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Cycle of Crisis - Monthly Roundtable

FICC Podcasts Nos Balados 08 septembre 2022
FICC Podcasts Nos Balados 08 septembre 2022


Disponible en anglais seulement

Margaret Kerins along with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton and Ben Jeffery from BMO Capital Markets’ FICC Macro Strategy bring you their outlook for Treasury rates, the shape of the yield curve, IG credit spreads, Canadian rates, and foreign exchange as the Fed and other central banks continue tightening campaigns and the Fed’s QT reaches maximum SOMA portfolio runoff.


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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 44, Cycle of Crisis presented by BMO Capital Markets. I'm your host Margaret Kerins here with Ian Lyngen, Ben Reitzes, Greg Anderson, Stephen Gallo, Dan Krieter, Dan Belton, and Ben Jeffery from our FICC Macro Strategy Team to bring you our outlook for Treasury rates, the shape of the yield curve, IG credit spreads, Canadian rates, and foreign exchange as the Fed and other central banks continue tightening campaigns and Fed QT reaches maximum runoff this month.

Margaret Kerins:

Each month, members from BMO's FICC Macro Strategy Team join me for a roundtable 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.

Margaret Kerins:

We are just under two weeks away from the next FOMC meeting with the market pricing a 95% chance of another 75-basis-point move higher in the Fed funds rate. If they do move by 75 basis points, this will bring the Fed funds rate up into the range of 3 to 3.25%. All eyes will once again be on the dot plot at the September meeting, which will be updated for the first time since June when, of course, the median projection for the end of 2022 was 3.40 and the terminal rate was about 3.80, clearly outdated.

Margaret Kerins:

As the market absorbed the July FOMC meeting, Powell's Jackson Hole speech, and subsequent Fed messaging, the Treasury curve bear steepened with 2s/10s moving off the deep inversion of negative 58 basis points achieved on August 10th to the current levels of about negative 21 basis points, of course driven by the backup in 10s.

Margaret Kerins:

So let's begin with Ian. Ian, have we seen the depths of the inversion in 2/10s, or is there greater capacity to see a drop back below the negative 50-basis-point level?

Ian Lyngen:

Well, our baseline assumption is that we will retest that negative 58-basis-point level that was established over the summer, but that price action won't be a straight shot. Instead, what we're anticipating is that as the Fed pushes forward with additional rate hikes and we have clarity from the SEP in terms of where terminal will be during this cycle, that that will allow investors a degree of clarity in terms of expectations for the upper bound of policy rates during this cycle. Once that occurs, we should see a degree of stability in terms of the outlook across a variety of different markets. And with that, we expect more dip buying interest will emerge and that will be an important inflection point that serves to invert the curve even further.

Ian Lyngen:

One of the bigger concerns that we have as we look at the balance of 2022 is what happens when effective funds start to converge with two-year yields? Will we find ourselves in a situation where two-year yields are using the effective Fed funds rate as a floor, or will that curve invert as it has in prior cycles? It's notable, though, that when that curve inverts, we're talking about 2s versus effective Fed funds. It tends to occur after the Fed has reached the terminal rate.

Ian Lyngen:

So in the event that we get 75 basis points on September 21st followed by another, let's call it 50 basis points in November, that would imply that there should still be upward pressure on nominal two-year yields, which will further contribute to the inversion of 2s/10s.

Margaret Kerins:

So Ian, you mentioned the possible inversion in Fed funds versus 2s. And we do know that the Fed looks at, say three months versus 10s as a possible recession indicator. It seems possible that we could see that type of inversion as soon as early next year. Do you think it's still a signal for a recession in this type of environment?

Ian Lyngen:

Frankly, Margaret, I think that we're right on the edge of a recession. Historically, when you have two back-to-back quarters of negative GDP, that has been characterized as a recession. What I think is so atypical about this cycle is the Fed pushing back against that traditional definition. And to your point about the inversion of three-month bills versus 10s, once that curve does invert, whether it's the end of Q4 or the beginning of Q1, I suspect that what we will hear from the Fed isn't a dismissal of any predictive quality that that curve might have, but rather an acknowledgement that an inverted three-month bills versus 10s curve is consistent with the Fed's objective of slowing the real economy the correct amount to take the edge off of inflation while cooling an overheated jobs market.

Ian Lyngen:

We've already seen the unemployment rate increase two-tenths of a percent. And that was a welcome development for the Fed. When we think about the notion that the Fed is about to move 75 basis points in the wake of the unemployment rate increasing, I think that that speaks to the unique character of the times that we're in in terms of monetary policy.

Ben Jeffery:

And it wasn't a new message we heard from Powell in his speech on Thursday. But it was telling that he reiterated this idea that the Fed is actively pursuing below-trend growth in order to get the labor market to a more balanced position and avoid spiraling wages that in turn risks inflation expectations becoming de-anchored.

Ben Jeffery:

So Ian and Margaret, to both of your points, the fact that we've already seen what was once called a recession combined with some of the more traditional recession indicators already starting to flash red is actually exactly what Powell has told us that he's pursuing, bringing growth below trend, driving up the unemployment rate, and decelerating the rate that wages are climbing.

Ben Jeffery:

Now, bringing it back to the latest price action we've seen in the Treasury market. We've gotten 10-year yields back well above that 3.25 level, still shy of 3.50. But I would say more telling than the move in nominal yields has been the fact that this bearishness has been almost entirely a function of higher real rates at the expense of breakevens. Lower breakevens is a vote of confidence in monetary policy's ability to contain inflation, while higher inflation adjusted yields are arguably starting to flow through to the real economy in terms of hiring that we saw in August's payrolls report and hopefully what we'll see next week in terms of the CPI data.

Margaret Kerins:

So Ben, you mentioned the impressive increase in real rates over the past several weeks and the implication that breakevens are reflecting Fed credibility regarding fighting inflation. So what does that mean for other asset classes?

Dan Belton:

We haven't seen any prolonged weakness in credit over the long term this year. Credit spreads are at 151 basis points in the ICE BofA Corporate Index, which is really about in the middle of the trading range, which has held since the beginning of May.

Dan Belton:

But more recently, there has been some underperformance which I largely attribute to tighter financial conditions, including the impact of higher yields. Credit spreads are out about 12 basis points from Powell's speech at Jackson Hole. And I even think the performance of credit yesterday amidst a strong rally in risk assets which saw equities finish 1.8% higher and IG CDX narrow about five-and-a-half basis points.

Dan Belton:

But index credit spreads barely budged yesterday. And I think expectations for tighter Fed policy really just illustrate that it's going to be a much higher bar for credit spreads to perform going into the end of the year. And we expect that spreads are going to break out of this 135 to 165-basis-point range to the upside by the end of the year. And we're maintaining a target of about 170 to 175 basis points for year end.

Margaret Kerins:

So basically, Dan, what you're saying is that the near-term implications of the Fed continuing to tighten monetary policy outweighs any longer-term implications surrounding inflation-fighting credibility.

Dan Belton:

Yeah, that's right. We think that the hawkish policy trajectory of the Fed, which results in tighter financial conditions, higher Treasury yields is ultimately going to send credit spreads wider for a prolonged period of time, especially as the Fed emphasizes that they're not likely to reverse course at any point in the foreseeable future.

Margaret Kerins:

So Dan, you mentioned the impact of tighter policy on credit spreads. And another aspect of this is QT. We are entering the period where QT is reaching the terminal caps this month. And the focus now also becomes on the impact of QT on credit, on Treasuries, on reserve balances. We have seen our P balances remain elevated given the attractive yield relative to short bills.

Margaret Kerins:

So Dan Krieter, how has QT evolved thus far, and is reserve scarcity something that needs to be on our radar?

Dan Krieter:

Well, I'll start with your question on reserve scarcity, because you said it, elevated RRP volumes does increase the risk of scarcity earlier than expected. However, this isn't something we're concerned with for the time being because banks that are currently leveraged-constrained really aren't competing for deposits, and that's why QT's really only been felt in bank reserves thus far with no change at the RRP.

Dan Krieter:

Two things could change that dynamic. First, if reserves were reaching any point of scarcity, it's likely that banks would begin competing for deposits, drawing money away from the RRP. And second is the potential for a tweak to SLR calculations, which we expect will receive more attention later this year. In fact, newly confirmed Vice Chair of Supervision, Michael Barr, made his first public appearance yesterday and explicitly listed the SLR as something the Fed is considering making changes to. If and when they do, bank leverage ratios will improve, which would likely result in money leaving the RRP. So scarcity is not something we're currently concerned with.

Dan Krieter:

But you also asked about the evolution of QT thus far, and the truth is it hasn't really begun yet. And that's because of a $265 billion decline in Treasuries cash account at the Fed over the past few months, which, as a reminder, is a liability on the Fed's balance sheet. So while Fed assets are down about 90 to 100 billion in the past few months, a $265 billion decline in the TGA means that liquidity in the financial system has actually increased over 150 billion since QT began.

Dan Krieter:

Now, that's set to change beginning in September with the combination of an increased TGA and accelerated balance sheet normalization, resulting in a reduction in financial system liquidity of about 145 billion this month, which is one of the largest monthly reserved drains on record.

Dan Krieter:

Now, I'm not saying that this liquidity leaving the financial system will have a significant impact. It likely won't in the near term. But heading into QT, as you said, Margaret, many investors were worried about the ramifications of balance sheet normalization for credit spreads, for swap spreads, for Treasury rates, et cetera. And I'm simply arguing that any potential impact coming from QT will only begin to start being felt now.

Margaret Kerins:

And I think we also have to watch how Treasury decides to refund this runoff. And we have seen them continue to cut coupons in order to get bill issuance up. And clearly, the heightened repo balances at the Fed indicate that there is still substantial demand for high-quality, short-term assets, including bills.

Margaret Kerins:

So let's switch gears a little bit. Today, we saw the ECB take an aggressive move. The Bank of Canada has been at the forefront of this policy tightening cycle. And this, of course, was the case again this week with another 75- basis-point hike. So Ben Reitzes, where does the BOC go from here? And will they continue to be a template for other central banks when the eventual pause comes?

Ben Reitzes:

The bank has definitely been at the forefront and they've been very aggressive on rate hikes with 300 basis points of rate hikes on a year-to-date basis. So part of that's just the calendar effect. The bank actually is just slightly ahead of the Fed. And we'll get the Fed later this month. And then surely, they'll do something pretty aggressive. But the bank has been the first to start quantitative tightening and, again, leading on rate hikes.

Ben Reitzes:

But from here, the picture does change a little bit. The bank seemed to soften their tone a bit. They changed their focus and their concluding paragraph of their statement to move from focusing on the pace of rate hikes to what the level of the rate will be at the end of the day. And so it's clear that while more rate hikes are still coming, and they made that very clear, we are at least approaching the beginning of the end of the rate-hike cycle. And we are forecasting a 50-basis-point rate hike in October, so still another sizeable move.

Ben Reitzes:

But from there, there's a lot of uncertainty. Central banks, including the Bank of Canada, need to take account of the impact of the rate hikes they've already put into place. As we all know, monetary policy has lagged in variable effects. And so we need to wait and see how big of an impact these monster rate hikes are going to have on the economy and how quickly inflation's going to slow.

Ben Reitzes:

Something that is new on the radar for central bankers is the big drop in oil prices. And that really does have a big impact on inflation and changes the game somewhat. The same way that oil pushed inflation significantly higher in the spring, it has the potential to bring things down pretty sharply in the winter, at least in North America.

Ben Reitzes:

And so that adds a new wrinkle. And it also changes the game to some extent from a global perspective and from a foreign exchange policy perspective.

Margaret Kerins:

Given the backdrop, Greg, that we should be getting more clarity on the terminal rate in the U.S. and the potential for the beginning of the end of the tightening cycle in Canada, how do you think that this impacts the U.S. dollar, and has the U.S. dollar peaked?

Greg Anderson:

So Margaret, I would just reemphasize that Fed tightening is just one of many fundamentals that have been pushing the dollar higher this year. So below-trend global growth and the risk of global recession probably is equally as strong of a upward impulse for this year on the dollar. And then we have capital flows issues, which seem to be down underneath and propping up the dollar as well.

Greg Anderson:

In that question of have we reached a peak, I get asked that a lot. I'll admit I'm reluctant to project a continued move massively higher for the dollar when according to the Fed's real-trade weighted dollar index we're the highest we've been since 1986. But nonetheless, it doesn't feel like a top yet and it doesn't look like there are enough shifts in the fundamentals underneath things to say that the market is going to call a top.

Greg Anderson:

The oil fundamental that Ben mentioned, that's noteworthy and it was another one that's pushing the dollar up. The Fed decelerates, maybe that helps to put the top in on the dollar. But I think ultimately for the top to be in, we need to be less worried about global recession risks or particularly risks in Europe and in Asia. We're not there yet. And it's kind of hard to say at what level of the Dollar Index we'll be there, how many percent higher, or in what month.

Greg Anderson:

So we just kind of continue with not yet, probably in the next one to three months we'll hit the top, 1 to 3% higher than we are today.

Margaret Kerins:

So Greg, you mentioned that the U.S. dollar hasn't peaked yet. And in this backdrop of a strong U.S. dollar, we've seen an extraordinary move in U.S. dollar/yen. What is your projection for this pair?

Greg Anderson:

Yeah, I'll admit, Margaret, when we were sitting at 115 back in March, I no way thought that we could get all the way to 145. And yes, we stopped at 144.99 yesterday. But it sure looks like we will get through that 145 figure and towards 150. And these are levels we haven't seen in most people's careers.

Greg Anderson:

I don't think it's over yet. Lower oil prices helps the yen somewhat. But the underlying capital flows for Japan have turned so negative that it's really tough to call the end. And I'll also note that while we might second half of next year get monetary tightening from the Bank of Japan that starts to put a dent in the gap between Japan's interest rate and now Europe's and the U.S.'s and so forth, there's nothing on the horizon between now and the end of Kuroda's term in April to turn the tide. So higher. 150 will probably be a tough level to break, but higher still in dollar/yen.

Margaret Kerins:

So we mentioned that the ECB finally moved by 75 basis points today. So Stephen, we know that you have been very bearish on the European currencies. Has the ECB's change in reaction function to inflation changed your view on the major currencies in the region?

Stephen Gallo:

Not fundamentally, no. The view on the major currencies hasn't changed all that much, Margaret. Yes, asset prices are adjusting to the fact that the ECB is moving at a faster pace now, but the ECB is also playing catch up with a number of other central banks. And I think you also have to consider the fact that risk premium, whether you're looking at the equity market or the bond market, they seem to be adjusting to the fact that we do have a more intense stagflationary picture in the Euro area. And we also have fiscal risks associated with this backdrop.

Stephen Gallo:

I think the bottom line is that in the short run, European central bank rate hikes, even if they're of a larger magnitude than we've been used to, they're unlikely to send the major European currencies sharply higher. Not with the risk of a hard landing in the Euro area and in the UK, you have the twin risk of either an economic hard landing or economic overheating leading to a delayed hard landing.

Stephen Gallo:

I think there's a couple of key factors that we have to keep an eye on here, Margaret, going forward. One is the potential for inflation divergence. So for example, if inflation between the U.S. and Europe starts to diverge notably such that U.S. inflation moderates even further while headline and/or core European inflation rates continue to climb, I think the Euro and sterling will potentially fall on that. They probably won't rally.

Stephen Gallo:

I think what we need for the Euro and sterling to sustain rallies other than a notable de-escalation in the war is for European inflation to really moderate, the quicker, the better. We think the peak in inflation rates will be in Q4. That's a BMO view. That's a BMO house view. But a lot depends on what happens this winter, of course, with energy supplies and the weather.

Stephen Gallo:

The second key factor other than inflation which to a degree feeds into the inflation outlook and feeds off of the inflation outlook is the fiscal risk. We're getting more expenditure in the UK, to the tune of at least 6% of GDP to fund the energy price cap. That was announced today. There's probably going to be an additional, at least 2% of GDP by year end. And then, of course, with the right-wing government very likely to take the reins in Italy from the end of September, there will probably be more flare-ups between Italy and Brussels related to the EU's fiscal rules. And that could pressure credit spreads in Europe wider.

Stephen Gallo:

There's a lot of pressure on governments right now to spend. And we know that the fiscal architecture of the Euro area is a point of vulnerability. So the autumn/winter period is going to be a very testing period for these European currencies.

Margaret Kerins:

Thanks, Stephen. I want to circle back to the FOMC. We are about to enter the pre-FOMC communication moratorium. And during these recent moratoriums, we have seen media reports coming out guiding the market with regard to FOMC policy. We will have some CPI data. So how much credit should we give to media reports on Fed action during this time? And I'll circle back to Ian and Ben on that.

Ian Lyngen:

Well, Margaret, I think that you make a fantastic point. The setup for this FOMC meeting is precisely like it was in the run up to June's meeting, i.e., the CPI is released during the Fed's radio silent period. And as a result, investors will be looking very closely at the financial media for any confirmation that 75 basis points is still on the table regardless of how CPI prints, or if we do see a market deceleration in consumer prices, whether or not the market should be focused on 50 basis points. So if nothing else, all eyes will be on the financial media in the middle of next week.

Margaret Kerins:

All right. Thanks, Ian. So we have covered a lot of territory today. Let's conclude with a rapid fire roundtable beginning with Ian.

Ian Lyngen:

So we're continuing to favor a deeper inversion with a nod to the fact that the Fed will go 75 on the 21st of September as long as the market gives him the green light, which we are anticipating will follow immediately in the wake of CPI.

Margaret Kerins:

Ben Jeffery.

Ben Jeffery:

And within the rates complex, the most apparent impact of the Fed's hawkishness that we've seen over the past few weeks has been the impressive increase in real yields that have worked to contain inflation expectations via lower breakevens. But higher real rates are starting to have an impact on both the economy and other asset classes.

Margaret Kerins:

Dan Belton.

Dan Belton:

In the near term, credit markets are going to be singularly focused on primary markets, which were strong on Tuesday, but have softened more recently. And this is a typically very supportive period for credit as investors set up for this supply as an opportunity to put money to work. And so any sustained weakness in the next week would be a noteworthy bearish development.

Margaret Kerins:

Dan Krieter.

Dan Krieter:

Simply put, the current level of credit spreads will only likely prove justified if the Fed is able to achieve a soft landing. I don't think they will be able to and spreads will need to move wider.

Margaret Kerins:

Ben Reitzes.

Ben Reitzes:

The Bank of Canada has made it clear that rate hikes are still coming. However, they're shift in focus toward the potential terminal rate has changed the narrative somewhat in Canada. Canada is more vulnerable to higher rates than the U.S. Favorite trade here remains to be long Canada against the U.S.

Margaret Kerins:

Greg Anderson.

Greg Anderson:

The dollar top probably is not in yet, although we are so far above normal that maybe it's a bit too hot to handle. So that shifts the focus to cross trades. And amongst crosses, I'll point out Aussie/yen. I believe it belongs at somewhere around 110 and could get there over the next year, but between now and year end could easily get to 100. Buy it here.

Margaret Kerins:

Stephen Gallo.

Stephen Gallo:

Yeah. I mean, Margaret, I've been bearish on cable for most of the year. I have to say that at these levels, the pair is vulnerable to upside on good news if there is any. But I still think the one to two-month path of least resistance for cable is ultimately lower. And it currently looks like the risk of a test of 110, however brief, within one to two-months is much higher than the risk of a move back above 120. I don't get the impression that leveraged funds are aggressively positioned on the short side yet in cable.

Margaret Kerins:

Okay. And that's a wrap. Thank you to all of our BMO experts. And thank you for listening. This concludes Macro Horizons Monthly Episode 44, Cycle of Crisis. 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 could take a moment to leave us a rating and a review. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's Marketing Team. This show is produced and edited by Puddle Creative.

Speaker 9:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Margaret Kerins, CFA Chef - Stratégie macroéconomique, Titres à revenu fixe
Ian Lyngen, CFA Directeur général et chef, Stratégie de taux des titres en dollars US
Benjamin Reitzes Directeur général, spécialiste en stratégie – taux canadiens et macroéconomie
Greg Anderson Chef mondial, Stratégie de change
Stephen Gallo Chef de la stratégie de change pour l’Europe
Dan Krieter, CFA Directeur, Stratégie sur titres à revenu fixe
Dan Belton Vice-président - Stratégie sur titres à revenu fixe, Ph. D.
Ben Jeffery Spécialiste en stratégie, taux américains, titres à revenu fixe

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