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Giving Thanks, Taking Stock - The Week Ahead

FICC Podcasts Nos Balados 18 novembre 2022
FICC Podcasts Nos Balados 18 novembre 2022

Disponible en anglais seulement

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of November 21st, 2022, 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.

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Disponible en anglais seulement

Ian Lyngen:

This is Macro Horizons, episode 198, Giving Thanks, Taking Stock 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 November 21st. Thanksgiving is upon us and topping the list this year will be the fact that our sponsors have yet to pull the plug on Macro Horizons even as we quickly approach the 200th episode. Clearly they're not listeners.

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 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 past investors in the US rates market got additional confirmation of a slower inflation profile. In October, PPI printed up just two tenths of a percent for the month and core PPI printed flat. We also saw industrial production underperform expectations. The consensus was for a one tenth of a percent increase and in fact what we saw was a one tenth of a percent decrease.

Now while that might not be a significant miss in outright terms, it does provide confirmation that the cumulative tightening effects are beginning to weigh on the real economy in aggregate. That said, the price action itself was a much more compelling development. We saw the 2s/10s curve trade below -70 basis points, and this is consistent with our near-term target of -75. In addition, this occurred at least initially in a bond bullish fashion as 10-year yields slip below 3.70. In keeping with our interpretation that the peaks for inflation and the peaks for US rates are in, at least in 10s and 30s, we're content to hold our year-end target for 10s at 3.50 with a year-end target for two-year yields at 4.50. This implies a three-digit inversion of -100 basis points. With only six weeks left in the year, clearly a move of this magnitude, we'll need some additional fundamental support.

For that, we're looking to the December FOMC meeting and expectations for a 50 basis point rate hike and the communication around the move being that the Fed still has more tightening to go and ultimately we are at the point where each incremental rate hike will become increasingly data dependent. In that context, the fact that the Fed's December decision is announced the day after the release of November CPI data implies that there will be a elevated degree of uncertainty in the event that we either have an upside surprise or downside surprise on core CPI. And as we have seen previously when CPI is released during the Fed's moratorium on communication, the press has been utilized by monetary policy makers to convey any potential shift in the Fed's thinking versus what the market is pricing in.

Said differently, the market will be on edge for any obvious attempts to further refine expectations via the media. That being said, there's still several more weeks of Fed speak yet to be seen, and we anticipate a consistent message of more rate hikes to be accomplished, once the Fed gets to terminal, it's going to be held for an extended period of time and overall financial conditions continue to merit the Fed's hawkish stance.

Ben Jeffery:

Another trading week in the Treasury market with no shortage of excitement, but most notably in terms of levels, we saw 2s/10s drop to a fresh depths of inversion this cycle trading below -70 basis points and putting our near term target of -75 squarely on the radar. There were a couple different drivers of the price action, but the most notable aspect of 2s/10s reaching -70 basis points was the fact that it's taken place with 10-year yields decidedly below 4%. And as we approach next week's market holiday in the US, in the outset of more apparent year end and holiday trading conditions, the departure point for the market is not with 10-year yields closer to 4.50, but rather at effectively 3.75 with a curve that is as inverted as it has been since the 1980s.

Ian Lyngen:

It's an interesting point in the overall rate cycle to be sure. We continue to expect 50 basis points in December is the path of least resistance. And beyond that, we are anticipating another two hikes in Q1 at just 25 basis points each. Now, that will bring the upper bound for the Fed funds rate to 5% when we add the roughly 75 basis points worth of tightening created by the unwind of the balance sheet, that gets terminal this cycle to 5.75. Now, as we heard from Bullard last week, there's an argument that the range for terminal should be somewhere between 5 and 7% based on a classic Taylor Rule model or a variation thereof. That being said, the messaging from the Fed has been relatively consistent in so far as they're ready for a downshift in December and we're moving closer to the point where each incremental rate hike will be data dependent.

And as we know, the most recent core CPI came in below expectations. In the week just passed we also saw PPI disappointing up just two tenths of a percent on a headline basis and flat on the core basis. This realized data has contributed to the peak inflation narrative and along with it the peak rates narrative. I'll add that in addition to the depths of the inversion of the yield curve, there was another important milestone reached this week and that was the inversion of Fed funds versus 10-year rates. Both effective, which is 3.83 and the bottom of the range, which is 3.75. When we look historically, it's not uncommon to see 10-year yields below effective Fed funds. We are however, in uncharted territory to have 10-year yields this far through Fed funds and still at least three more rate hikes yet to be delivered. Typically, nominal rates don't trade below effective Fed funds until we've been at terminal for some period of time.

Ben Jeffery:

And while we've seen the first inversion of effective funds versus tens, that doesn't necessarily mean the path from here is going to be a straight shot toward even deeper inversion, but rather as evidence that investors are starting to become more and more willing to add duration exposure, the fact that we've seen the first inversion of this curve so early in the cycle speaks to the building sense that we are reaching the point in the cycle when to quote the Fed, “the cumulative and lagged impact of policy tightening is starting to flow through to the real economy,” is adding to slow down worries in such a way that's making a ten year rate at 3.75 more attractive than an overnight one at the same level, and it's this trend that we'll argue will actually be exacerbated by further rate hikes, particularly if we start to see more evidence of slowing inflation similar to what we saw in October's data.

There's also a timing aspect to consider given that the Fed has been consistent in its messaging that they're looking for consistent evidence that inflation is decelerating, saying that a different way, they need to see multiple consecutive months of decelerating core inflation, which means that while yes, October's data was encouraging through the lens of containing inflation, really we're going to need to see at least November and December's data before there can be any serious tone change from the Fed that they no longer need to be raising rates.

So drawing that logic forward, that gets us through the early February meeting with another 25 basis point hike, and then it won't be until we arrive at the March meeting that the Fed will likely be comfortable making the transition from actively hiking to messaging that the rate cuts which are still priced in the Fed funds futures market in the later part of 2023 are not in line with how the Fed is thinking. This of course brings up the question of the shape of the dot plot and just how much policy easing, if any, the Fed's going to be willing to signal at some point in 2024.

Ian Lyngen:

It goes without saying at this point that the Fed's objective in transitioning to an on hold policy stance will be to communicate to the market that they intend to hold terminal for an atypically long period of time. The groundwork for that has already been well established via Fed speak and the official communications. What remains to be seen is the extent to which the market was going to continue to push back against that. When we look at Fed funds futures, we see 50 basis points of rate cuts priced into the market next year.

That is 100% probability of 225 basis point cuts, yes, but it also can be interpreted as a 25% probability that the Fed will need to move 200 basis points. And let's face it, if the Fed is forced to cut rates next year, it will be a function of much tighter financial conditions, which will presumably be driven by a dramatic selloff in risk assets. So in reading the proverbial tea leaves of the Fed fund's futures market, we're less convinced that the Fed will need to aggressively try to talk the market out of some probability of a shift in policy.

Ben Jeffery:

And bringing this back to the start of the conversation in terms of what this all means for the shape of the curve, really it points to the next big trade being a bullish re-steepening led by the front end as yields reprice to a policy level that is not quite so far in restrictive territory. Now, as with so many things in the market, the question is one of timing and when it is we'll start to see the more durable trend shift from flattening to a drift steeper. We would argue that's going to come along with the Fed's final hike of this cycle, which as we've discussed will probably be sometime late in the first quarter, but this doesn't mean one should rule out an even deeper curve inversion and even something as extreme as 2s/10s reaching negative triple digits in the run up to the end of the year or even coming out of the 1st of January.

Ian Lyngen:

And returning to Bullard's comments for a moment, he did say that the potential range is 5 to 7% for terminal this cycle, and that does beg the question of whether R* will be higher on the other side of the pandemic than it was prior to 2020. Our take is that the Fed wasn't actually that far off with the transitory characterization of inflation early in the cycle. What they missed was the timeframe. Inflation has been driven primarily by pandemic related moves associated with the supply chain, and of course the exodus from densely populated urban centers to the first and second reading suburbs. Now it's this latter factor that remains a pillar for core inflation. Eventually, OER and Rents will begin to moderate. There was some early evidence of that in the most recent CPI print, but for the time being a higher inflationary environment is a given.

For a higher R* to emerge, we would need to see inflation expectations become embedded in the economy and that translate through to consistent nominal wage gains and a version of the wage inflation spiral that we saw in the '70s and '80s. There are a few reasons that we anticipate that is not going to occur. The biggest of which being the Fed's commitment to the 2% inflation target. If the Fed is willing to follow through with the amount of demand destruction associated with getting PCE back to 2% over the long run, that's going to imply a higher unemployment rate and a slower overall growth profile. Now, the counter argument is that there have been true structural changes such as a sustainably lower labor force participation rate that a deeper recession won't be able to offset.

There are three major disinflationary pressures that were in place prior to the pandemic that are going to remain relevant going forward. First is the demographic trend in the US. Second, technology does remain by definition disinflationary, and of course the rise of automation that was accelerated during the pandemic is going to increasingly replace frontline service sector jobs that have driven the current tight labor market conditions. The biggest unknown is, of course, how long it will take for these influences to bring inflation back in line with prior norms.

Ben Jeffery:

And the one important and very valid counterpoint is another dynamic that began well before the pandemic and was accelerated by the unique nature of the shock brought on by COVID, which is that well before 2020, the global economy was undergoing an important shift away from more free trade policies in open borders back to on-shoring or friend shoring the means of production away from low cost areas in parts of the developing world back toward higher cost areas in North America or Western Europe. Obviously, the supply chain disruptions that were exacerbated by COVID only pushed this dynamic further as the inability to source goods that were exclusively made overseas became a severe health problem. And as the pandemic has faded, this trend has not significantly reversed. And in the US, despite the political changes brought on by the Biden administration, we really haven't seen a significant unwinding of some of the protectionist policies that were put in place under President Trump.

And really what this all means is that unlike the deflationary trend that was accelerated by globalization throughout the 90s and early 2000s, now we may be entering a regime where things simply cost more to produce and ultimately cost more to purchase. Now Ian, I completely agree with you that the factors you mentioned will overwhelm this dynamic in terms of setting the outright level of inflation, and maybe that means inflation will be higher or more likely the outright price of things will be higher, not necessarily the rate at which they become more expensive, but nonetheless, this is going to be a question of R* at call it zero or 50 basis points, not one of R* at zero or two or 3%.

Ian Lyngen:

So essentially, Ben, what you're saying is that our star and your star and my star don't have much upside.

Ben Jeffery:

No, but we knew that already.

Ian Lyngen:

In the holiday shortened week ahead, the market will be focused on the known Fed speakers, Mester and Bullard on Tuesday in particular, as well as Supply. On Monday, there's $42 bn two-year notes that will be auctioned in the morning and in the afternoon we'll see $43 bn three year notes. This will continue to provide inversion pressure as the market prepares to absorb supply and prices in a concession of some sort. This dovetails well with our -75 basis point target in 2s/10s. Although once we reach this level, we would anticipate a period of consolidation as the market becomes habituated to the depths of the inversion. Let us not forget, we have the 35 bn seven-year on Tuesday, and that will be the last coupon supply before the November month end. On the data front, there's really very little that we expect will contribute to the broader macro narrative, although Wednesday afternoon’s FOMC minutes will be closely followed for any indication of what the Fed is thinking about the magnitude of the December rate hike.

Recall that in the most recent FOMC statement, the committee focused on the cumulative tightening impact and the lagged nature of monetary policy action, both of which were interpreted, and we think correctly so, by the market as suggesting that there will be no more 75 basis point hikes and instead a transition to 50 and then subsequently 25 will be the path of least resistance. Any discussion about terminal and what the Fed considers to be an atypically long period for holding terminal in place will also garner attention if offered in the FOMC minutes. Liquidity conditions continue to remain topical in the Treasury market, and as we push toward the end of November and into the December holidays, we anticipate that liquidity will become increasingly stressed and as a result, we expect choppier price action as flows that might not typically have triggered outsized price responses in the Treasury market lead to bigger moves in an environment where investors are unwilling to take the other side of any trend, given the collective sense that rates are reaching an inflection point.

Adding to the host of reasons to expect the Fed to continue hiking rates in the new year is that the equity market continues to perform reasonably well, all things considered. This means that overall financial conditions are easier than they might have otherwise been. Had the S&P 500 still been down 25% on the year, presumably equity volatility would be higher and financial conditions tighter. Said differently, as stocks continue to bounce on the optimism that the Fed will pivot sooner rather than later, that dynamic actually reinforces the fact that the Fed will ultimately need to follow through on at least the next 100 basis points of rate hikes.

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. In keeping with the holiday spirit, we'll offer the weather outside is frightful, Monetary policy is undelightful. Since Powell's the Hawk we know, watch bonds go, watch ‘em go, watch ‘em go. Inflation doesn't show signs of stopping, even the ECB is hopping. Since there's no support below, watch the curve go, watch it go, watch it go. When we finally hit terminal, how we'll debate where rates can go. Since there's no way to know, look out below, look out below, look out below.

Thanks for listening to Macro Horizons. Please visit us at 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 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:

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

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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