an into the recovery more soon than would otherwise be ideal. So I would characterize that as a policy trade off rather than a policy error.

Ben Jeffery:

And Ian, I think there's another dynamic of this that's probably of a significant amount of concern on the Fed, which is the shape of the curve and just how flat we've seen the yield curve move before we've actually even seen the first rate hike of the cycle. We got 2s/10s as low as 33 basis points on the peak of the concerns over this past week.

Ben Jeffery:

And with some of the hawkishness being walked back, it's going to be very interesting to see the relationship between how much further investors are willing to push upfront 10 yields, reflecting maybe the chance of a 50 bit hike, maybe not in March but May or June, and how that's going to impact the longer end of the curve, exactly as you highlight, in a world where we're already facing lower growth assumptions both in the U.S. and now Europe with this added unknown of the impact on energy costs and just general uncertainty around what's going on in Ukraine.

Ian Lyngen:

Another aspect that has made this particular cycle so unique is the dramatic magnitude of the recession in the beginning of the pandemic, the quick rebound, and then the translation of this to inflationary pressures has created a very condensed cycle. So everything is happening very quickly, whereas previously, or in previous tightening episodes, we would not expect to see as much curve flattening as has already been achieved during this cycle.

Ian Lyngen:

And so when I look at 2s/10s at 33 basis points and I see what's on the horizon for the balance of the year, it's very difficult to envision a path in which 2s/10s doesn't invert and along with that will come the 5s/30s continued flattening, which has also been a rather dramatic move. Now the outperformance of the long end of the curve also is reinforced with some of the geopolitical risks because while the U.S. is 100% focused on the inflation environment, other foreign investors in particular are looking at the comparatively attractive rates in Treasuries as a buying opportunity given all the uncertainties, not only in terms of geopolitics, but also the state of the recovery.

Ian Lyngen:

Recall that not every nation and not every economy has had same experience during the pandemic. For the U.S., it's been very inflationary, for other parts of the world it has been a bigger tax on consumption, and still others it's been even more inflationary. So the divergence that we're seeing in terms of monetary policy response also flows over into the divergence we're going to see in terms of the performance of real economies, at least on a comparative basis.

Margaret Kerins:

So Ian and Ben, you mentioned the impact of higher energy prices on consumption. We know that the financial conditions have tightened over the past several sessions. Ben, you mentioned the possibility of the market pricing in a 50 basis point rate hike, not at liftoff, but at some point during the year. So Ian, are you holding your call for 25 basis point rate hikes in the backdrop of these higher energy prices and what it means for inflation?

Ian Lyngen:

Well, I think that the key for the tightening cycle is that the backbone of rate hikes will be 25 basis points a quarter with the off cycle meetings used to augment the tightening. So we're on board with 25 basis points in March, 25 basis points in May and 25 basis points in June, followed by a July balance sheet runoff. And then the situation becomes a lot less clear and directive for the Fed. By that point, we'll have a lot more information in terms of the performance of the real economy during the first half of the year, all else being equal, the Fed would like to continue hiking at a 25 basis point a quarter or even 25 basis point a meeting cadence.

Ian Lyngen:

The fact of the matter is right now, the Fed Funds Futures market is pricing in six and a half 25 basis point hikes over the course of 2022 and we have seven meetings left. So we don't expect that that will be prescriptive at this point, rather that the Fed is going to provide us a lot more information regarding their reaction function on the 16th of March when we get, not only the liftoff details, but also more forward guidance via the updated projections. And we'll see the number of hikes that the Fed is willing to communicate at that point.

Ian Lyngen:

So while we are worried about inflation and it is very much in the system, we don't see any upside for the Fed starting with 50, if for no other reasoning, that the signaling would imply that each hike going forward would be 50 basis points. So measured and predictable will continue to be this cycle's mantra for the Fed I suspect.

Margaret Kerins:

I agree in that the uncertainty surrounding the outlook calls for a gradual approach and that the Fed needs to hike to keep inflation expectations anchored, even though we all know that they can't fight today's inflation with today's policy, it's really about those expectations and time passing so that we can see how the economy evolves. And as you pointed out, things have happened very rapidly in a very condensed type of cycle. And I don't think the Fed wants to find themselves in the position of having overtightened at the same time some of the pandemic related frictions and the decline in the massive stimulus starts to take effect.

Ben Jeffery:

Yeah, Margaret, I think your comment on the stimulus aspect of it and just the massive amount of money in the system is also something else that's playing out in the debate on the Fed. We've seen Governor Waller and James Bullard come out in favor of a 50 basis point move at some point in the first three meetings. But on the other side of that debate are those on the committee that are advocating for maybe a little bit more aggressive move on the balance sheet.

Ben Jeffery:

And given the profile of SOMA's Holdings, even excluding the $326 billion of bills that they have, just by letting the Treasury coupons that they hold that mature over the next three years run off, that gives them $2.2 trillion of ammunition to run down the balance sheet. Presumably pull some of the excess capital we're seeing in the RRP facility out and remove accommodation in a way that they're hoping at least doesn't continue to unduly flatten the curve.

Ben Jeffery:

So while all these risks face the Fed, and we've heard from several committee members that they still want to lean more aggressively on rate hikes and forward guidance than the balance sheet, I think it's safe to assume that the balance sheet is going to play a much bigger role in this round of normalization than it did in the previous cycle.

Margaret Kerins:

Yeah, I agree, but I think it'll be faster, but I also still think they want it to happen in the background. And I think that's one of the biggest questions that we're getting today and some of the biggest disagreements in the marketplace, where there are many people who think that the Fed will sell their balance sheet in an attempt to steepen the curve. But really they don't know what the transmission of selling off of their balance sheet is to the real economy. And I suspect they'd rather take a more gradual approach and that's actually what they've messaged.

Margaret Kerins:

So let's shift gears a bit here. IG spreads have been widening on the back of Fed liftoff expectations. And in fact, credit spreads have already hit our target of 125 basis points. So I'd like to turn it over to Dan Krieter. Dan, how does this heightened geopolitical risk impact your outlook for credit markets?

Dan Krieter:

Yeah, Margaret you're right. Coming into the year, we were targeting 125 basis points on the Broad IG Index. And that move was really reflective of a shift from the stimulus driven lows of 2021 to something more reflective of fair value given the path of inflation and a more hawkish Fed that you guys just finished talking about. And after we saw the IG Index widen seven consecutive weeks, something that's only happened three times since the financial crisis.

Dan Krieter:

We'd argue that moved to fair value has probably been achieved. But now we have to factor in how geopolitical risk impacts the view on spreads. And there's really two ways that it does. The first, now that we have something of a worse case scenario or what we would've considered a worse case scenario on the geopolitical front just a couple weeks ago now realized perhaps some of the upward pressure on spreads arising from the current situation will start to fade. But that said, we probably need to see a risk premium just price into risk assets for the next couple months, until we have a better understanding of how this will fully play out and what Russia's full scale intentions really are here.

Dan Krieter:

And we really don't have a good way to estimate what that risk premium is worth, but it will certainly take us past our initial target. So we're going to widen past the 125 to 130 basis point range we are projecting, but once we start to see spread stabilize and demand start to materialize it now higher spread levels, we think we're going to enter in something of a range-bound environment here while the market just waits for more information on the growth and inflation side that you talked about, which actually brings me to the second impact of geopolitical risk on spreads. And that is the impact of higher oil prices.

Dan Krieter:

Now, if we look historically oil prices and corporate earnings actually tend to be positively correlated. And so it's unsurprising then that at periods of high oil prices, spreads tend to narrow. That may seem counterintuitive, but when you think about it, both oil prices and corporate profitability are heavily dependent on consumer demand. And when both of those things are heavy, you can see oil prices and corporate earnings move together. That implies inherently that at previous periods of high oil prices, corporations have been successful in passing along that higher input price along to consumers.

Dan Krieter:

That may not be true this time since we're dealing with not only a supply shock of oil given the geopolitical risk, but also potential growth concerns arising from the conflict and some of the other things you guys talked about earlier with stimulus pricing out and more restrictive Fed policy.

Dan Krieter:

So we're going to have to wait to see. Ultimately the next leg in credit spread is going to depend upon the path of inflation and how successful corporations are in passing along the higher input prices along to the consumer. And we're not going to know that for a period of months. So once we see spread stabilized here in the near term as we expect, it's likely we're going to enter into somewhat of a range-bound environment here where spreads just have to continue to wait for more inflation data.

Ben Reitzes:

Dan, you mentioned inflation, and that's really the key for Canada. The Bank of Canada has a meeting next week on March 2nd. And they're still very much on track to hike rates 25 basis points. And I think there maybe was a little bit of concern with the market volatility that things might change a little bit for the bank, but we're still firmly in the camp that they'll go 25 basis points next week. If anything, I think the recent volatility just solidifies that position. Any talk of a potential 50 basis point rate hike that should be pretty much off the table at this point, put to bed at least for this meeting.

Ben Reitzes:

Going forward, all options are open just given the uncertainty out there and the potential for inflation to surprise on the high side as it has consistently done in recent months. And the Russia-Ukraine conflict really comes down to energy prices for Canada. And so the initial spike in energy prices that we saw on Thursday, what was worrying because it just would've meant even stronger inflation pressure and even more pressure on the Bank of Canada to be pushing rates higher, but energy prices have backed off. And so the impact should be pretty negligible and that's what keeps the bank on track for a rate hike next week.

Ben Reitzes:

And we think they continue to push rates higher slowly but surely, 25 basis points at a time at the next four meetings consecutively. At that point, they could pause a little bit and see the state of things, but the conflict really just highlights the uncertainty that can crop up at really any time. And it doesn't really change the near term path for policy, but it could bring down the endpoint. If the conflict persists, if it causes more global macroeconomic damage, that could make it more difficult to get to what the market currently believes is the endpoint for policy rates for Canada.

Ben Reitzes:

Where there might be some opportunity is right now the market's pretty much pricing a straight line for the Bank of Canada to get to 2%, pretty much 25 basis points at every meeting. But again, this week's events tell you that things don't necessarily move in a straight line and the conflict could create a potential opportunity for the Bank of Canada to pause maybe for a longer period of time after an initial foray of rate hikes.

Ben Reitzes:

From a curve perspective, in Canada I'm very much in line with my U.S. colleagues. The curve does look likely to continue flattening. That's going to be the case at least until the Bank of Canada backs off of their rate hike path and again, that doesn't seem very likely near term. One thing I will note, and this is an important aspect of this crisis, the economic backdrop for Canada generally is that historically oil and the Canadian dollar have been very well correlated, but that really hasn't been the case lately. And you could have seen it yesterday with the Canadian dollar weaker despite oil prices being up 10% at one point.

Ben Reitzes:

So if we do get another leg up in oil prices, that probably won't be the same positive as it has been for Canada. Won't be the same positive for the Canadian dollar for sure. And part of that is because we just don't get the same type of investment inflow that we once did. There isn't an appetite that existed call it 10, 15 years ago to invest in Canadian oil sand to get fresh capital into the country to put to work in that sector. That's just not the case. And so you're not seeing the same type of positive impact of higher oil prices on the Canadian dollar. And so perhaps that's the clearest indicator of why you're seeing this divergence between oil prices and the Canadian dollar.

Stephen Gallo:

Ben, that's a great point on the Canadian dollar. And maybe I can just add to that, not so much a structural factor like the one you were talking about, but a market factor. I think the Canadian dollar has become a bit desensitized to the strength in oil because there has been a shift in the drivers of dollar Canada to factors that are more related to risk appetite. It's also possible that the global risk environment has sat some of the demand for non dollar currencies because I've noticed a similar relationship between oil and the Norwegian krone, for example, the kroner.

Stephen Gallo:

So I think there are short term and maybe structural factors involved there, but I need to back up at the moment and cover Europe and Russia-Ukraine. Where to begin? I think in terms of context, the situation Europe now faces has been building up for years. There are many important causes of why we're here. We're mostly aware of them, all of them, but I think the number one reason for Putin's stance today is bitter resentment of the way the Soviet Union was dismantled at the end of the Cold War.

Stephen Gallo:

And now that's important in the current environment, if it's true, because if that's the factor that's driving his determination to reclaim lost territory, there is a risk that he's not going to stop the process with Ukraine. Now that doesn't make a Russian invasion of an EU, NATO member state imminent, but since Putin knows the West is fearful of using so-called nuclear options against him, there aren't many other deterrents to stop him from, for example, gradually amassing troops on the borders of an EU member state as a means of threatening to destabilize the EU or just creating leverage.

Stephen Gallo:

So I expect the tension related to this shift in geopolitics to linger for months, possibly even years. And that's one point I would stress, which is that Putin is probably playing the long game here so as to avoid overextending himself. You just have to recall that the annexation of Crimea was eight years ago. So that's a pretty long time. What I think is important is maybe to have a couple of scenarios in mind of where things go from here from a geopolitical perspective.

Stephen Gallo:

So first scenario, and I think this is the one that's probably quite a bit more likely. Putin and the Russian military take Kiev, install a pro Russian government, dismantle parts of the Ukrainian military, occupy strategically important parts of the country, and then start to gradually deescalate. And going back to my thought about Putin playing the long game in this scenario, I think it's highly unlikely that he will completely switch off the supply of fossil fuels of natural gas to Europe. I think he'll keep his hand on the tap, so to speak, to exert leverage, but the tap will probably stay on. Again, I think that's the most likely scenario from this point forward.

Stephen Gallo:

The second scenario is probably what you're imagining. Putin and Russia the military they move on from Ukraine quickly, Russian troops and military equipment are amassed at the Western borders of the Ukraine with EU member states such as Poland or Hungary, and that's where you get the risk, for example, of much more severe sanctions.

Stephen Gallo:

Just a few comments, I guess, on what this means for the ECB and the Euro. In my opinion, the Russian invasion of Ukraine, even in the absence of very severe Western sanctions as of right now, I think it's injected a fresh dose of upside inflation risk into the European backdrop, partly because importers may start to shift suppliers and then you end up with capacity constraints and higher demand forcing up prices. For the ECB this will have only strengthened the arguments of the more hawkish members of the governing council.

Stephen Gallo:

Of course, there are many things that they look at when they come to their decisions or formulate their views. But I think a lot of the more hawkish members are very worried about the potential for persistent weakness in the euro for a variety of reasons. And one thing worth considering is that in retaliation for financial attacks on Russia from the West, the Russian Central Bank could destabilize the euro potentially by liquidating it for selling it from its reserve. And that is something we should ponder because the euro share of the central bank's reserve is probably around 35% or 40% and potentially higher than the U.S. dollar share.

Stephen Gallo:

So in light of those factors, I would expect that in March the ECB will announce a slightly faster QE taper pace than what was previously laid out in December. But I think the dovish aspect now that we have this situation in Ukraine is that it will probably refrain from announcing an end date for asset purchases for now. I think that result if it plays out next month will stabilize euro/dollar above 1.10. The only thing I would add is that a more prolonged ECB QE cycle increases the risk of divergence with the Fed, which could cause the euro to weaken more so than it did before when the assumption we were working with was that a Q3 or Q4 ECB rate hike was pretty much nailed on.

Stephen Gallo:

Also if the inflation backdrop in Europe has increased by a notch or two or three or whatever because of recent developments and the ECB is incapable of tightening in response, I think the FX market would view that as an added downside risk to the euro. However, this is a very volatile and uncertain environment. And if the Russia-Ukraine situation further adds to upward pressure on inflation in the euro area, there is still a lingering risk of a pain full squeeze on euro short positions and possibly on risk assets if the ECB is forced to normalize policy more rapidly.

Ben Reitzes:

Ian, I have a question for you. What do you think it would take for the Fed to go 50 basis points at the March meeting? We still have a jobs report and a CPI report. What's the threshold to get them to go at this point?

Ian Lyngen:

I think that's a great question. The biggest issue from my perspective is to go 50 the Fed would be signaling that they were much further behind the curve than I believe that they are comfortable with behind the inflationary curve. So realistically as a market and the Fed as well, I think that the general assumption is that during the second quarter, so this is the April, May and June CPI series, the base effects will make the year-over-year numbers look a lot more manageable from monetary policy perspective.

Ian Lyngen:

So what would it take between now and March 16th? I struggle to see it with perhaps the exception of a extremely strong non-farm payrolls report, the easing of geopolitical tensions, and the perception that while the significant overhang, from an inventory perspective there's a big buildup in Q4 GDP figures that we saw in the inventory side and that will weigh on the first quarter. So the perception that either that's not going to matter, which we suspect it will from a real GDP perspective, and an even stronger trajectory of jobs gains with the backdrop of accelerating inflation that we know is here.

Ian Lyngen:

Is it a bad idea to go 50? I would say not. I would say that there's a very strong argument to do it, but I don't think that they will ultimately because the market will simply say, "Well, if they started with 50, then that means each subsequent hike is going to be 50. And so we'll price that in as a market." The 2-year will go from roughly 1.60% to above 2%. You'll see inverted 2s/10s curve. You'll see the long end rally on an outright basis. And that's where we'll change the conversation from this idea of a policy trade off to a true policy error that risks putting the U.S. economy into a recession in 2022. I think to a large extent that's why they don't want to lead with such a strong move.

Margaret Kerins:

So, as I mentioned, this podcast is a recast of a client call that we did earlier today. And one of the questions that came in today is the BOC sensitivity to curve inversion, which we pass to Ben Reitzes.

Ben Reitzes:

Thanks for your question. Good question and I've heard that from a number of folks. The bank is a little bit less focused at this point on the curve. It certainly is something they think about for sure, but to some extent, I mean the Canadian rate environment is subject to what goes on in the U.S. And it's difficult to see those curves moving in any opposite directions at this point, we do expect them to continue flattening.

Ben Reitzes:

I don't know how much power the bank really has to impact the longer end of the curve at this point. Like if they were to come out and start selling their portfolio, that would likely have some effect. But if you look at the Bank of Canada's assessment of the impact of QE, they only believe that it had about on average 10 basis point impact across the curve. So even if they were to sell outright, which they're not signaling that they're going to do at this point, but if they were to do that, if you use their analysis, the impact likely wouldn't be all that significant.

Ben Reitzes:

So as much as they do certainly pay attention to it as a potentially indicator for what might come next, I don't know that there's that much they can actually do about it at this point. If you were to see the Fed become more concerned and they were to start selling and the Bank of Canada also did the same, maybe that changes things a little bit, potentially at least in the short term, but it's challenging at this point for central banks to believe that they can impact the curve while they are pushing the front end rates notably higher with rate hikes.

Ben Reitzes:

This not something that they've dealt with in the past. And I guess it's one of the challenges of the cycle. And we'll see if it's something that they do indeed have to deal with at the end of the day.

Margaret Kerins:

Ian, maybe you can talk a little bit about your interpretation of Powell watching the curve-for-curve inversion and what that might mean for monetary policy.

Ian Lyngen:

Yes, I'd think that this is yet another unique characteristic of this particular cycle. And that is, as we mentioned earlier in the call, we're starting to a large extent where we might have typically been once the Fed had already begun the process of normalization. And by that, I mean, the curve is much flatter than we would typically see before the first rate hike. Recall even at this point, the Fed is still actively engaged in QE and buying bonds until the beginning of March.

Ian Lyngen:

And so to very quickly shift gears is somewhat unique for the Fed. But the other reality is there's a fair amount of debate at this moment in the tTreasury market about what happens when the Fed actually does choose to run down its balance sheet. We've heard comments earlier on the call regarding the magnitude of balance sheet run off that could be needed or could be achieved. And I think that that puts it into perspective that the possibility of outright sales this year out of SOMA is very low in the Treasury space.

Ian Lyngen:

If we find ourselves 12 to 24 months from now, the economy is on strong footing, the Fed wants to more aggressively run down the balance sheet, there's an argument to be made that the mortgage holdings in SOMA should be the first stop for such a move. But in terms of how this all is going to be interpreted by Powell and the Fed, I do think that this cycle, the inversion of 2s/10s, has much different implications than it might have in previous cycles. If we look at the Fed research around the topic of curve inversion, while as a market we always tend to focus on 2s/10s, the reality is that the economics really show it's the three month bill rate versus the 10-year yield that's the curve that matters.

Ian Lyngen:

So as it presently stands, there's no immediacy in terms of the potential to invert there. And I suspect that that gets the Fed plenty of leeway to begin the process of rate normalization. And if it is able to do five or six rate hikes over the course of the next seven meetings this year, that will put the longer into the curve in a different situation, because that will also imply that the real economy has continued to perform well enough, inflation continues to be a big enough concern and real yields will also be higher in that environment.

Ian Lyngen:

One of the things that we've observed during this cycle is that the performance of breakevens has been a defining characteristic at the end of last year because we continue to see breakevens push higher and higher even as the Fed brought forward the tapering announcement and then accelerated tapering in December. It really wasn't until the decidedly hawkish rhetoric started at the beginning of this year that we saw breakevens start to moderate.

Ian Lyngen:

And at this moment, 5-year forward breakevens are below 2/10, which is a very good place for the Fed. So when we think about what's going to drive this next stage of the cycle, we will be looking closely at real yields and the implication of higher real rates on risk assets. And as you mentioned earlier, Margaret, the feedback loop between that and tighter financial conditions will be far more important than the shape of the yield curve during this cycle than perhaps it has been in the past.

Margaret Kerins:

Thank you everyone for dialing in today and listening to the podcast. Please reach out with any additional questions or comments that you have. This concludes Macro Horizons Monthly Episode 38: Trading through the Heightened Geopolitical Risks. 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.

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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
Stephen Gallo European Head of FX Strategy
Dan Krieter, CFA Director, Fixed Income Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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