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A September To Remember - The Week Ahead

FICC Podcasts Nos Balados 02 septembre 2022
FICC Podcasts Nos Balados 02 septembre 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 September 5th, 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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Ian Lyngen:

This is Macro Horizons, episode 187, A September to Remember, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery to bring your thoughts from the trading desk for the upcoming week of September 6th. And as the final days of summer slip from grasp and the jobs market remains in focus, we're reminded that there's only one course of action when rejected from a position at a sunscreen manufacturer, reapply.

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 I-A-N.L-Y-N-G-E-N @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 past, the Treasury market put in a remarkably volatile performance. Now, to be fair, there was enough in terms of fundamental inputs to justify a relatively choppy week in terms of price action. We saw the 2s/10s yield curve steepen back to negative 25 basis points, give or take. We also saw the 10-year yield push above 3.25 and this occurred in a steepening fashion, part of the underlying impetus being the fact that the Fed's balance sheet runoff is entering its terminal velocity in September, that is 60 billion running off from the treasury side and 35 billion running off from mortgages.

Ian Lyngen:

Now that 35 billion number is particularly notable because given the outright level of rates in the economy and prepayment speeds, for all intents and purposes, that 35 billion dollar number means that the Fed is effectively out of the mortgage market. Now that does bring up a very interesting question and one that we've heard several times over the course of the last few weeks, and that is, will the Fed ultimately choose to sell mortgages directly out of Soma? Obviously up until this point, the answer has been maybe, but not until some point in the distant future. As the Fed's bounce sheet runoff hits the maximum levels, it follows intuitively that questions will begin to arise about if and when outright mortgage selling will become a reality.

Ian Lyngen:

We maintain that the Fed stance is and will continue to be that the most impactful tool that they have for curtailing demand and fighting inflation comes in the form of rate hikes, not the balance sheet. The fact that the Fed has utilized the balance sheet as much as it has during this cycle is largely a function of the effective lower bound for rates. And now once the FOMC reaches this cycle's terminal policy rate and has held it there for several meetings, then the question about selling mortgages outright becomes a bit more relevant, but that puts us into the first half of 2023. For the time being, we anticipate that the Fed will be content to let the balance sheet run off in the background at the maximum levels and watch for any stress or strain evident in the system.

Ian Lyngen:

We remain skeptical that QT in and of itself is going to be worth a 50 or 75 basis point re-steepening of the 2s/10s curve. That being said, as a trade, it's very clear that many market participants believe that QT should be worth a more significant steeping of the curve, at least to the point of bringing 2s/10s out of the depths of the inversion. Nonetheless, we do anticipate that this will be a key battleground for the macro narrative over the course of the fourth quarter as the balance sheet runoff becomes increasingly significant in terms of the cumulative numbers, or the amount that the balance sheet has been reduced thus far.

Ben Jeffery:

Well, Ian, it was an anticipated payrolls number. We got a slightly stronger than expected read in terms of headline hiring. The unemployment rate moved up two tenths of a percent, but that was really a function of a rising participation rate that's now back to levels we haven't seen since before the pandemic. And of course, average hourly earnings, which are still growing at an impressive rate, but not as fast as we have seen recently and slower than expectations. So I would argue from the Fed's perspective, it was a not too good, not too bad jobs report.

Ian Lyngen:

I think that's a fair characterization, Ben. The one caveat that I would add is that the Treasury market was under pressure in the run up to the event itself. We saw 10-year yields breach that 3.25 level, which brings into question the peak yields thesis, whether or not the high yield marks for 10 and 30 years are in for the cycle. Now, the takeaway for the Fed has to be a positive one because they've seen the labor force participation rates start to increase, which was something that has been somewhat perplexing for monetary policy makers and it occurred in a way that illustrated that the prime working age cohort has reengaged in the labor market. Now, the bigger question quickly becomes will there be more upside risk for the unemployment rate, which now stands at 3.7% between now and the time that the FOMC ultimately brings policy rates to terminal? If anything, the August non-farm payrolls report definitively leaves a 75 basis point rate hike on the 21st of September on the table.

Ben Jeffery:

And the market reaction after we saw the numbers was interesting insofar as we did see some probability of a 75 basis point hike taken out, but still in terms of Fed funds pricing, we have a 65, 70% chance that the committee ultimately decides to deliver another upsized rate hike in September. To explain most of that move, I would point to the increase in the unemployment rate, given that at least on the margin, it suggests that we've reached the point in the cycle when we're starting to see a slowing hiring landscape and arguably the early days of the Fed's tightening starting to flow through to the labor market.

Ben Jeffery:

Now, given the first rate hike of this cycle was only six months ago, I think it's fair to say that the impact of the vast majority of the Fed's rate hikes have yet to truly flow through to the economy and in the discussion about if a higher terminal rate might be warranted, the fact we're already starting to see the Fed makes some progress toward their goals, adds to the argument that while Fed funds might need to go to 3.75 or 4%, they probably won't need to go to 4.75 or 5%.

Ian Lyngen:

I think that's a fair characterization. There is an open question whether or not terminal is the range between 3.50 and 3.75 or 3.75 and 3.40. I think that the combination of the August non-farm payrolls report and the Jackson Hole comments not only suggest that another 75 basis point rate hike will be the path of least resistance, but also should skew expectations for the terminal rate slightly higher to that 3.75 to 4% range. Now, accompanying the next FOMC decision will be an updated SEP, or the beloved dot plot. Within there, we should get a better sense of precisely where the Fed sees terminal and recall that in the June update of the dot plot, 3.75 was seen as terminal. Now, obviously that suggesting a bit of debate whether it was the 3.50 to 3.75 or the 3.75 to 4% range. So needless to say, the market will be watching this very closely for any indication that the Fed has upped the proverbial ante when it comes to terminal.

Ben Jeffery:

And in terms of the price action we saw in Treasuries, it was a crucial week in 10s, just given the fact that we saw that 3.12 level probed multiple times and ultimately break, which then led to some further selling pressure that saw 10-year yields reaches high as 3.25, 3.26 going into the payrolls report itself. Remember it was that 3.25 level we saw challenged in mid-June of this year and that is also the zone that represented the double top and cycle high yield marks that were set in late 2018 at the end of the last tightening cycle. And along with the selloff this week, we somewhat intuitively feel that a lot of questions on whether we're going to get back to that 3.50 level and interestingly from a monetary policy perspective outside of the Fed funds target band, the degree to which the now ramped up pace of quantitative tightening should be credited in driving the latest leg of the bear steepening we've seen in Treasuries.

Ian Lyngen:

I'm certainly cognizant that the QT argument resonates with monetary policy makers, i.e., if QE served to flatten the curve, shouldn't QT serve to re-steepen the curve? Now in practical terms, the translation of Soma stepping back from bond buying at auction as add-ons really doesn't have comparable implications to QE, which was in effect, the Fed coming in and buying from market participants. We've made the point in the past, and I think it's worth reiterating, that what's truly important from a flow perspective is how the Treasury department ultimately chooses to make up the funding shortfall created by Soma stepping back. As it stands currently, the Treasury department has focused on increasing bill issuance, continuing to cut nominal coupon issuance, and overall as tax receipts have remained relatively high, there's been something of a cushion to absorb QT. Let us not forget that while quantitative in nature, tightening is still tightening and it will slow the real economy, undermine demand and keep forward inflation expectations anchored, which in practice has compressed 10-year breakevens, pushed real yields higher and help to continue tightening overall financial conditions.

Ben Jeffery:

And the path of the balance sheet is another contributing factor to what we expect is probably going to be the defining theme for monetary policy in 2023, that is the Fed's going to reach terminal, whether that's in Q4 of '22 or Q1 of '23 at this point is probably still up for debate, but by the second half of 2023, policy rates will have almost certainly reached their finish line and the Fed's challenge is going to be holding rates in restrictive territory for as long as the labor market allows. And this is coming in contrast to the rate cuts that we're starting to see priced in to the second half of next year. But along with the fact that Powell wants to keep rates restrictive for as long as possible to bring inflation down, there's also the balance sheet aspect of this. And what I mean by that is holding rates at terminal while continuing to allow QT to run in the background is another aspect of normalizing policy that the Fed is really going to want to pursue.

Ben Jeffery:

A balance sheet north of eight trillion dollars is not something that the Fed has demonstrated they're comfortable with and all else equal, this suggests that the Fed is going to want to hold terminal longer than what we've seen historically, which remember is right around seven months. Now, there is the discussion to be had of whether or not the Fed could explicitly message fine tuning rate cuts to bring policy more back in line with neutral while also running down the balance sheet, but that's going to be an issue that will be a late 2023 story at the very earliest and certainly a challenge for Powell and the rest of the committee to communicate as the push and pull of a shrinking balance sheet and maybe the necessity for rate cuts come into clearer focus.

Ian Lyngen:

And let us not forget, both Powell and Bullard, among other Fed speakers, have already begun the process of socializing the idea that the Fed will keep terminal in place much longer during this cycle than the Fed has previously. And so what that suggests is A) as you point out, some of the rate cuts that are priced in for 2023 might be premature and more importantly, it contributes to the argument that the Fed is knowingly hiking the economy into an economic slowdown that might ultimately end up being an outright recession. Keep in mind, we are still coming off of two back to back quarters of negative real GDP growth, we've seen the unemployment rate increase now two tenths of a percent, which is very consistent with what might have historically been characterized as a recession. The fact that monetary policy makers have pushed back on the market's attempt to characterize this as a recession is very telling. If nothing else, it suggests that the Fed is doubling down on the higher for longer narrative.

Ben Jeffery:

And in addition to that hire for longer narrative, we also heard from Williams this week who repeated the idea that the size of September's rate hike needs to be about the "totality of the economic data," and given the Goldilocks-ish NFP report that we saw, really what this does is make the operative question, the performance of CPI, which we get on September 13th, which also notably will be coming during the pre-FOMC communication moratorium. And so from that perspective, and, Ian, I think you're on the same page with me here, what's going to be most telling in terms of what the consensus is for the size of September's hike is going to be market pricing. If the market has priced to 75 or frankly, even nearly to 75, the Fed will probably take that opportunity to take another upsize step further into restrictive territory and stick with their mantra of frontloading this cycle's tightening.

Ian Lyngen:

It certainly isn't wasted on me that the CPI release comes during the radio silence period for the Fed. If anything, this is the Wall Street Journal Full Employment Act.

Ben Jeffery:

And this means as was the case going into the June FOMC, we'll be on the lookout for any unofficial guidance from the media ahead of time.

Ian Lyngen:

And as we've observed in the past, the Fed's decision to use the financial media to communicate near term monetary policy direction isn't historically new, although there was a period in which the Fed stepped back from this practice and so the fact that it has been reintroduced does, as with so many things seen in 2022, introduce another degree of volatility and uncertainty in pricing forward expectations for monetary policy.

Ben Jeffery:

And 2022 has definitely been the year of volatility and in a more typical environment, we might expect that the other side of the Labor Day holiday might bring in cooler heads and less choppy trading, but really, I think the potential inflection point during this calendar year is going to be the September Fed. So, unfortunately, I think investors will still have to be on guard for more outsized yield moves and generally less conviction within the market until we get clarity from the FOMC statement, Powell's press conference and of course the latest look at the dot plot that will help give some clarity around the question of where it ultimately is the Fed wants terminal to be this cycle.

Ian Lyngen:

And all of this with a backdrop of other major central banks continuing the rate hike process, expectations are for 75 basis points from the ECB on Thursday, which given the outlook for the European economy is quite an aggressive stance all things considered, particularly as investors focus on the winter months and the potential for an energy crisis on the continent.

Ben Jeffery:

But the good news is with the dollar now at parity with the euro, that European vacation just got a whole lot cheaper.

Ian Lyngen:

Yeah, but prices are about 9% higher.

Ben Jeffery:

Oh.

Ian Lyngen:

In the week ahead, the holiday shortened trading week will have very few economic inputs of any relevance. We do have the ISM services component for the month of August, which is expected to print at 55, solidly in positive territory and frankly at something of a divergence with what we are seeing in Europe and in China and other parts of Asia. The reality is that the service sector in the US remains on strong footing, even if off the peaks. Also on the calendar for the week ahead, we will see the ECB on Thursday with an anticipated 75 basis point rate hike. It's worth highlighting that Powell speaks the same morning and market participants will be looking for any indication that either the move in Europe is consistent with a more aggressive approach being taken by the Fed in September, or if there's some acknowledgement by Powell that the more other central banks ultimately end up hiking, the less heavy lifting the Fed will be forced to do.

Ian Lyngen:

When we think about how that might manifest itself in market pricing will look to the commodities market as the obvious go-to, which as energy prices remain contained, will take away some of the upside risk for headline inflation. So if a hawkish ECB further weighs on energy prices, that will compress US breakevens and push higher real yields, which will serve to increase the tightening already seen in financial conditions and if anything takes some of the upside risk off of how far the Fed needs to push target policy rates during this cycle. We're taking the Fed's comments about keeping policy rates at neutral longer during this cycle than we've seen in the past at face value, at least for the time being. We remain in the peak yield camp, suggesting that that 3.50 level seen in 10-year yields will represent the upper bound. Now that doesn't eliminate the possibility that we see a round of consolidation with 10-year yields above 3.25 in the run up to the FOMC meeting.

Ian Lyngen:

All else being equal, we anticipate that the period between Labor Day and the September 21st Fed decision will be bearish on net as the market readies for an updated SEP, a 75 basis point rate hike and a universally hawkish tone for monetary policy makers. In the context of tighter financial conditions, we do continue to monitor equity market volatility. The fact that the stock market performed reasonably well in the wake of the non-farm payrolls print speaks to the idea that while financial conditions might be notably tighter, they have not tightened to the extent that would derail or shift the Fed's intended path towards higher rates. That said, this will be a background component to gauging the probability that the Fed goes 75 or 50 basis points.

Ian Lyngen:

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. With tennis stars congregating in Queens and football once again underway, we are reminded of a key lesson learned from our athletic endeavors, "If at first you don't succeed, skydiving's not for you." 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:

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.

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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