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Treasuries and Tryptophan - The Week Ahead

FICC Podcasts November 19, 2021
FICC Podcasts November 19, 2021

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 22nd, 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 147, Treasuries and Tryptophan, 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 22nd. And with the holidays upon us, we are reminded of the travails of navigating family gatherings. This year, we are thankful Zoom has a mute function.

Speaker 2:

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

Ian Lyngen:

Each week, we offer an updated view on the US rates market and a bad joke or two. But more importantly, the show is centered on responding 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.

Ian Lyngen:

So, that being said, let's get started. In the week just passed, the Treasury market started with a decidedly bearish tone. This was due in large part to hedging associated with series of large corporate bond offerings. Once those deals flowed through the market, we saw a stabilizing bid occur even before Friday's flight [inaudible 00:01:34] that was driven by an increase in COVID cases in Europe and the announcement of an Austrian lockdown along with chatter that Germany might soon do the same.

Ian Lyngen:

Auction performance during the week didn't provide any greater clarity with the 1.3 basis point tail at the 20 year auction, as well as a 9/10th of a basis point stop through at the 10 year tips reopening. Now it follows intuitively given everything that's going on in the real economy that there would be a bid for inflation protection.

Ian Lyngen:

In terms of economic data, we saw a strong start on the regional manufacturing side. Empire State came in above expectations for November, as did the Philly Fed Index. Both of which illustrated increased prices pain as well as prices received, which fits well with the Reuters inflationary concerns, which have proven to be thematic in the fourth quarter. Let us not forget that we also saw the retail sales print for October come in above expectations at 1.7%.

Ian Lyngen:

Now, this isn't an inflation adjusted number, although presumably it still represents an increase in real terms. This is relevant not only in gauging the pace of real GDP growth in the fourth quarter, but also in the context of consumers bringing forward holiday spending as a result of concerns related with goods availability as supply chain issues persist.

 

Ian Lyngen:

It's certainly far too early in the process to suggest that consumers have front loaded consumption in Q4. Although there's little question that the notion of goods scarcity will continue to drive investor expectations over the next several months. Briefly returning to the COVID case count issue, we did see the increase in Europe, but also in the US. The seven day moving average of COVID cases has increased steadily since the beginning of November and while we're still shy of the mid-September peak, the trajectory of increased case count as we move into the winter months should provide a bullish underpinning for the Treasury market, if for no other reason than what I'd characterize as self-imposed restrictions on travel and consumption, comparable to what we saw during the late summer months.

Ian Lyngen:

We've long maintained that it's challenging for any trend to develop in a perfectly straight line. So, the idea that the path out of the pandemic would come and fits and starts resonates, and it also fits well with the choppy price action that we are anticipating to dominate the Treasury market over the balance of the year.

Ben Jeffery:

Well, Ian, I would argue this was a week about what didn't happen. Namely, we didn't see tens get back to challenge that 170 level. And in fact, if Friday's price action was any indicator, anything meaningfully above 160 is seeming to be viewed as a viable dip at this point in the cycle.

Ian Lyngen:

And I think that's a fair assessment. We've been focused on that 155 to 160 range in tens as the path of least resistance for consolidation with the bullish expressions beyond that putting the 150 level in tens on the radar. Now the increase in COVID case counts in Europe that were in focus at the end of the week really have reiterated this notion that the pandemic isn't over and it's going to continue to provide a bullish underpinning as all of the uncertainty associated at the next stage of the recovery continues to build into the end of the year.

Ben Jeffery:

And it's worth highlighting the nature of the rally that we saw in response to some of those headlines out of Europe, specifically that it was a bull steepening rather than a bull flattening. And that gets at something that has been thematic, frankly, throughout the last several months, which is that at this point, the most in influential uncertainty on the path of rates is the trajectory of monetary policy. And what I mean by that is the risk of a more severe winter episode of COVID will presumably translate to a more patient normalization bias, which in turn is why we saw the front end and the belly of the curve outperform in response to this latest pandemic risk.

Ian Lyngen:

Let us not forget that an increase in COVID case counts at a moment where we've already seen a number of different vaccines rolled out that have a relatively high rate of effectiveness. Really does imply that at this stage in the pandemic, an increase in cases might have different implications than it had in the past.

 

Ian Lyngen:

When we think about how the Treasury market traded the Delta variant in the middle of September, our core tenant at that moment was that we weren't just trading Delta, but we were trading the ongoing variant risk. And this idea will be challenged over the course of the next couple weeks if in fact we do see a continued trend higher in US COVID case counts.

Ben Jeffery:

And outside of the path of the pandemic, let's not forget we also got a very strong first look at spending in the fourth quarter. October's retail sales data came in well above expectations, both on a headline and control group basis. So once again, this begs the question that if in fact growth is doing okay in an environment when we're getting such high inflation prints, why are tenure yields still below 160 and 30 year yields not even at 2%?

Ian Lyngen:

I think that is simply a reflection of not only forward expectations for US growth and inflation to eventually mean revert, but also the idea that treasuries, particularly the 10 and 30 year sector, are a function of global macro influences. Whereas twos, threes, and fives are simply wedded to monetary the expectations. The reality is that Greenspan's conundrum never truly went away. And based on our conversations with market participants, that has been one of the most perplexing aspects of the recent price action in treasuries, I.E., the persistent flattening of the curve.

Ben Jeffery:

I would also to that, maybe not principally, but as a contributing factor, the quote unquote, "tax on consumption risk," which is that given the fact we're seeing not only higher realized prices, but also the expectation that we're going to see inflation accelerate, that's dragging fairly meaningfully on consumer confidence.

Ben Jeffery:

And at this point in keeping what we heard from Powell at the November FOMC, that's mostly a supply side story. So, even if the Fed is committed to containing spiraling prices, I'm at least a little bit concerned that tighter monetary policy isn't the answer for the current variety of inflation that we're experiencing.

Ian Lyngen:

Yeah, Ben, that's an interesting debate. There's this notion that the Fed is faced with a type of inflation, I.E. supply driven, that they cannot effectively offset with monetary policy. I'll take the other side of that argument and I will note that the Fed has the ability to crush inflation they just don't want to increase policy rates so dramatically, they don't want to end QE immediately, and they don't want to start to adjust the preserve ratio, for example. They have the tools to end inflation, but they don't want to risk putting the economy into a tailspin.

Ian Lyngen:

And that's one of the biggest concerns that I have over the course of 2022, is that in effect, monetary policy makers are being called upon to orchestrate a soft landing. And if history is any guide, central banks have truly struggled with the soft landing scenario. The tendency is to overshoot on the downside, which then highlights the risk of a modest double dip.

Ian Lyngen:

Now, simply because the Fed starts putting the brakes on the economy, that doesn't necessitate that we're going to see real GDP below zero, but it does imply that the growth profile that we saw at the beginning of 2021 is going to struggle to be reproduced in 2022. But this is consistent with what the Fed has been telling us all along, I.E. 2021 was always set to be a very strong year in terms of growth and inflation with both moderating in 2022. The question then becomes what happens when growth moderates, but inflation pressures remain elevated? That's the scenario that I suspect the Fed is struggling with at the moment.

Ben Jeffery:

And this brings us to what are really the three big event risks over the balance of this year. On December 3rd, we get NFP, on December 10th, we get CPI, and then finally on the 15th is the December FOMC meeting. And while yes, at this point the debate in the market is one of liftoff timing, in my opinion, I think the Fed's first step in hinting at a more aggressive normalization timeline will be the acceleration of tapering.

Ben Jeffery:

After all they've told us that they don't want to simultaneously be buying bonds and raising rates. But in looking at the calendar in the first half of 2022, I'm not so convinced that the benefit of speeding up tapering outweighs the risk of triggering any undue tightening and financial conditions. We already know that the current pace of tapering is going to run through mid-January.

Ben Jeffery:

So, in the event that the Fed would like to signal an acceleration at the December meeting, that wouldn't take place until the middle of January. More realistically, I think, would be an announcement of that at the January or March meeting. But at that point, the tapering process would be more than halfway done. So I think that hawkish risk is something to consider.

Ben Jeffery:

Now, of course, if we continue to see these large upside surprises on the inflation data, that would certainly be sufficient to inspire a change of tune at the Fed and is definitely going to be something to watch, not only on December 10th, but also as we get into January and February.

Ian Lyngen:

Yes. And let us not forget that the Fed doesn't need to continue buying bonds into the middle or the latter part of June. They can simply cease QE in its entirety if the economic data dictates that. So again, not our base case scenario, but in trying to read the proverbial tea leaves of the timing of a particular announcement, it is worth keeping in mind that for the sake of flexibility on the rate hike front, it is not unreasonable to assume that the Fed might get to the March meeting and say something to the effect of, "Inflation has pushed so far beyond the committee's expect that they're going to end bond buying now."

Ian Lyngen:

The market ramifications from that are pretty straightforward as we've already seen that play out several times, I.E. higher five year yields, but lower 10 and 30 year rates as the curve flattening becomes even more thematic. Now, just to reiterate, that's not our base case scenario, but as we get closer to the point where investors are going to begin to start pushing back against the Fed's transitory narrative, it is important to keep in mind that there is a reasonably straightforward path for the Fed in QE sooner than late June.

Ben Jeffery:

And that brings us to what's probably going to be the most tradable event in this short week that we have coming up, which is front end supply. We get twos and fives on Monday, followed by sevens on Tuesday, and the willingness of auction participants to buy probably especially fives at these levels will be very telling as to the conviction investors have on current lift off timing assumptions. Any significant concession, either via an intra-day cheapening or a larger tail at fives would point to either A, a sooner lift off or B, a higher terminal rate. And the inverse logic would also hold. A meaningfully strong auction and robust dip buying willingness would hint that some primary market buyers are of the mind that the Fed will need to be more patient, especially following the latest pandemic developments that we talked about earlier.

Ian Lyngen:

But it's not for forget, we also get the FOMC minutes from the most recent meeting on Wednesday afternoon. Now, the timing of the release at 2:00 PM on Wednesday suggests at least to me that the immediate price action associated with the Fed's details from the meeting won't be necessarily tradable in the traditional away. But nonetheless, we'll get some insight into the thought process around initiating tapering at the November meeting and the committee's perception of the degree of flexibility embedded in the program as it's already been announced.

Ian Lyngen:

It's very conceivable that the minutes could reveal that they were members on the committee who advocated for and did bond buying long before the middle of 2022, and the FOMC minutes would be a good forum for the hawks to express this bias.

Ben Jeffery:

And another defining feature of the market narrative this week was uncertainty about who it ultimately will be that president Biden nominates for the Fed chair seat. And regardless of whether or not Powell or Brainard ultimately get the nod for the big job on the FOMC, it's also important to consider that we do still have several meaningful vacancies that need to be filled on the Fed board.

Ben Jeffery:

And regardless of politics, it's certainly likely that whoever is nominated to fill those positions will lean more dovishly. After all, let's not forget, we have midterms that are going to be quickly approaching and for any presidential administration that would like to perform well at the polls, having an easier monetary policy bias and a title labor market would obviously be a benefit.

 

Ben Jeffery:

It is however worth considering that given the pickup in an inflation is now a household topic, that there is an argument to be made that being viewed as willing to combat inflation by politicians is now a very important issue for the electorate. Now, the degree to which that can be effectively communicated to voters, I'm not so sure about. But it is something to think about as we will presumably soon be hearing about some of these renominations and new nominations.

Ian Lyngen:

And in that context, I'd also note that there will be presumably this dovish bias, but also there'll be a bias toward increased financial regulation. And that might ultimately be one of the biggest takeaways from how Biden chooses to make his mark on the board. On the topic of board, have you listened to any good podcasts lately?

Ben Jeffery:

No, not really.

Ian Lyngen:

Yeah. Me either.

Ian Lyngen:

In the week ahead, Thursday's market closure and Friday's half day will serve to limit the most important price action to the first three days of the week. The bulk of the front end auctions hit on Monday. We have the seven year on Tuesday and that'll mark the end of supply for November. Recent auction performance further out the curve suggests that underwriting treasuries in this moment of uncertainty has become incrementally more difficult and if anything, bigger auction concessions versus the 1:00 PM W.I. rate will be needed as the Fed continues to step back from the market.

Ian Lyngen:

This is consistent with investors adjusting to primary issuance in the Treasury market in the absence of the Fed conducting QE. On the other side, this is by no means the first time that the Treasury market had has undergone such a transition and we suspect that when the proverbial dust settles, we'll see auction performance returned back to the norms, a small tail in certain benchmarks, but generally fair underwriting.

Ian Lyngen:

One of the most relevant questions that we continue to hear is why is the long end of the Treasury market outperformed in an environment where inflation is running high, forward inflation expectations are elevated, and the market continues to bring forward Fed rate hikes?

Ian Lyngen:

So, to some extent, it's that latter point that has translated into a contained sell off in tens and thirties. The more aggressive the Fed is either forced or compelled to be in tightening monetary policies to offset inflation, the lower one would expect inflation and real economic growth to be going forward.

 

Ian Lyngen:

I'll argue that the disconnect has to do with the divergence of the outright levels of CPI and real GDP versus what we're seeing in terms of nominal rates in tens and thirties. The logic being that traditional models would suggest that given the amount of inflation that's going through the system, 10 and 30 year rates should be substantially higher. But we have seen over the course of the last 20 years is an ongoing compression in term premium, and even an environment where inflation is running higher than anticipated, the amount of inflation premium required to go further out in the curve, while higher than it might otherwise have been, still remains contained in historic context.

Ian Lyngen:

This trend is also consistent with the increase in central banking transparency that has occurred and as we have learned over the course of 2021, the Fed has been and will continue to be unwilling to risk decades of hard one credibility as an inflation fighter during one cycle.

Ian Lyngen:

Now, this does bring into question how committed the Fed is to their new framework and the shift toward maximum employment, as opposed to full employment. But when faced with the realities of decades high core inflationary pressures, it seems clear that the Fed is comfortable on the side of being more hawkish than one might have otherwise expected.

Ian Lyngen:

We've reached the point in this week's episode, where we'd like to offer our sincere thanks and condolences to anyone who has managed to make it this far. And as 2022 outlooks come into focus, our cynicism compels us to note the uptick in sales of hand baskets. Just saying.

Ian Lyngen:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive as possible, we'd love to hear what you thought of today's episode. So, please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the Vic Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

Speaker 2:

This podcast has been repaired with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns 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.

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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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