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Uncharted Transitory - Monthly Roundtable

FICC Podcasts August 03, 2021
FICC Podcasts August 03, 2021

 

Margaret Kerins along with Ian Lyngen, Greg Anderson, Dan Krieter and Ben Jeffery from BMO’s FICC Macro Strategy team bring you their debate on the longer-term viability of the Fed’s characterization of inflation and the implications for U.S. rates, high quality spreads and FX.


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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 30, Uncharted Transitory presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Dan Krieter and Ben Jeffery from our FICC macro strategy team to bring you our debate of the main narratives that are dominating market pricing and what these themes imply for US rates high-quality spreads 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.

Speaker 2:

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

Margaret Kerins:

Since our last podcast on July 13th, 10-year yields have settled into a new lower range on the back of a global flight to safety due to the rising COVID Delta variant cases and renewed concerns over slowing growth. The global economy and financial markets are interconnected and an extended pandemic timeframe may lengthen the supply chain frictions impacting the transitory characterization of inflation. Monetary accommodation removal in the form of tapering is also another theme dominating the market narrative, and we continue to expect the Fed to remain patient while waiting for the evolution of employment once schools reopened and the extended employment benefits expire in September.

Margaret Kerins:

As Chair Powell noted last week, in the US we have lower than desired employment and higher than desired inflation on the ground, which is actually the opposite of the Fed's objective. So let's kick it off with Ian. Ian, Chair Powell continues to characterize inflation as temporary and continues to message that there is a long way to go before the Fed meets their employment objective. At what point will inflation no longer be able to be considered transitory by the Fed and how quickly will they be able to change their tune without shocking markets?

Ian Lyngen:

Well Margaret, I think one of the underlying questions is what does non transitory inflation actually look like? When does inflation become self fulfilling? And the short answer is it needs to be visible and sustainable in wages. Now at the moment, we've all seen the anecdotes about frontline service sector firms needing to pay hiring bonuses to get workers into fast food, for example, or small businesses. What happens when that not only persists, but also other workers start to look around and say, Hey, why is the new hire being compensated at market rates where existing employees are comparatively underpaid. And that's when one would expect to see the quits rate increase further and people seek new opportunities to rebase their compensation.

Ian Lyngen:

So that then leads to more disposable income that drives true demand side inflation, and that's when it becomes self fulfilling. Now, when we think about where within the data complex we would look for that, first we need to see used auto prices moderate as well as some of the upside realized in travel-related industries. And a broadening out of inflation would really change the Feds tune from transitory to something more sustainable. What I worry about is whether or not the Fed is actually willing to risk credibility on the inflation side to reinforce the new framework. What we saw at the June meeting with an increase in the 2023 dot plot was arguably the Fed showing their hand that they're starting to get nervous about inflation.

Margaret Kerins:

So Ian, talking about broad based wage gains, even if it's broad base and it only happens one time, would that be considered persistent or would that still be considered transitory?

Ian Lyngen:

So one-off increases are in fact not the type of sustainable upward pressure that the Fed would need to see. We would need to see the stubbornly low labor market participation rates stay that way and a scarcity of workers seeking employment. At the end of the day, there's more resource slack than the current unemployment rate implies simply because there's a significant amount of the labor force that is sidelined because of the pandemic. And it's that dynamic that I suspect will ultimately be the next stage in the market narrative once we digest the realities of the Delta variant.

Margaret Kerins:

Yeah. So I think it has a lot to do with the return to the office, the pace at which that occurs and the degree that which the Delta variant slows that down that results in continued frictions in the labor force with regard to where the supply of labor is and where that demand of labor is coming from as well. So Ian, you raised one of the main concerns in the marketplace and that is the balance between the inflation objective and the employment objective. And I think the worst case scenario for the Fed of course is having continued persistent inflation with an employment situation that is less than what's desired. So that basically gets into the risk of stagflation with not really knowing what the new normal is going to look like after the reopenings there is a slight chance of that. Is the market pricing to the stagflation risk?

Ian Lyngen:

I would say that the market is pricing the transition of what we thought was good inflation at the beginning of the year to more concerns that higher prices are actually translating to lower consumer confidence and a reluctance to spend. So to some extent, we're already trading stagflation but we're trading it in the form of a policy error response. And that's why we had such a dramatic bull flattening when it looks like the Fed was going to accelerate the timing of their liftoff rate hike. Now we find ourselves in a situation where real yields are still extremely low, 10 year real yields are at their record low levels. Breakevens are above 225, but nominal rates keep drifting lower and lower. And that's a reflection of a market that has returned to trading something that's beyond the Feds control, which is the pandemic and I'll argue that that's the most compelling explanation for why 10 year yields are where they are at the moment.

Ben Jeffery:

And Ian within the moves in the TIPS market, you touched on something that's very critical at this stage, which is that yes, while breakevens have pulled back from the peaks we saw earlier this year in the context of nearly the last 10 years at above 225, they're still well above what we saw when the Fed was actively trying to push inflation into the system and maybe more importantly, drive inflation expectations higher. So the fact that we've seen this stabilization and an elevated plateau alongside real yields that have set all time lows in the ten-year sector speaks to this idea that this pickup in inflation expectations is now coming at the expense of the outlook on growth. You can also see this in several sentiment indices, most notably probably the University of Michigan survey, which shows rising inflation expectations, meanwhile, headline confidence and good time to buy things like cars and houses is falling off.

Margaret Kerins:

So Ben, you mentioned the implications of rising inflation expectations on growth on the ground and on sentiment. And Dan, this brings me to the IG market. IG spreads remain near post great financial crisis tights. So far, this earning season has been relatively positive, but lingering in the backdrop our concerns about the sustainability of growth. We heard that over and over again in some of these earnings calls and rising input prices. How does this play out in IG spreads?

Dan Krieter:

Yeah Margaret you're exactly right. We've seen a very robust earnings season, but sort of the second layer of this very strong earnings was these forward warnings that earnings aren't going to be so robust going forward. And we have seen a bit of a widening. You're right that spreads are still within six, seven basis points of cyclical lows here, but we have gotten a little bit of a widening. I think that widening at least thus far is really reflective of the growth concerns that Ian talked about earlier in the call. For me, the question is actually going to come down to inflation and the answer to that question of whether inflation proves to be transitory and the characterization of inflation that Ian used earlier, good inflation or bad inflation. Because when you look at things from an IG perspective, good inflation maybe isn't all that bad for spread. Sure that there's some refinancing risk and whatnot, but good inflation is obviously reflective of a strong economy where the consumer is in a good position to, with rising wages, as Ian talked about, to continue to consume.

Dan Krieter:

If you look at things from a bad inflation perspective, which is maybe what we're sort of starting to price now with gross concerns, but also inflation still being high, you get to a scenario where corporations have to pay higher costs for their inputs that they're going to struggle to send along down to a weak consumer. And that to me represents the worst case scenario for IG credit. And that is really, apart from something truly redefining on the COVID front, such as vaccine efficacy starting to fall short here, the big concern for me would be this inflationary outlook where we could see spreads move sustainably and significantly wider for a couple of reasons. First economic outlook, but also then even further stimulus at that point doesn't provide the same support to credit as it did the first time around.

Margaret Kerins:

And I guess in the backdrop of a high inflationary environment, the Fed wouldn't be stimulating the economy. They would have to address the inflation concerns and you'd see a rapid tightening in monetary policy to put the inflation genie back in the bag. Another potential risk factor for IG spreads is Fed tapering. Fed purchases clearly pushed investors out the risk curve. And as the Fed begins to slow purchases, other investors will have to emerge to fill that loss demand.

Margaret Kerins:

So to put some numbers on it, if the Fed tapers over say nine months, they will have reduced purchases by 600 billion. Now we do expect Treasury to cut coupon auction sizes quite substantially either later this year or early next year. And that could be in the range of 400 or 600 billion. It was at the higher end of the range, of course it pretty much offsets the reduction in Fed purchases. But that said there is some uncertainty surrounding deficit and funding projections with the possibility of a $3.5 trillion budget resolution spending package. Dan, how are you thinking about the impact of Fed tapering on corporate spreads and what happened the last time the Fed tapered?

Dan Krieter:

Well, so I guess started with the last time the Fed tapered. We start with the taper tantrum, which I want to remind everyone for credit actually wasn't so dramatic. The taper tantrum was more of a rates event. Spreads moved maybe 20 basis points wider at the absolute peak to trough and then quickly retraced. So from a taper tantrum perspective, just to start the conversation, it's not something we're worried about. It really wasn't that big a deal in spreads even back in 2013 and now with the market having much more experienced trading QE and how well the Fed has communicated everything this time around, I wouldn't expect any type of a taper tantrum in corporate spreads. So now looking at the actual impact of the tapering of purchases themselves. If you look at a long-term chart of net Treasury supply alongside corporate spreads, you see a pretty reliable long-term correlation there where more Treasury supply leads to higher spreads in the long term.

Dan Krieter:

And that's what we would expect. You can see some short-term variations there, but in the long-term more net Treasury supplies should lead to wider spreads as corporations are crowded out. And that is the pattern that I expect we follow this time around. It takes a long time because at first, small increases in net Treasury supply can be readily digested by the market. But as that Treasury supply continues to build in the financial system, investors will demand more and more spread to buy a corporate bond instead of a Treasury bond. So like you said Margaret, it will come down to what does Treasury's auction sizes look like next year? What type of infrastructure package are we going to get? We just saw the bipartisan bill get passed. It could be as much as 3.5 trillion. If it is, maybe those cuts aren't as significant as perhaps you talked about, and then it's going to be I think ultimately a widener for corporate spreads. But it's something that's going to take a long time, certainly a 2022 story. And I would expect it to be a late 2022 story.

Greg Anderson:

Dan, you mentioned the taper tantrum not being that big of a deal for spreads, but I can tell you in the FX market, the taper tantrum was a huge deal and it caused a dollar surge. So one of the interesting things that we've been watching in FX over the last year is not just US dollar taper tantrum, but taper tantrums kind of across the spectrum of different countries that have QE programs right now. So active QE programs, it's pretty much all the G10 central banks. And actually we've seen some tapering already. So going back to the fourth quarter of last year, the RBNZ was the first country to begin to taper. And we saw kind of an immediate response where Kiwi dollar appreciated about 5% against US over the span of a couple of months, appreciated maybe 3% on what is the key cross for them, Kiwi relative to Aussie.

Greg Anderson:

And then that was it. And so the RBNZ that has continued to taper over the last six months with really no impact on the currency and not much of a feed through to a longer 10 year yields and so forth. Next central bank to taper, Bank of Canada with first increment also in the fourth quarter of last year, and then April and July further tapering increments. And I would say the April taper increment contributed to a sharp move lower in dollar Canada, although oil by $70 a barrel was probably the bigger factor there. But at this point, the July taper increment from the Bank of Canada, the market just yawned at that. As we look to the Fed this time around we're going back to QE3, yes the market response to taper was fairly violent. I don't really expect it in the FX market for the eventual Fed taper either late this year or early next. I think it will mostly be a non event for the US dollar.

Margaret Kerins:

So Greg speaking of US dollar strength, the US dollar had a nice rally going into July, but then it turned sharply last week. Why do you think this happened?

Greg Anderson:

Margaret you're right. It was a very interesting turn in FX market sentiment. And I think that there are three factors behind it. First thing I'll point to in speaking with Asian investors in particular in July, their expectation of Fed hawkishness was maybe a little bit beyond the expectation in the domestic US market. And so, I would say a less hawkish than expected by Asia in particular, Fed is part of the reason for the dollar turn. Another couple things I'll point to. So an improvement in the price action in both commodities and global equities was part of the story. And then the last thing that I think is particularly important and I'll call it, the Chinese market stabilization move. So late July, kind of 19th through the 24th, we saw a 12% decline in Chinese equities over the span of three sessions.

Greg Anderson:

And that risk-off sentiment pushed dollar China above 650. And at that stage, Chinese authorities stepped in a fairly aggressively. One of the things they did they called a meeting with all of the major financial institutions to discuss how to restore market confidence. And coming out of that, the government gave a little bit of a mea culpa of sorts and just said that in future policy announcements, they would involve market participants and think carefully about communication so as not to derail financial markets.

Greg Anderson:

And then the second thing that happened is the finance bureau came out with a written statement that reiterated their policy of wanting to keep the exchange rate basically stable, and then actually in the market. They have leaned on the market and put a ceiling in dollar China above 650 and that ceiling has held over the last week. And that stabilization move, it transmits to the other Asian currency and it transmits to the Euro dollar and it just sort of killed the upside for the US dollar. And at that point, the market has been long dollars and so dribbling out of those positions. I think that's the story behind the turn.

Margaret Kerins:

All right. Thanks Greg. So let's shift gears a little bit. We have Jackson hall coming up in a few short weeks and many market participants seem to think that Chair Powell will use this platform to announce the taper timing. To me, this seems unlikely especially after last week's press conference where Powell continued to state that the economy was a long way from the employment objective and time is needed to see how the data evolves. And the flip side, he did say that the Fed would be providing clarity and to listen to upcoming Fed talk. So Ian, what are you expecting at Jackson hall?

Ian Lyngen:

I think that Powell will make it very clear that we're in for a simultaneous taper. That was one of the open questions in the market, whether or not the Fed scaled back mortgages before they scaled back Treasury buy-in. Now in his press conference, he made it clear that there was no compelling reason to not do a simultaneous taper, but I expect that that will be reiterated at Jackson Hole. He will also continue to lay the groundwork for an announcement sometime in the fourth quarter to be implemented in the first quarter of 2022. The only compelling argument in my mind, at least for the Chair to ever have brought it forward to September or November, for example, is if there were more uncertainty around whether or not he would be re-nominated for the position of Chair and therefore he would want to hand over a clean slate as it were. But given the current conditions, it seems that he's most likely to retain the position, which means that there'll be plenty of time for the Fed to continue evaluating the incoming data, particularly in the context of the new risks presented by the Delta variant.

Margaret Kerins:

So we have three meetings left. We have three Fed meetings left September, November, and December for the Fed to provide additional clarity. And Ian, what you're saying is that you do expect Powell to use the Jackson hall platform as an opportunity to begin some type of formal messaging beyond what he already said at the presser last week.

Ian Lyngen:

Yeah. I think that that will be the key takeaway. I would also note that one thing that we are certain of is that they're not going to move in October.

Margaret Kerins:

Nice one, Ian. 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 30, Uncharted Transitory. 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 BMOs marketing team. This show is produced and edited by Puddle Creative.

Speaker 2:

This podcast has been prepared 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. 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. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment or strategy referenced here in maybe suitable for you.

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Margaret Kerins, CFA Head of FICC Macro Strategy
Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Greg Anderson Global Head of FX Strategy
Dan Krieter, CFA Director, Fixed Income Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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