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Accelerate Debate - The Week Ahead

FICC Podcasts 03 décembre 2021
FICC Podcasts 03 décembre 2021


Disponible en anglais seulement

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of December 6th, 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.

Podcast Disclaimer

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Ian Lyngen:

This is Macro Horizons, Episode 149, Accelerate Debate, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of December 6th. And as treasuries sell off despite a 340,000 payrolls miss, we are reminded of the sage market wisdom. Yields will go up. Yields will go down. But not necessarily in that order.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates for 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 past, the Treasury market had a lot of new information to digest, and the resulting price action, frankly, triggered more questions than it answered. Initially, we came into the week with a solid bid as a result of the most recent variant of the coronavirus. Expectations associated with lockdowns, the effectiveness of the vaccines and all of the uncertainties surrounding another potential wave weighed on rates. And we saw 10-year yields dip back to that 141 level, and the curve continued the flattening trend that has been in place throughout the fourth quarter.

Ian Lyngen:

For context, we are reluctant to fight against the flattener at this point, if for no other reason than it's consistent with the Fed's recent hawkish pivot. Powell's congressional testimony effectively retired the word transitory, which because it was accompanied by an expressed openness to consider accelerating the pace of tapering, has near-term monetary policy implications. Specifically, as our recent pre-NFP client survey revealed, 78% of market participants now expect that the Fed will accelerate the pace of tapering in December.

Ian Lyngen:

Logically, from the Fed's position at least, there are really only two meetings that matter in terms of an acceleration of the pace of tapering. Those are the December meeting and the January meeting. Because if the Fed were to wait until March or beyond, it's largely a moot point, simply because the window of remaining purchases would be so small at that point that a tapering wouldn't provide the Fed with any increased flexibility per se.

Ian Lyngen:

This leaves us very sympathetic to the idea that the Fed, who'd rather not be buying bonds anyway, all else being equal, will be eager to take this opportunity to wind down QE sooner rather than later, providing an incremental amount of flexibility, if and when the economic data dictate that a rate hike is warranted.

Ian Lyngen:

Now, the Fed Funds futures market has been very aggressive in their pricing in terms of two-and-a-half-plus rate hikes now priced in for 2021, although historically the market does tend to price in more rate hikes at the beginning of the cycle than are ultimately realized. That said, we're certainly sympathetic to the idea that the balance of risks at this moment are tilted toward the upside in terms of inflation.

Ian Lyngen:

This reality will complicate the Fed's communication strategy. It's one thing to accelerate the end of tapering. It's another to pre-commit to a rate hike as soon as the March meeting. We certainly don't think that that's the Fed's best-case scenario. Nonetheless, the combination of an accelerated tapering and an increase in the beloved dot plot will lead to fully pricing in a June, September and December rate hike and get the market excited about the prospects for a March move.

Ian Lyngen:

Given the Fed's operating assumption that inflation pressures will ease in the second quarter of next year, we struggle to see the needed degree of urgency for a March move at this point and therefore would consider that pricing to be a fade.

Ben Jeffery:

So Ian, what do you make of the argument that it was a Goldilocks jobs report? Sure, the headline NFP figure was well below consensus, but we did see the participation rate creep up and the unemployment rate decline much more than expected.

Ian Lyngen:

To be fair, I do like my porridge bearish, but the fact of the matter is that there was a fair amount of variation between the household survey as well as non-farm payrolls, which suggests that either the household survey is giving us a better glimpse of what's going on in the employment, or it's simply catching up with some of the recent gains.

Ian Lyngen:

Regardless, when you drill down into some of the details, what you see is a declining unemployment rate, an increase in the labor market participation rate, which is very important given the Fed's emphasis on labor market participation at this point in the cycle. My biggest takeaway from the jobs report was there was nothing contained within the release that would keep the Fed from accelerating the pace of tapering when they meet on the 15th of December, barring a material deceleration of inflation, which we will get the CPI series related to on Friday.

Ben Jeffery:

And I would argue that the bar for NFP to really move the monetary policy needle was already quite high, just given the fact that based on what we heard from Powell at his congressional testimony this week, the Fed seems to, at this point, be moving toward a bias where they're content to call the improvement in the labor market good enough. And that means that while an extension of strong NFP prints is going to be encouraging for the recovery, really at this point what is most consequential is the direction of inflation.

Ben Jeffery:

So, Ian, you and I had been talking about, coming into this week, how there were are three main event risks left this year. We now have one of them in hand via the good enough NFP read, which really leaves the main uncertainty of if CPI will be meaningfully enough off consensus to derail expectations for the December 15th Fed meeting.

Ian Lyngen:

I'll offer a bit of nuance to this idea that the payrolls report was good enough. I would say that it was good enough to keep accelerated tapering in play, but not necessarily the type of prints that the Fed is going to need to justify the liftoff rate hike. I don't think the Fed is interested in drawing attention to that difference at this point, but at the end of the day, if the Fed chooses to accelerate tapering, it goes without saying that the market is going to bring forward rate hike expectations, will fully price in a move in June, and then all of a sudden a March rate hike would be on the table.

Ian Lyngen:

Now in terms of market implications, that's going to put more upward pressure on rates in the two, three and five-year sector and this at a moment when the 5s/30s curve has pushed back within striking distance of the 50 basis point level, which once again focuses our attention on that 2018 range of 25 to 40 basis points.

Ben Jeffery:

But there is a critical difference between now and 2018, namely that in 2018 the Fed was in the middle of their regular and predictable quarterly hiking cycle. So the dynamic we're seeing where the curve is beginning a flatter trend from a very low outright departure point must be inspiring some concerned conversations at the Fed, just given how suppressed the entire rates complex is.

Ian Lyngen:

If we look at rates overseas, particularly in Europe and Japan, there's very compelling comparables that would lead us to believe that we are not going back into an environment of a consistently steeper curve. So the idea that the Fed might be looking at the shape of the yield curve with some type of underlying concern, at least enough concern to get them to act, really doesn't resonate at the present moment the way it might have in prior cycles. Because the reality is that the Fed is content to use financial conditions as a key guide for monetary policy decisions, and financial conditions are extremely easy at this moment, which does afford the Fed a degree of flexibility that they seem comfortable using to end QE, which all else being equal, the Fed does not want to be buying bonds if they don't believe that the system ultimately needs that magnitude of support.

Ben Jeffery:

We talk a lot about 5s/30s and 2s/5s, but there's definitely an argument to be made that one of the more relevant curves to keep in mind as liftoff approaches is going to be between the very front end and belly. 2s-3s, 2s-5s, 3s-5s are all going to be very telling in terms of evaluating the market's expectation, not only for when we get liftoff, but how quickly and by what size policy rates are going to be increased thereafter. This then leads to an uncertainty that you and I have been talking about, Ian, which is, will the Fed ultimately need to bring rates to a higher terminal level than there were last cycle, just given the amount of inflation in the system?

Ian Lyngen:

This is actually one of the primary questions that we've been hearing from clients as of late. Specifically, what will the terminal rate for this cycle be? And should we be looking for something above the two-and-a-half percent that is assumed at this stage? Our read on the Fed's recent age in rhetoric, i.e. retiring transitory, had more to do with the Fed's communications efforts than it necessarily did with their belief in the forward path of inflation. And in that context, we can point to some of the testimony from Powell where he effectively said that the market is misinterpreting what transitory might mean, and therefore more descriptive language around the issue is warranted.

Ian Lyngen:

All else being equal, I might have put that in the category of simply classic Fed semantics, but the fact that Powell then went on to introduce the idea of accelerated tapering, I think, puts it all into a different context. All of this being said, regardless of the Fed's current interpretation of the risks between now and the second half of 2022, there are meaningful base effects that are going to come into play for the core inflation series in the second quarter of next year that will make it much more difficult for consumer prices to stage a repeat of what we saw in the second quarter of 2021.

Ben Jeffery:

And another thing that's unlikely to be repeated is the impressive out-performance of breakevens that has been the defining feature of the Treasury market throughout 2021. It was encouraging to see the response in the tips market following Powell's remarks, just given the fact that the chair's more hawkish inclinations translated through two declining inflation expectations and higher real yields. Now that we've seen 10-year breakevens move decidedly off the peaks they set not that long ago, at this point it's reasonable to assume that the market is demonstrating enough faith in the Fed's ability and willingness to step in and offset inflation that it's going to be difficult to get inflation expectations back to such elevated levels.

Ian Lyngen:

Yeah, I think it's safe to say that the breakeven peaks for this cycle are in, unless we find ourselves in a situation that, for some pandemic-specific reason in terms of curtailing aggregate demand, the Fed needs to pivot back to a more dovish stance. Again, by no means is that our best-case scenario, but the only way that we can envision forward inflation expectations drifting higher than the levels that we saw in 2021 would be, to your point, Ben, if the market lost faith in the Fed's ability or willingness to address inflation.

Ian Lyngen:

What I find fascinating about this particular point in the cycle is the Fed has come out and said specifically that it doesn't necessarily have the tools to deal with the type of inflation that we're seeing in the system at this moment, i.e. supply chain-related issues that have pushed up prices and are residual of the dislocations that occurred because of the pandemic.

Ian Lyngen:

Another aspect worth noting is that the Fed's recent focus on the Omicron variant hasn't been what it could mean in terms of lockdowns and restrictions on consumption in the US, but rather how it's going to continue to disrupt supply chains and therefore put further upward pressure on consumer prices in the US. That's a very important shift in the Fed's view of the coronavirus, especially since as recently as the Delta variant, we saw growth and employment edge lower as a result of the most recent wave.

Ben Jeffery:

And it's pretty telling that we've made it this far in the conversation without even mentioning the latest developments relating to the coronavirus. And this emphasizes something that's probably going to be thematic throughout 2022 and maybe even into 2023, which is that given 10 and 30-year yields are far more beholden to global growth and inflation expectations versus solely domestic ones, the evolving pandemic and what looks like could be the re-implementation of some fairly meaningful restrictions in Europe serves as a reminder that, while the US is faring comparatively well, there's still a long way for the world as a whole to travel to completely leave COVID behind.

Ian Lyngen:

And let's face it, for the foreseeable future, there will always be a variant risk, and it will be a long time before or COVID is a distant memory.

Ben Jeffery:

And as an indication of the ongoing willingness of foreign Treasury buyers to add duration exposure at these levels, we do have the final long-end supply series of 2021 with 10s and 30s coming on Wednesday and Thursday respectively. Now remember that the November refunding auctions were not particularly well-received at rates that were meaningfully higher than where we are now. So it's going to be very interesting to see the collective willingness of primary market participants to bid aggressively even with 10-year yields now just off that 140 level.

Ben Jeffery:

Obviously a lot has changed since the first week of November, not least of which being the latest variant and also the information gleaned from Powell's testimony. But as the last four trading weeks of the year play out, the auctions could help in setting the overall tone of exactly where it is 10-year yields are going to end this year.

Ian Lyngen:

And as we consider where we anticipate 10-year yields will end 2021, we did come into the year with a target range of 125 to 135 in 10s for year end. And given the price action that has occurred over the course of the last week, we're going to retain that target zone with an acknowledgement that we still anticipate the beginning of 2022 will take on a much more bond-bearish character as the market focuses on the Fed's liftoff hike, the realities of inflation, and essentially attempts to re-trade the reopening and inflationary narrative that was so pervasive during the first quarter of 2021. The difference in the year head is that we've actually seen more realized inflation, and there's been solid jobs growth, to say nothing of the recovery in the real economy.

Ben Jeffery:

But you are still going to wear your mask, right?

 

Ian Lyngen:

Of course I am. It covers the problem areas. In the week ahead, the Treasury market has remarkably little economic data with which to contend until Friday's release of the November CPI figures. The consensus is currently for a six-tenths of a percent month-over-month gain for the headline number and an impressive five-tenths of a percent move in core. When we break down what's been driving the core figures, the emphasis on new and used auto prices remains. Upside in that category while still consistent with the Fed's characterization formerly known as transitory will nonetheless get the market refocused on the potential for consumer price inflation to become self-perpetuating.

Ian Lyngen:

Also within the details of the series, we will be watching for OER and rent. Inflation linked to housing is another complicating factor for the Fed. Given the space occupied by home ownership in the United States, the idea that the central bank would actively try to undermine the value of a core store of wealth for American consumers is difficult to imagine, especially when a good portion of what we've seen in terms of upside inflation surprises have been in the headline categories of food and energy.

Ian Lyngen:

This is, in part, one of the reasons that the Fed has attempted to temper expectations insofar as what a tighter monetary policy can actually do for the near-term risk for inflation. There are supply chain issues. That goes without saying. And one of the primary concerns that the Fed surely has at this stage in the cycle is that by attempting to take some of the upward momentum off the inflation complex, they instead undermine demand to a point that we risk a mild recession.

Ian Lyngen:

Again, this is not our best-case scenario, but if we think about the dismal track records that central banks have at orchestrating soft landings, we'd be remiss not to at least highlight a more significant slowdown in growth as a material risk over the course of the next two years. We do continue to like the flat in trade, particularly in 530s. There's a strong argument that it has been overdone and we're way too far ahead of where we should be in the cycle. The flip side is that while positions are less short than they were, the market is still collectively looking for higher rates by the end of the year.

Ian Lyngen:

So if nothing else, the pain trade toward lower rates is difficult to ignore. That said the very front end of the market and the belly of the curve are mechanically tied to monetary policy expectations in such a way that we are unwilling to fade the weakness that we're seeing in 2s, 3s, and 5s, and therefore our default bias between now and year-end will be in favor of the flattener.

Ian Lyngen:

We have 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 with all this talk about tapering, we cannot help but have a sense of nostalgia for boot-cut. Straight-legged or a good old-fashioned bell-bottomed approach to monetary policy-making. You think Volcker owned a pair of flared jeans? If he did, they were probably tie-dyed.

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 FICC Macro Strategy Group and BMO's marketing team. This show has been 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 with BMO, who are involved in fixed income and foreign exchange sales 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. Notwithstanding the foregoing, this podcast should not be construed as an offer or a 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.

Speaker 2:

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Speaker 2:

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Ian Lyngen, CFA Directeur général et chef, Stratégie de taux des titres en dollars US
Ben Jeffery Spécialiste en stratégie, taux américains, titres à revenu fixe

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