Bid Still Standing - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 206 Bid Still Standing presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of January 23rd. And as we watch 10-year yields reach equilibrium south of 350, we are reminded that the more rates change, the more they stay the same. Home, home in the range.

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. So that being said, let's get started.

In the week just passed, the treasury market saw a remarkable amount of price action driven by a series of events, some internal, some domestic, and some overseas, which has netted to a persistent bid in treasuries with 10 year yields, comfortably below 3.5% percent and two year yields a lot closer to 4% than one might have otherwise expected as the Fed readies to increase the effective Fed funds rate from 4.33 to 4.58.

Now at the end of the day, the front end of the curve is pricing in a more significant recession than the Fed seems to be anticipating and a response by monetary policymakers that would ultimately be more dovish than Powell and company have been signaling. We also saw the Bank of Japan double down on yield curve control by not increasing the band by an additional 25 basis points as had been speculated but not predicted by most Bank of Japan pundits. Kuroda went on to endorse yield curve control for its sustainability as well. This implies that the Bank of Japan will not be abandoning this particular policy tool anytime soon. Let us not forget that there was a variety of Fed speakers, all of whom left the market with the impression that the Fed is on track to deliver a 25 basis point rate hike, but didn't push back against what has been a continued easing of overall financial conditions as equities continue to stabilize and perform at least on net.

Certainly stocks have been performing versus what one might have otherwise anticipated given how far into restrictive territory monetary policy has already become and the Fed's signaling that they're going to keep policy restrictive for quite some time. All else being equal, we would expect risk assets broadly to underperform in such an environment and the fact that the market is content to pull forward rate cuts despite the Fed's cautioning against it certainly contributes to our apprehension about the performance of equities over the course of the first two quarters of the year.

Now, investors also saw the retail sales numbers for December, which revealed a negative 1.1% move. Now a modest downside in headline retail sales was anticipated, but the magnitude of the move does bring into question the trajectory of consumption as Q1 gets underway, and let us not forget, there was very strong sponsorship yet again for treasury supply with a 20-year auction stopping through 2.4 basis points and 10-year tips stopping through 4.7. Overall it's safe to say that bonds are back and there appears to be solid evidence of renewed foreign buying of US debt.

Ben Jeffery:

Well, as Elton John said it first and Ian Lyngen said it second, the bid in treasuries is still standing. It was a very consequential week both in terms of what we saw on the economic data front, heard from several Fed speakers, and also the results at both the 20 year and 10 year tips auction that stopped well through and reinforced this idea that as the new year has gotten underway, there is certainly a stronger buying interest in the treasury market than we've seen for quite some time.

Ian Lyngen:

The first observation that I'll make is that it was a holiday shortened week, although it certainly didn't seem like it in terms of the developments and the price action. We came into the week with a negative tone in terms of upward pressure on treasury rates and a lot of that was predicated on the idea that the Bank of Japan could seek to widen the band around yield curve control or potentially abandon yield curve control altogether. Now we're certainly sympathetic to that as an outlier risk and the fact that it didn't come to fruition was in fact one of the primary causes for Wednesday's rally that then carried through and proved to be sustainable as the week came to an end.

Now, Kuroda's term ends on April 8th, which means that he has one more meeting at the helm of the Bank of Japan and we're not expecting any change at this point. More importantly, when we think about his successor who's expected to be one of his proteges, our operating assumption is that there'll be at least several meetings of stability on the monetary policy side in Tokyo. So that means that as a potential bond bearish impetus, a change from the Bank of Japan is off the table for the foreseeable future.

Ben Jeffery:

And the BOJ's decision to hold YCC policy steady was absolutely the catalyst for that round of buying that started overnight coming into Wednesday and left 350 tens in the rear view mirror. But then the rally became far more a domestic story as the most important data of this week in terms of the state of the real economy was the retail sales report, which came in lower than expected on both a headline basis and within the control group and further calls into question just how strong the consumer is at this point despite what is still obviously a very strong labor market. So slowing consumption to conclude last year during holiday shopping season doesn't point to domestic households that are particularly willing to spend and given the week ahead holds the first look at fourth quarter GDP, the recession question and whether or not Powell is going to be able to avoid a year of negative real growth is very much top of mind and this dimmer outlook on the state of the US economy also contributed to 10 year yields dropping decidedly below 340.

Ian Lyngen:

When we think about the composition of growth during the fourth quarter of 2022, it is worth highlighting that while consumption is expected to be a core contributor, we're also anticipating an inventory rebuild that will be net positive to real GDP. So in this context, the disappointing retail sales figures, while they might take the edge off of the upside potential for GDP, there's very little chance that we see a negative print. So that means that any recessionary conversations need to be brought forward to the current quarter and therefore the trajectory of consumption as 2023 started will be the biggest takeaway from Thursday's data.

Now, one of the more interesting developments in the week just passed that's worth highlighting is not only did we see a 2.4 basis point stop through for the 20-year auction, but the 10-year TIPS refunding of 17 billion stopped through 4.7 basis points. Now, interpreting the performance of tips auctions is always a bit of a challenge. Intuitively, if investors are paying up for inflation protection, that would translate into an investor base that's also biased for higher nominal rates. However, given what we're seeing in terms of the indirect bids at all of the coupon auctions thus far in 2023, it seems much more likely that treasuries as an overall asset class have benefited from, what we are assuming, is strong foreign interest as the year gets underway.

Ben Jeffery:

And there were certainly signs of that within December’s supply series as well. We saw 30s, 2s, 5s, and 7s all show decidedly above average foreign take downs. And so as an early indication for our assumption that the same dynamic has played a role this week, December's investor class data was certainly encouraging. And on Tuesday we will get the same information for January's 3s, 10s, and 30s results that also were very strong and showed higher indirect demand, and that will be some more concrete evidence that unlike a foreign buyer base that spent much of 2022 on the sidelines in the treasury market, as we've reached the new year, presumably the terminal rate is now much closer at hand, large buyers abroad are more willing to bid aggressively at supply events, especially as it relates to Tuesday's two-year auction. And given the sensitivity of the two-year sector to Fed policy, it's going to be especially telling if we see another strong bid in large stop through with that higher indirect allocation.

Now, Ian, I think you and I both agree that looking at the unassumed path of Fed funds, two-year yields probably remain too low, but clearly that has not prevented substantial buying interest from benefiting the two-year sector over the past few weeks.

Ian Lyngen:

I think it's useful context that a basic fair value model based on the geometric mean of forward monetary policy assumptions gets us to 4.6% in two year yields, assuming three more 25 basis point rate hikes, holding terminal into 2024, and then factoring in four quarterly 50 basis point rate cuts. So that is twice what the SEP is projecting, and still we find two-year yields at 415 to end the week. So, said differently, the market is telling us two things. One is the Fed is more likely to increase policy rates by just 50 basis points between now and terminal, and rate cuts will come sooner and be of a greater magnitude than even our 200 basis point assumption over the next 24 months.

Ben Jeffery:

And as this debate continues, it was the last week for the Fed to offer official communication on how it is they are thinking about both the size of February's rate hike, but also the appropriateness of terminal above 5%. And while at this stage, a 25 basis point hike on February 1st is serving as our operating assumption, beyond the February meeting I would argue just as important as the size of the rate hike is how we see the DOT plot evolve and what it means for exactly the assumptions that you're talking about, Ian. Namely, how many DOTs continue to hold above 5% and what that implies about the likelihood of a final hike in May, but also how the Fed's formal forecasts shift in 2024. In December, we were admittedly a bit surprised to see the spread between the 2023 and 2024 DOTs widen to a full percentage point. And so as that meeting approaches, how many additional policymakers see even larger rate cuts in 2024 as appropriate will also be critical in deciding when is the opportune moment to start scaling into the 2s/10s steepener trade that we ultimately expect will emerge later on this year.

Ian Lyngen:

And to be fair, two year yields well below effective Fed funds has been a core prediction of ours for this year, and that does fit in well with the recent price action and also the process of attempting to appropriately time and effectively scale in to the cyclical re-steepening of the 2s/10s curve. A curve that has had a more consistent steepening trend has been the fives bonds curve. Now five year yields versus 30 year yields should, and certainly intuitively, steepen out given that the Fed's next 200 basis points in rate moves are going to be lower rather than higher.

So the belly will outperform and as investors watch the Fed eventually transition back to an easier monetary policy stance that will rekindle forward inflation expectations or in an environment such as this, keep forward inflation expectations from falling as far as they might if in fact the Fed is able to keep policy on hold throughout 2023 and doesn't feel compelled to deliver the first rate cut until the middle of next year. In terms of specific levels, we've been targeting fives 30s at positive 10 basis points and that level was breached and we would look to reenter that trade back at zero as we expect that fives 30s will remain positive throughout the bulk of this year.

Ben Jeffery:

And if there was going to be Fed communication endorsing the idea that maybe a rate cut at some point in 2023 was appropriate, we would've looked for vice-chair Brainard's comments on Thursday to serve as the operative venue to deliver that messaging before the pre-meeting communication ban took hold. Instead, the vice-chair stuck very much to the script in saying that inflation remains too high, policy is restrictive and needs to remain restrictive for some time without any indication that even one of the most dovish members of the committee and probably the most dovish member on the board is entertaining the idea that unwinding some of the delivered tightening in 2023 is going to be appropriate. And while the market is still priced for a much more forgiving Fed over the rest of this year, we continue to expect that the unifying message in response to the rate cut question is still going to be one of too soon.

Ian Lyngen:

Brainard's comments also brought the benchmark 2s/10s spread back into a very familiar range in that negative 70 to negative 80 zone that we expect will continue to contain the 2s/10s curve until we get the February 1st decision. And the market is tasked with interpreting the fact that the Fed is still hiking, but will be transitioning to a less uber hawkish tone as the end of the cycle nears. Let's face it, Powell and company face a very significant communications challenge in early February, and investors will, likewise, be challenged to appropriately incorporate the new information into US rates pricing, particularly ahead of the January Non-Farm Payrolls report that follows the Fed by two days.

Ben Jeffery:

Speaking of appropriate pricing and really the perfect level in treasuries, if everyone agreed we wouldn't be here.

Ian Lyngen:

Get it?

In the week ahead, the Treasury market will be tasked with taking down three nominal auctions, $42 billion 2s, $34 billion 5s, and $35 billion 7-years. Overall, in light of the results of the recent coupon auctions in the treasury market, we are anticipating a continuation of the solid underwritings with a bias to see stop throughs rather than tails at these three auctions. It's also notable that the market will have no additional Fed speak to guide expectations ahead of the February 1st decision. This is the traditional Fed moratorium on public comments ahead of the meeting. That of course, won't preclude a response funneled through the financial media in the event that the Q4 GDP release on Thursday warrants an update of any sort.

Investors will also continue to ponder the longer term implications from the fact that the debt ceiling was just reached in the week just passed, and Yellen has started implementing extraordinary measures that are expected to keep the government functioning until some point in June. Now, given the level of contention in Congress at the moment, I think it's a safe assumption that lifting the debt ceiling is not going to be an easy process this go round. Now, we don't think that this ultimately translates into a US default.

Recall that the last time that the US missed a payment was in the seventies. There were two specific issues. There were maturing bills, they were ultimately made whole, but it occurred later than scheduled. Now keep in mind that unlike a corporate borrower, the US Treasury does not have a cross default, so by missing a payment on one security, that doesn't impact the rest of the US federal debt. In fact, if we do find ourselves in a situation where extraordinary measures are exhausted sooner than Congress can fix the debt ceiling problem, then a government shutdown would ultimately be a bond bullish affair.

Admittedly, that's somewhat counterintuitive, however history suggests that's precisely how things will ultimately play out. The administration always has the ability to mint a trillion dollar coin and deposit it at the Fed, thereby circumventing the debt ceiling. Although this certainly is not our base case scenario, nor do we expect that it will come to fruition during this episode of the debt ceiling debate. Earning season continues in the equity market and we do anticipate some potential, at least for sharp moves in the equity market, to influence US rates at least on the margin as investors get a better understanding of how the corporate sector's performance played out as 2022 came to close.

We've reached the point in this week's episode where we'd like to offer our sincere thanks and condolences to anyone who has managed to make it this far. And as we debate between playoff football and the Australian Open for this weekend's entertainment, it dawns on us that we should just throw in the towel and concede it will be two days of catching up on the recently released 2017 FOMC transcripts. Sure, wish that came in audiobook form with Yellen doing the dramatic reading. Maybe next cycle.

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 3:

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