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Won’t Back Down - Monthly Roundtable

FICC Podcasts July 12, 2022
FICC Podcasts July 12, 2022

 

Margaret Kerins along with with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, and Dan Belton from BMO Capital Markets’ FICC Macro Strategy team to bring you their outlook for the second half of the year for US and Canadian Rates, IG credit, and foreign exchange as the market grapples to price the terminal rate and beyond. Most certainly, the Fed is unlikely to back down until it is certain that inflation has been tamed.


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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 42, won't Back Down, presented by BMO Capital markets. I'm your host Margaret Kerins here with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter and Dan Belton from our FICC macro strategy team to bring you our outlook for the second half of the year for US and Canadian rates, IG credit, and foreign exchange. The market narrative for the second half will continue to swing between inflation containment and recession. We find ourselves back in the waiting game, where the passage of time is needed to narrow the range of potential outcomes, bringing more clarity to the market. But, before we dive in, the institutional investor poll is now open and we really appreciate your support in our focus areas.

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:

Uncertainty will remain elevated as the market grapples with terminal rate expectations and just how long the economy can withstand the tightening before the Fed is forced to reverse course with either fine tuning cuts or a full blown easing cycle. The Fed is operating under the cover of the strength in the employment market as job openings remain plentiful, relative to the number of people seeking employment. Therefore, the Fed's reaction function to an economic downturn will be muted if inflation persists.

Margaret Kerins:

Today's rate hikes will fight tomorrow's inflation and their impact will not be known for some time. Right now, it's all about Fed credibility and containing medium and long term inflation expectations. Growth is slowing as evidenced by falling expectations for real GDP and the market will continue to price the end of the tightening cycle and the beginning of its reversal.

Margaret Kerins:

Historically, employment holds up just fine as the Fed raises rates and employers continue with plans that were set in place several months earlier. However, the risks are that employers might just be much more nimble than in the past and the excess job openings might be indicative of a mismatch between skills and vacancies or other labor market frictions such as location. Let's face it, not everyone can fly a plane. Ian, speed has been one of the main themes in the market narrative with the current focus on the Fed's rapid pace towards restrictive territory and the market's pricing beyond this cycle with an eye on future Fed cuts. We know that the Fed will risk going too far into restrictive territory, rather than going too little and risk losing the fight with inflation. Basically they are maneuvering under the cover of a large employment umbrella, so they can stand in heavier rain or stand in the rain for longer. What does this mean for US rates and the shape of the curve?

Ian Lyngen:

Well, Margaret, I think the second half of the year is going to be a particularly fascinating episode for the Treasury market, because the base line expectation for the year was always going to be that the Fed would commence with the hiking campaign, push forward until something was broken. What we're seeing in terms of the first thing to give, it turns out was the economic outlook, which I think is surprising, given that we did initially see some wobbles in the equity market, but that has stabilized. The dollar continues to be strong and while expectations for the forward pace of real consumption have lagged, the reality is, as you point out Margaret, the overall employment market still remains on strong footing with a nod to the fact that it is a lagging indicator.

Ian Lyngen:

As we translate this environment into the US rates complex, we can't help but favor the long end of the curve and continue to hold our 10 year forecast for an end of 2022 with tens at two and a half percent. Now this implies an inversion of the yield curve, not dissimilar to what we saw in 2000, i.e., 2s/10s between -40 and -55 basis points. When we think about how that will play out in the front end, we are reminded that two year yields don't necessarily need to trade above effective Fed funds, nor do they need to trade above the terminal rate assumption for a given cycle. For that reason, I think it's very reasonable to expect sub 3% two year yields at the end of the year, as the market starts to consider the potential for the Fed to need to cut rates in 2023 or later.

Dan Krieter:

Ian, you mentioned the likelihood that the curve would significantly invert, and I wanted to get your thoughts on what Fed president Esther George said in her speech yesterday, after she sort of famously dissented to the 75 bp rate hike at the June meeting. She provided further rationale for that dissent and it centered on the interplay between raising rates quickly and quantitative tightening, specifically raising short term rates much faster than long term rates could further invert the yield curve, challenging traditional banking models and providing another challenge for a significant reduction in the balance sheet. Fellow Hawk Bullard has also expressed similar concern over the shape of the yield curve, amid QT, so I guess my question for you is this, do you think this concern over the shape of the yield curve will have any impact on Fed rate hikes as we get into the later part of the year and ultimately curve inversion?

Ian Lyngen:

I don't think that the Fed is as concerned about the inversion of the yield curve as they are with the overall level of rates. We have heard from monetary policy makers in the past that the runoff of the balance sheet, they don't know the exact impact. It's difficult to quantify in terms of what it means for rate hikes, but roughly speaking it's somewhere between 50 and 75 basis points worth of hiking, if the Fed is able to get the balance sheet down as much as they would like to see. To your point, I think that that does limit the terminal rate assumption for this cycle, but not dramatically so.

Ian Lyngen:

In fact, what I think will ultimately prove to be the binding constraint for this cycle will be the real economy and specifically the labor market. If the Fed finds itself in a situation at the end of the year, where the unemployment rate is a percent and a half higher, this wouldn't be inconsistent with their projections. But I think that will bring into question whether or not the Fed can continue hiking in 2023, if the momentum is in fact so negative for the real economy.

Margaret Kerins:

Ian, you've mentioned the Fed's reaction function to the real economy, but this time could be different depending on their outlook for the real economy and where inflation expectations are at that time. How do you think this backdrop of inflation will impact their reaction function? In other words, can they actually respond to a downturn as quickly as they may otherwise would've in the past?

Ian Lyngen:

Yeah, Margaret, I think that's a great question. Essentially, are we going to see the Fed willing to curtail the terminal rate goal if we're still running at decades high levels for CPI? I think that the short answer to that is no. I think that the Fed is unwilling to concede that they've lost control of inflation and they are willing to hike us into a deeper recession with the goal of keeping forward inflation expectations well anchored.

Ian Lyngen:

I'd also add that one of the nuances of this cycle has been a de-emphasis on the trajectory of financial conditions and how quickly they've tightened as well as overall financial system stability, i.e., equities are off relatively significantly, volatility is higher and the Fed has made it abundantly clear that they're going to continue hiking rates, because monetary policies are battling to retain decades of hard won credibility as an inflation fighter and they're just not willing to risk that for a single cycle.

Margaret Kerins:

Yeah, so basically the Fed tightens until something breaks, but their tolerance for what breaks might be a little bit different than we might have expected a year ago.

Ian Lyngen:

Precisely. I think that's important when we discuss the Fed's commitment to fighting inflation, that we keep the differing time horizons in mind. I say that they're fighting to retain decades of hard won credibility, not glibly. The Fed has a very strong reputation fighting inflation, as we have seen over the last 15, 20 years. If they lose that credibility, a lot of things change in the real economy for the negative and that trade off simply isn't worth it for Powell and I agree.

Margaret Kerins:

I completely agree. Ian. Ian, you mentioned your call for US Treasury 10-year yields of 2.50 at the end of the year. We have seen quite a bit of volatility in interest rates with very large intra-day swings. Rates have moved up rapidly and down rapidly in very short timeframes. Do you think that tens will revisit the 3.50 type of level before reaching 2.50?

Ian Lyngen:

Given the amount of inter day and intro week volatility that we have seen in the Treasury market, I think one would be remiss not to say we're going to have a shot at retesting 3.50, whether that's 3.20 to 3.25 or ultimately all the way to 3.50, but at the same time, a breach below 3.75 with an attempt at 2.50 should also be on the radar.

Ian Lyngen:

In terms of sequencing, whether we see 3.50 before 2.50 will largely come down to not only the realized inflation data, but, and I think this is the more important aspect of it, the Fed's willingness to step up their hawkishness in the case that we see another higher than expected CPI or PCE print. It's not difficult to envision a world in which this week's inflation data prints above expectations and the market starts to contemplate the prospects for a hundred basis point rate hike.

Ian Lyngen:

Now that's certainly not our base case scenario, but it would be very consistent with the way this market has been trading to see Fed funds start to price in a non-zero probability of that in the event that June's inflation data errors on the side of being stronger than expected. This gives rise to a very important question, and that is how does the long end respond in that environment? If we price in a hundred basis point rate hike, the curve will be inverted, yes, but I think at the end of the day, that will be accompanied by lower outright yields. If that is the case, that suggests to me that we're going to see 2.50 and in fact 3.50 will remain the peak for this cycle's 10-year yield.

Margaret Kerins:

Yeah. Basically the Fed is willing to sacrifice growth for inflation, and they're quite credible about that and sort of the long end of the curve and the market pricing gets that narrative. There is a key difference this month with regard to the timing of the CPI data relative to the July FOMC meeting, where they have a little bit more time to message any change in what we should expect in terms of the increase in the target rate.

Ian Lyngen:

Precisely. I think in July, we'll be looking to Fed speakers, not the financial media to set up the actual FOMC meeting itself.

Dan Krieter:

Ian, you provide a pretty strong rationale for your call for 10 year rates to fall to 2.50 by the end of the year, and transitioning over to credit spreads now, I think that is one of the major reasons I think that an inflection point in credit spreads is now starting to appear on the horizon. Where, we've held a pretty bearish view on credit really since last September. I think the point where spreads maybe start to turn lower, is now within sight. One of the major reasons there is expecting yields to start falling. I do think that there has been a demonstrated desire from this FOMC to potentially slow the pace of rate hikes if and when inflation allows. I mean, we've seen even after the June FOMC meeting, we saw them not commit to 75 at July, even in the minutes, not committing to 75 and now commentary from Esther George yesterday, talking about the impact of rapid rate increases alongside QT.

Dan Krieter:

Even Bullard and George now two hawks on record is potentially wanting to slow the rate of rate hikes. I think if and when inflation allows, the Fed will start to take their foot off the brake pedal. We're just at a point in spreads now, where historically from a long term perspective, things are looking pretty attractive. I mean, there's only been five instances since spreads started being published, where spreads were wider than now, two of them being COVID and the great financial crisis.

Dan Krieter:

From a long term perspective, we're at very attractive levels in spreads on an all in yield perspective, it's even more attractive. We haven't been at such high all in yields in corporates since the great financial crisis and a great deal of pessimism has already been priced into the market. Over the past few months, we've been tracking an index of 15 leading economic indicators and that index is at the third lowest point since the financial crisis, only lower during the peak of the pandemic and once in 2011.

Dan Krieter:

A lot of negativity has been priced in. Spreads are now at a point where they're pretty attractive, but I don't think we're there yet. I don't think things have bottomed yet. First of an economic perspective, but also, and most particularly, from a corporate fundamentalist perspective, as we head into earning season with very difficult technicals now facing the market.

Dan Belton:

Yeah, Dan. Fundamentals have been a real source of strength in the high grade market this year. Year to date, we've seen upgrades outpace downgrades in the corporate market by a ratio of 2.2 to one, which reflects just real longstanding, fundamental strength among corporate borrowers, but that's slipped in recent months. In June, we had just 1.3 upgrades for every one downgrade. Then with second quarter earnings set to kick off tomorrow with the largest US banks, it seems really possible that fundamental deterioration comes under more scrutiny, particularly in commentary from some of the larger bank and non-bank CEOs, talking about consumer strength and other potential sources of weakness.

Dan Belton:

Then another near term headwind that we're looking at for credit is technicals. They have really been a major source of weakness for most of this year. In the second quarter, we saw the lightest supply of any second quarter since 2013 and even still, new issue execution levels have been arguably their worst since data has reliably measured them. Borrowers have had to pay an average of 10 or more basis points above secondary market comps in order to place new debt in each month since February. And that's the longest stretch that we have on record.

Dan Belton:

There's really no signs of improvement here either. We saw yesterday six and a quarter billion dollars was priced and the average concessions were 27 basis points. That's the highest of any single day with more than $5 billion in supply since April of 2020 and excluding the pandemic, it's the worst single day since early 2016. Then if you look over at demands technicals, they're similarly weak with the current 15-week streak of high grade outflows, representing the longest such streak on record.

Dan Belton:

Then I want to circle back to a point that we've talked about a little bit at the top and that's the risk that the Fed's reaction function provides, particularly in the possibility that inflation does not moderate as soon as expected. That's another potential headwind for credit, both in the near term and the longer term, given the potential for Fed messaging around this upcoming meeting. I think it's a sizeable risk, because I find it hard to envision a scenario in which the Fed is really responding to growth concerns anytime before inflation has demonstrably slowed, of course, depending on the degree of real weakness that its tightening might cause.

Margaret Kerins:

Dan, the widening new issue concessions has been a theme as you mentioned over the past several weeks, as issuers need to entice investors with wider and wider spreads. Do you think that the new issue concessions are bleeding into the secondary market or are these new issues at the wider concessions tightening on the break?

Dan Belton:

Well, it's a great question and it's very dependent on both the individual deals and the risk tone that persists on the day that these new issues are pricing. But I would highlight that liquidity has been very poor in high grade space. That has made it a little bit more of a muddied issue as to the performance of new issue debt after pricing. But we're thinking about it in terms of, we can't see this type of dislocation between primary market levels and secondary market levels persist forever. At some point something's got to give, and it seems more likely right now that secondary spreads will need to widen in order to come more in line with the levels that investors are willing to put money to work at.

Margaret Kerins:

When you've had several months of outflows in some of the big funds and I would assume that they're having to remain liquid in case that continues, do you see stability in the inflow- outflow picture for investment grade funds?

Dan Belton:

I think that investment grade fund flows generally take their cue from market performance. What I mean by that is fund flows typically chase total returns, not the other way around. Fund flows are typically made up of primarily retail investors and they react in response to total returns. We don't think of that as something that necessarily has led to this under performance, but at 15 straight weeks of outflows, it certainly has exacerbated some of the weakness. I think that those flows will stabilize once we see more stability in rates and in credit spreads.

Ben Reitzes:

Danny, the risk tone to the market that you've mentioned has certainly been challenging, and it's not just a US story, clearly it's a global story and we'll get to the FX picture after me. But I'm going to talk about Canada quickly. One of the themes that I'm picking up so far today in our podcast is the historical perspective and where things are relative to where they've been for the past decade or so. I think that's where we run into a lot of challenges and that's where things are very challenging in Canada as well.

Ben Reitzes:

We have on tap the biggest rate hikes in over 20 years, inflation running at 40 year highs and really an economic backdrop that we haven't had to deal with for decades, if not really ever. I mean, it is a very unique time for the global economy. It's a very unique time for Canada. It creates a very difficult backdrop for policy makers. The question is at what point does the economy weaken sufficiently that policy makers back off and is it more of an inflation question or is it more of a growth question?

Ben Reitzes:

Right now, I think it's more about inflation than growth and as Ian mentioned that the Fed is not going to back off until it's clear that inflation's been vanquished or at least looks like it's going to be. They can say the same thing about Canada. The Bank of Canada has no interest in backing off one iota until it's clear that inflation is at least moving in the right direction at an absolute minimum. The problem here is we're likely many months away from that.

Ben Reitzes:

Still a number of rate hikes to go and what's particularly interesting about Canada, maybe interesting is the wrong word, but what's particularly challenging about the Canadian backdrop is the housing market. We are a very levered economy and levered to housing significantly. Housing's 10% of Canadian GDP, and you can compare that to the US, it's about 4.6% or so. More than double the share of the economy is housing in Canada than the US.

Ben Reitzes:

As rates go up and housing gets pummeled, there's a lot more downside in Canada than the US. Despite that, you have higher two year rates in Canada, higher ten year rates in Canada. Canada looks pretty cheap here generally, based on fundamentals. Flows have dictated otherwise, but fundamentally we still look pretty cheap here on the rate side. I'm not sure I'd be speculating on the front end at this point, given that there are still plenty of right hikes to come, but that's certainly the way that we lean at the moment.

Ben Reitzes:

Curve wise, similar to Ian. Flatter, flatter, flatter, It's really hard to argue against that with central banks remaining aggressive, the data generally rolling over. It should really mean flatter curves pretty consistently until we get to that point where either, one, inflation backs off enough, I'm not sure when we're going to get that or the data we can sufficiently that central banks have no choice, but to back off. Whether that means rate cuts or not like the market is currently pricing in the first half of 2023, I'm pretty skeptical on that, but they'll at a minimum back off. That still does mean a flatter curve ahead for the next few weeks and probably months in the second half of the year, likely in its entirety.

Ben Reitzes:

In addition to the flatter curve, liquidity has been an area of substantial challenge in Canada. The market has been a tough spot. Part of that is just the broader risk environment. I think that's something that we are seeing globally, the challenges on the risk front likely aren't going to go away near term as the macro backdrop continues to deteriorate, and that's expected to be a theme going forward.

Stephen Gallo:

Ben, on your note about global conditions and liquidity risks, I think it's a good time to transition to currencies. I actually want to pick up on something Dan Belton mentioned, when he was going through the weeds on secondary spreads. He mentioned, to paraphrase, that there is a necessary repricing of risk that must occur before investors will look to get involved at specific levels. I think currency markets are playing a role in the same type of phenomenon. They're adjusting, they're repricing risks at the global level. One of the most famous places, I guess, where we have seen risks being repriced is in Europe, in Euro. Euro/dollar has reached parity for the first time since 2002. I'd make a few points on this move. The first is that levels in currency pairs like parity in Euro/dollar, they're at times a bit more important to markets than central banks.

Stephen Gallo:

What I mean by this is, a move slightly below par in Euro/dollar, I think is much less of an issue for the ECB than a move below parity and cable would be for the Bank of England because a move below parity and cable has never happened before, ever. That's the first point. Second point, I think is that we should get ready for rhetorical defense of parity by the ECB, but, and we've kind of been saying this for a big part of the year, the ECB can't reverse structural or fundamentally driven weakness in the Euro with rhetoric or even rapid rate hikes, given fragmentation risks. It's going to take a shift in other central bank policy stances, an improvement in European trade flows, and clear market friendly developments on energy prices and inflation.

Stephen Gallo:

That the inflation questions come up multiple times in this podcast. It's clearly a big issue, particularly US inflation. If all of those stars align, then we can see this ship in Euro/dollar turn around. But otherwise I think the ECB is going to have limited success in trying to prop up the Euro. I think probably the last point is we're now expecting Euro/dollar to trade a bit below parity at the one to three month part of the curve of the outlook curve. But that is where we think it will base, absent another Russian energy supply shock or severe disappointment risk materializing at the ECBs July policy announcement. Absent those two risks materializing, we think Euro/dollar is going to base just below par. I think this is actually a good time to pass it over to Greg, because you need to give us a synopsis on what's been driving the broad dollar.

Greg Anderson:

Yeah, I would argue... Look, this move from, we'll call it 1.04 at a parity in euro over the span of the first half of July. A little bit of that is about Europe, but most of it is about the USD, so yes, the USD is up 4% against the euro, but it's up two and change against Aussie and against the loonie and yen, et cetera. Most of it is a dollar story and I want to go back to something that Dan Krieter said about spreads, and if I could summarize, I think he said, it will get a little bit worse before they reverse, but the levels are juicy and they're tempting, but in FX, the dollar is really strong and on a historical basis, we've only been this far away from the long run average about 6% of the time.

Greg Anderson:

But if you want to step in and short the dollar, you're going to pay for that in terms of carry. You probably got to be a little bit more sure that the reversal is occurring before you're going to jump in on that versus on spreads. Okay. The green back, what's the story behind the strength? Of course it is Fed tightening, and definitely was the story in the first quarter. But we came out of June and the back half of June out of the June FOMC, and there was no dollar action higher, but what we've seen in July, I believe is the pricing in of much higher probability of global recession and therefore a stronger dollar across the board. This is a risk off dollar rally rather than a Fed on dollar rally. They've kind of been trading off back and forth all year, but that's how I would characterize the latest phase.

Greg Anderson:

I guess I would say, I don't think it's over yet. It's probably got a couple, three, four more percent to go before we're done. How do you stop it? Because, I think we're at levels that Europe's not happy. I don't think the Fed should be happy either. To stop it, I don't think the ECB could do it. It has to be led by the Fed in terms of a rhetoric response, job owning the FX market led by the Fed, but it has to appear coordinated. I just don't know if that can be pulled off in today's geopolitical environment.

Greg Anderson:

I would look for it. It's there as a risk and maybe it would work, but not sure that it would, and not sure that it's going to happen. The path of least resistance is still a bit higher for the USD. Just quickly on dollar/Canada, because it tends to get dragged along for the ride. We have reached 1.30, I would say 1.30, 1.50 to 1.32 is probably where there would be a tremendous amount of selling pressure. In that particular pair, people do not have to pay to short the green back, it's basically free.

Margaret Kerins:

Okay. Thanks Greg and Stephen, for your insights on the currency market. We have covered a lot of territory today. Let's conclude with a rapid fire round table, beginning with Ian. Ian?

Ian Lyngen:

Our big take is at this point, the Fed is committed to pushing forward with higher rates at the expense of the economy and in that context, the flatness and the inversion of the yield curve will persist. But when the proverbial dust ultimately settles, 10 year yields are going to be closer to two and a half than they are three and a half and the front end of the curve and the two year sector will be content to yield below effective and terminal Fed funds.

Margaret Kerins:

Dan Krieter?

Dan Krieter:

In credit, I think we are now starting to approach levels that will look attractive from a long term perspective, but in the near term, technicals remain so unsupportive in the market. My aptly focused on the Fed tightening into potentially recession that we're going to have to see some more spread widening before we see the peaks.

Margaret Kerins:

Dan Belton?

Dan Belton:

In the near term, watch for fundamentals and commentary out of earnings reports to drive potentially the next leg wider in credit spreads, which might lead to some better levels that investors could view as an attractive buying opportunity. We target 175 basis points in the broad IG index is our year end target levels.

Margaret Kerins:

Ben Reitzes?

Ben Reitzes:

Don't fight the bank of Canada, similar to the Fed, the bank is entirely focused on inflation at the moment, and it's going to take a lot to get them to back off. That means the front end's going to remain under some pressure, especially relative to the 10 year point. Still flatter curve ahead. Same story as the US generally and it's going to be a continued challenging environment for the rest of 2022.

Margaret Kerins:

Stephen Gallo?

Stephen Gallo:

Yep. Okay. To sum up, absent another Russian energy supply shock this summer or winter, we think euro/dollar will base just below parity. One final thought, despite all of the hype about euro dollar parity, the British pound is still my preferred short versus the dollar in Europe. My rationale is the potential for a summer of acute stagflation and balance of payments risk for the UK economy. I definitely think a test of levels sub 1.15 in cable is not out of the question before the cycle turns.

Margaret Kerins:

Greg Anderson?

Greg Anderson:

The US dollar rally is not over yet, still another, let's say 1 to 3% higher over the next one to three months. It should curl later this year and when it does, probably your most attractive sell is dollar/Canada. I would give out a year end target somewhere around 1.27.

Margaret Kerins:

Okay. That's a wrap. Thank you to all of our BMO experts. Thank you for listening. Please remember to vote for team BMO in the II survey. We really appreciate your support. This concludes Macro Horizons monthly episode 42. 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/macro horizons. We'd like to hear what you thought of today's episode. You can send us an email at Margaret.kerins@bmo.com.

Margaret Kerins:

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Speaker 2:

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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
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

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