Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

Why So Negative? - Monthly Roundtable

FICC Podcasts April 05, 2022
FICC Podcasts April 05, 2022

 

Margaret Kerins along with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton and Ben Jeffery from BMO Capital Market’s FICC Macro Strategy team bring their debate on how the recent geopolitical developments impact their outlook for the shape of the U.S Treasury curve, Canadian rates, high quality spreads and foreign exchange and the risks of a global slowdown.


Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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

Read more

Margaret Kerins:

This is Macro Horizons, Monthly Episode 39. Curve, Why so Negative? Presented by BMO Capital Markets. I'm your host Margaret Kerins. Here with Ian Lyngen, Ben Reitzes, Greg Anderson, Steven Gallo, Dan Krieter, Dan Belton and Ben Jeffrey from our FICC macro strategy team to bring you our debate on how the recent geopolitical developments impact our outlook for the shape of the U.S Treasury curve, Canadian rates, high quality spreads, and foreign exchange, and the risks of a global slowdown.

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, it's affiliates or subsidiaries.

Margaret Kerins:

Two year yields are now about 175 basis points higher year to date in a swift move that is inverted twos tens for the first time since mid 2019. The market is pricing in over 200 basis points of Fed hikes by the end of the year and a 3% level by mid 2023, as the Fed has socialized the possibility of 50 basis point moves. All of this is occurring in the backdrop of heightened geopolitical risks. As the war in Ukraine persists supply chain frictions continue and inflation reaches its highest levels since the 1980s. At the same time, the employment picture in the U.S is strong. Certainly giving the Fed the cover to focus on raining and inflation. With the Fed poised to move rapidly away from accommodation, slowing the economy to contain inflation, the market focus is on the extent of the slowdown and if the Fed will tip the economy into a recession. So Ian, what does the recession risk imply for long end yields and the shape of the curve?

Ian Lyngen:

Well, Margaret, I think that you did a very good job of articulating the balance of risks at this moment, and that is essentially the Fed is all in to do everything they can to make sure that inflation is contained and forward price expectations are stable. They have communicated indirectly that they're willing to risk a, if not recession than a much slower recovery previously assumed to make sure that they can retain their decades of hard one credibility as inflation fighters.

Ben Jeffrey:

And aside from nominal rates in the nominal curve, we've seen this play out in the tips market as well. 10 year break evens reached their record high, moving beyond 3% for the first time ever following the initial surge in oil prices that resulted from Russia's invasion of Ukraine. But now that we've heard from Powell, New York Fed President, Williams and several other FOMC members as well, that a 50 BEP rate hike is definitely on the table at the May meeting, the retracement and inflation X expectations is a vote of confidence, at least from the tips market perspective in the Fed's ability to contain runaway prices in the longer term. Now that's clearly come to the detriment of the front end of the Treasury market. Exactly as you pointed out, Margaret, we now have twos tens trading at a level that has not been seen since the 2006, 2007 cycle. And despite all the uncertainty, despite the risk of a global slowdown, for the time being the Fed is clearly willing to go full steam ahead in the process of normalization.

Margaret Kerins:

So Ian, you mentioned the Fed's willingness to accept slower economy and also risk a recession in order to contain inflation. We have the inverted curve right now. What is this telling you about the potential for a recession?

Ian Lyngen:

Well, Margaret, that's a question we've received a number of times from clients and other market participants, and our answer has been pretty consistent insofar as the true informational value to be extracted from the shape of the yield curve is less about twos, tens or fives thirties or any of the longer dated benchmarks, but more a function of three month bills versus 10 year yields. Now, the Fed has a fair amount of research published regarding the reliability of this particular spread in predicting economic performance. The one thing that I will observe is that given the assumed path of policy rate normalization by the end of 2022, the three month bills versus 10 year curve should be flat if not slightly inverted. So said differently, while twos tens inverting this early in the cycle, doesn't indicate necessarily that within the next 12 months, the U.S economy will be facing a recession, by the end of this year, we might have the key curve inverted, which does not bode well for growth in 2023.

Margaret Kerins:

In addition to that, we have the Fed minutes coming out tomorrow, where we will get more clarity on the balance sheet rundown, which is expected to be quite aggressive. And of course the issue there is going to be how Treasury decides to fund Fed balance sheet runoff and the amount of 10 year equivalence that must be absorbed by the private market. This does have the potential to way on the long end. How should we be thinking about that?

Ian Lyngen:

I think we'll get a lot more information as the actual announcement nears, but there will, almost without question, be a knee jerk response to the announcement itself. All else being equal, it does bode for higher rates in the long end of the curve, especially at the beginning of the process as the realities of balance sheet runoff are absorbed and market participants are allowed to recalibrate expectations. However, as is often the case with supply, I suspect that the impact will occur by and large within a defined range and perhaps be worth 15 or 20 basis points in the 10 year space, not 150 or 200 basis points. Now that might come off as needlessly glib, but I think the reality is that as we push forward into the balance sheet runoff, and we're reminded that tightening above all else is tightening in so far as it will undermine growth prospects, that the flatness of the curve will ultimately prove to be more sustainable than initial give back of the twos tens inversion implies.

Ian Lyngen:

Another quick thought here, when we project the forward path of 10 and 30 year rates from here, what we're assuming is that to some extent it will be difficult for the twos tens curve to deviate very far from zero at this point in the cycle. So plus or minus 20 basis points, let's call it. So that gives us a 40 basis point range for tens. However, that doesn't mean that tens will be limited to a 40 basis point range. By that I simply mean that the front end of the curve is now in the driver's seat for the outright level of rates in such a flat curve environment. And so this once again puts the onus back on the Fed and Fed expectations.

Ian Lyngen:

So a quick glance at the Fed funds futures market shows that we are fully priced for 50 basis points in May and June followed by 25 basis points at every other meeting this year, with that chance of another 25, making one of those meetings 50. Said differently, there's a lot of tightening priced in at the moment.

Ben Jeffrey:

And despite the curve inversion, and while yes, we still have ample room to go in three month tens, there's no doubt that slow down worries and recession risk chatter has already picked up, but Dan and Dan, correct me if I'm wrong, there's not really an abundance of warning signs in the credit market at the moment. Is there?

Dan Belton:

No, Ben. You're right. It's a great point in the risk on tone that we've seen in our markets over the past few weeks really does seem to indicate that credit markets are not pricing to this risk. That like you said, the Fed is willing to risk the growth outlook to contain inflation. And we've seen a remarkably strong rally and credit spreads. So over the past three weeks, spreads have moved about 33 basis points narrower since their peaks in the middle of March. And it's really a historic move given where credit spreads are currently trading. We've seen spreads narrow by 30 basis points or more over a three week period, only three times before. And each of these times in 2011, 2016 and 2020, spreads were rebounding from a much bigger stress event than we saw over the past month. And each of these three times, the index began at least 107 five basis points or more. Last month spreads topped out at only 145 basis points in the middle of March. So a really significant move in the context of spreads that were already within their long term historical averages.

Dan Krieter:

And Dan, I think when you look at what's driving the move and spreads, it's hard to really say that it's been a fundamental rally and credit. I mean, obviously the main factor has been some relaxation of fears around the Russia, Ukraine situation, particularly in the financial sector where the unknown impact of economic sanctions led to some funding stress in February and March, which has basically disappeared now. Just looking at the June for OES contract were 16 basis points lower in for OES in just three weeks and the Ice BAML global financial stress index, which is our preferred measure of looking at financial conditions is 0.56 units lower, which is a large move for that index.

Dan Krieter:

Now plugging that into our model for credit spreads implies that we should see spreads about 31 basis points narrower as a result of the calming and financial conditions, which lines up relatively well with the recovery we've seen, but you have to look at the fact that we're seeing earnings expectations dropping in higher Treasury yields, which has combined to put about eight basis points of upward pressure on spread.

Dan Krieter:

So saying all that differently. We've seen spreads outperform what we would expected them to do in the last year weeks by 10 to 11 basis points, which just adds quantitative credence to the feeling I've gotten certainly during this recovery that spreads have just gone further than maybe we would've expected. And it strikes me as just almost like a FOMO rally and credit at the moment where we typically see a lot of cash get put to work in credit markets at the beginning of the year. And there really hasn't been much of an opportunity with spreads widening almost in a straight line for the whole year until mid-March. And I think we just saw a big technical up. And I think Dan, you have some evidence that adds to that rationale.

Dan Belton:

Yeah, we're seeing really strong demand for credit. And a lot of it is due to the fact that all in corporate yields are higher than they've been for most of the past three years. So there's two investor bases for U.S dollar corporate debt that are seeing really attractive risk reward profile and credit it right now. And the first is foreign investors, which make up the highest proportion of holders of U.S dollar corporates. And they're facing the highest currency at hedged returns since about 2016 right now. And then you have pension funds which have seen a massive improvement in their funded status, at least for the 100 largest public U.S dollar pension funds. Those are seeing a funded status that's better than at any point since the financial crisis. And typically when we see funding status improve for pension funds, that brings a rotation into fixed income, which should bode well for credit spreads.

Dan Belton:

Yeah. Dan, I think that builds a strong case for how we've seen spreads perform so well recently, but I think looking ahead, I think we have to maintain a pretty cautious view on credit for the same reasons that Ian and Ben talked about earlier. I mean, we're looking at the most restrictive Fed policy likely in the months ahead that we've seen in multiple decades and spreads should likely be on the wide of the historical experience, not on the tight side. And what we've seen is that credit spreads now add only about yield enhancement of about 45% compared to the 2010 to 2019 average of 62%. So we're quite narrow from a historical perspective in the spread markets and given the outlook for the Fed and the outlook for the economy, particularly with high commodity prices that could put a significant debt in the corporate earnings, I think we need to see spreads wider from current levels in the months ahead.

Ben Reitzes:

Dan, I'm glad you mentioned commodity prices because that's Canada's wheelhouse. The spread dynamics in Canada have actually been pretty similar and rates as well. We've seen high quality spreads, provincial spreads, CMBS come in. Well off their wides in recent weeks, matching the U.S move to some extent. And the rates curve in Canada looks very similar to the U.S, not quite as flat in general, but some parts of the curve are actually more inverted. Tens thirties, for example, in Canada has gone inverted while that remains positive in the U.S. And the broader dynamics are similar in Canada, but not quite the same as in the U.S again, because of that commodity price dynamic. We do have the Bank of Canada coming up next week and they are expected to be quite aggressive. We expect them to raise rates 50 basis points at next week's meeting. And again, at the following meeting on June 1st, so matching what appears to be likely for the Fed at least in the very near term.

Ben Reitzes:

And that's similar to the U.S contributing to weakness in the front end and flattening that curve notably and listeners should keep in mind, this cycle is very different from what we've been accustomed to for the past decade. And really, even longer than that. We really haven't seen a cycle in which central banks have had to aggressively fight inflation for a number of decades now. For decades, central banks have been ahead of the curve and now we're well behind the curve. And so there is a possibility that the curve actually flattens significantly more than what history would suggest is kind of quote unquote normal for any period in time in the past 10, 20 years or so. So that's definitely something I think investors should keep in mind and using history to judge levels, to get into those steep numbers, maybe that may not be the best way to go at this point.

Ben Reitzes:

However, I would say that as we've seen from the Fed to some extent on the balance sheet and we are going to hear from the Bank of Canada as well on quantitative tightening, there's room for the curve to steepen in the back half of the year with that QT. And if the economy order weakens sufficiently, central banks can back off and given the kind of straight line pricing of rate hikes that we have in the market, especially in Canada, we have rates that the market's pricing a 3% overnight rate about a year from now. So pretty much straight line rate hikes for 12 consecutive months. That's pretty extreme, especially in the caning case when you consider where housing is where household debt is. And so there's definitely room for the front end to back off, probably not near term, that's probably a second half story, but it's definitely there, but for now it's definitely flatter curves ahead, at least for the next few weeks.

Ben Reitzes:

Another interesting dynamic for the bank of Canada and for Canada general is the Canadian dollar. And what we've seen is that strength in the commodity prices really hasn't translated into the strength in the Canadian dollar and so that's made the Bank of Canada's job that much more difficult. Inflation's gone up that much more. At some point we do expect to see the dollar rally a little bit on the back strength and commodities and the better trade backdrop, but so far it's been a pretty big challenge for the Looney

Greg Anderson:

Ben, you seem a bit surprised by the lack of Canadian dollar appreciation on the back of high commodity prices. Just looking at the price action over the last 24 hours, we seem to have a move of foot in the commodity currencies, and maybe we'll get more Looney appreciation over the next few days and in response to the Bank of Canada. But actually I'm not just surprised by the lack of Canadian dollar appreciation, I'm surprised by the lack of U.S dollar appreciation. It's kind of like the spread story. Normally the expectation of aggressive rate hikes would be good for any currency and for the U.S dollar where it's a global numeralar  and a safe Haven, normally fears of the central bank tightening too far and triggering a recession would just be extremely U.S dollar positive, but we really haven't seen much of a U.S dollar move.

Greg Anderson:

There is though an exception to that. It's in dollar-yen. From the early March low to the late March high dollar-yen has moved about 9% on the month. That's a massive swing for a G 10 exchange rate. I think what makes the yen stand out a bit and maybe why it has taken the brunt of the U.S dollar pressures is the fact that it's both a commodity importer as well as a non rate hiker and until last week, it didn't seem that Japanese officials cared if dollar-yen moved higher. Japanese officials, including BOJ head, Kuroda had to do it about face last week when dollar-yen rallied above 125. They began to verbally intervene against the move while they were at the same time intervening in the JGB market to keep the 10 year JGB yield below their 25 basis point ceiling.

Greg Anderson:

Thus far, Japanese policy responses seem to be sufficient to calm the market and we dropped into a consolidation range in dollar-yen between 121 and 124, but I would just argue that the pressures that caused the yen to drop and by that, I mean, high oil prices, widening interest rate differentials. Those pressures are still there and are likely to remain there for some time. So I wouldn't rule out a break above 125 in dollar-yen at some point later this quarter. Similarly, well, I think the Looney in I'm going to lump the Australian dollar in with the two. Well, I think these commodity currencies are likely to continue to just slowly drift higher. I wouldn't entirely rule out a chaotic surge higher because the commodity currencies have lagged the strength in commodity prices by one or two orders of magnitude.

Stephen Gallo:

Greg, you mentioned a number of important variables there that have been driving one segment of the FX market, but there have certainly been splits in the FX market because while investors, as you point out have been trading the Fed outlook and higher commodity prices through dollar-yen, there have been so many more moving parts in Europe, much higher levels of uncertainty. So participation on the long dollar side of that trade in Euro dollar has been lower than in dollar-yen, I think, and now we're heading into the French presidential election. So that just adds to the list of uncertainties.

Stephen Gallo:

So I think looking out to about one month, the best we can do at the moment is kind of form a base case and highlight risks to that base case. Base case, Russia continues to focus on taking portions of Eastern Ukraine, but we see continued fighting as Ukraine attempts to purge Russia or retake territory and energy supply shock remains a risk. And because of all that, and with the Fed tightening faster now, FX investors have more confidence to drift into those short Euro dollar positions.

Stephen Gallo:

Macron just manages to sneak by with a victory in the second round of the French presidential election. And I think in that overall scenario, Euro dollar can drift to about 108 in one month, and then consolidate there. The Euro positive scenario, the upside risk to the Euro out to about one month would be a ceasefire or Russia fully withdrawing from Eastern Ukraine. I think in that case, you get a three to four big figure move higher in Euro dollar, and that move would be further help if Macron wins the French presidency, even just narrowly after the second round. You probably look to fade that move eventually in Euro dollar once you get the sort of three to four big figure pop, given the prolonged hit economic growth from sanctions, the weak net trade picture, high inflation, and the ECB generally lagging other central banks with policy normalization.

Stephen Gallo:

The one I guess, negative scenario know I can think of where things get really chaotic is a severe energy supply shock that pushes Euro dollar to 105. You may see in that case, the ECB normalizing a bit more rapidly in order to cushion the Euro. But if the Euro move gets really chaotic and destabilizing, the G7 might be forced to step been. And by the G7 I'm course, mainly referring to the members that are of that group outside of the EU. The only other thing that would be an extreme negative scenario for the Euro, other than on the geopolitical front would be a Marine Lappen victory in the presidency even if it's just by narrow margin. I think in that case, you get a move to at least 105 in Euro dollar if for no other reason, then the fact that so many people are focused on the war and not French politics. So a Lappen win in France would come as an enormous shock. The polling for the second round of the French election currently looks like it's very, very tight. So this is not something that we should lose sight of.

Margaret Kerins:

Thank you, Steven, for that base case on the Euro and the different risks posed to the currency given this geopolitical backdrop. So in summary, the market is facing the rapid removal of accommodation globally, and certainly this poses the risk of choking off the recovery and tipping the economy into a recession, something we're clearly watching as is the rest of the market. Okay, that's a wrap. Thank you to all of our BMO experts. And thank you for listening. This concludes Macro Horizons, Monthly Episode 39. Curve, Why so Negative?

Margaret Kerins:

As always, please reach out to us with feedback and any ideas on topics you'd like us to tackle.

Margaret Kerins:

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 can take a moment to leave us a rating and a review. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO has the burned 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 a suggestion that any investment or strategy referenced here in may be suitable for you.

Speaker 2:

It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice, or are representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise it constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts, and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the U.S commodity exchange act. BMO is not undertaking act as a swab advisor to you, or in your best interest in you to the extent applicable you'll rely solely on advice from your qualified independent representative in making hedging or trading decisions. This podcast does not to be relied upon in substitution for the exercise of independent judgment.

Speaker 2:

You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative if applicable. BMO assumes no responsibility for verification of the information in this podcast, no representation or warranty is made as to the accuracy or completeness of such information. And BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter, and information may be available to BMO and, or I affiliates that is not reflected here in. BMO and its affiliates may have positions long or shorts and affect transactions or make markets in securities mentioned here in or provided advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned here in. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

 

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

You might also be interested in