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Summit, Descent - The Week Ahead

FICC Podcasts 11 août 2022
FICC Podcasts 11 août 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 August 15th, 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 184, Summit Descent, 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 August 15th. And with the final days of summer upon us, we'll observe that the doldrums, I'm air quoting here, is a popular nautical term that refers to the belt around the earth near the equator where sailing ships sometimes get stuck in windless waters, at least according to the National Ocean Service. SIFMA, on the other hand, defines it as a period in financial markets where holidays and recommended early closes should be avoided at all costs.

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

Ian Lyngen:

In the week just passed, we saw CPI print at 0.0 for July. Now that's on a headline basis and clearly reflected the decline in energy prices, particularly gasoline, that occurred during the month of July. Nonetheless, core CPI also came in notably below expectations, increasing just three tenths of a percent. Now this is very consistent with the peak inflation argument. However, it does come on the heels of July's non-farm payrolls release, which was especially strong with the unemployment rate declining to just 3.5%. That's tied with February 2020 as the lowest since 1969.

Ian Lyngen:

As a result, the combination of these two data points, which are arguably the most important measures of overall economic performance at the moment, we've seen the debate between 75 and 50 basis points for the September meeting start to heat up. Now within the BLS series, the higher than expected average hourly earnings numbers certainly make a solid case for 75, as well as the lower than anticipated unemployment rate, and of course the 500 plus non-farm payrolls added. On the flip side, a more benign inflation reading does suggest that the Fed, if they choose to, will have justification to slow the cadence of rate hikes from 75 to 50 basis points.

Ian Lyngen:

Our take is that we still have two major data points between now and the time that the Fed ultimately needs to make the decision of 75 or 50 basis points. One is going to be the September 2nd release of August non-farm payrolls numbers and then of course the August CPI figures. All else being equal, if the Fed were making the decision whether or not to hike 75 or 50 today, we suspect that they would err on the side of 75, if for no other reason, then to push decisively into restrictive territory. After all, there's a lot of economic performance yet to be realized over the course of the year.

Ian Lyngen:

In terms of the Treasury market, we were very encouraged to see strong demand for the 10-year refunding auction, which stopped through eight tenths of a basis point. And we have seen 10-year Treasury yields struggle to get north of 2.85, which suggests that while there might be an active debate in terms of the outright shape of the yield curve for the time being, ultimately we expect that longer dated yields will drift lower with our 2.50 target in tens being maintained between now and the end of the year.

Ian Lyngen:

One of the aspects that we anticipate will define trading in US rates in the coming months has to do with Powell's decision to no longer give such specific guidance as far as the next rate hike. Market participants have characterized this as abandoning forward guidance. However, we'll offer the caveat that there is still a lot of forward guidance contained within the FOMC statement and of course the SEP. Nonetheless, Powell has effectively communicated to the market that policy makers are transitioning into a data dependent mode. And as a result, each significant data point will in and of itself be more tradable. In practical terms, that means investors will see more volatility around the major data releases. Now this implies nothing for directionality of rates per se, but it does suggest that what might have typically been the summer doldrums in the latter part of August could prove far more dramatic in a trading sense if nothing else.

Ben Jeffery:

Well, maybe it was transitory after all?

Ian Lyngen:

I think that's a reasonable interpretation, given the July CPI numbers. We had headline CPI at 0.0, remarkably similar to your GPA in undergrad. In addition, we saw the core CPI print come in at just 0.3% month over month. Now this is consistent with a core PCE print in the 0.1 to 0.2 range, which will represent a remarkable shift in the overall trajectory of inflation based on the Fed's favored measure. Now, when we think about the composition of what drove the decline in core CPI, what we see is that in fact OER and rents continue to be net additive, and pretty significantly so. But used auto prices dropped for the second consecutive month, and airfares were off rather sharply, down negative 7.8% month over month.

Ben Jeffery:

And those were the areas of focus within the core series. But on airfare specifically, Ian, I think you agree that that's a version of gas prices. And that is why the meaningful undershoot versus expectations on the headline front can primarily be credited to the pullback we've seen in the energy complex over the past month and what that has meant for jet fuel, but also prices at the pump.

Ian Lyngen:

And the observation about gasoline prices for the average consumer I think is a very important one. What we saw during the first half of 2022 was that inflation had been so significant that the GDP price deflator, for all intents and purposes, edged real growth into negative territory. If energy continues to come off the highs and there's more relief at the pumps, as it were, then it's reasonable to expect that not only will we see GDP turn back into positive territory, but also real wages will go from deeply negative, presumably back to at least less negative, if not positive. And that in and of itself will be truly additive to the outlook, at least for the next couple quarters.

Ben Jeffery:

You touch on what moderating inflation means for real growth, real wages, real consumption. And while yes, by the definition of real growth, lower inflation is going to be a tailwind, I also think it's worth mentioning that lower inflation will also take some of the edge off the tax on consumption that we've been seeing from higher necessity prices that are deferring disposable income away from discretionary spending, which given consumption accounts for 70% of the US economy, is obviously a meaningful detriment to overall growth. So very much in keeping with Powell's reframing of inflation as public enemy number one for growth and hiring, by slowing the pace of rising consumer prices, the Fed is surely hoping to be able to bring the economy to the ever-elusive soft landing.

Ian Lyngen:

Well, Ben, it's clearly much too early in the process for us to have a strong or at least compelling argument in either direction about whether or not we'll ultimately see a hard landing versus soft landing. One of the things that we can say with a reasonable amount of confidence, however, is that the Fed is going to push back against the hard landing scenario, at least in the near term. Now the logic makes a lot of sense. The Fed still has at least another a hundred or 125 basis points of rate hikes yet to deliver during this cycle, and they need the cover of a macro narrative that suggests that the economy can handle higher rates. So it follows intuitively that recent Fedspeak has reiterated this idea that not only is the employment landscape strong enough to absorb higher rates, but, July's flat inflation numbers is just one in a series of reads that the Fed will be looking at to drive monetary policy.

Ian Lyngen:

Now it goes without saying that if August CPI prints similarly soft, then that would make a very good case for a 50 basis point rate hike in September as opposed to a 75 basis point move. But one thing can be said with a fair amount of confidence. They're not going to pause in September and they're not going to go 25.

Ben Jeffery:

And beyond September, what we saw very quickly after the inflation data was in hand was a chorus of Fedspeak from Kashkari, Evans, Daly, reinforcing exactly the point that you just made, Ian. It's a single month of inflation data, and that by itself is not sufficient to alter the calculus on the FOMC or meaningfully alter the base case scenarios that have been laid out in terms of the path of policy. The upper bound currently at 2.50 is seen moving in probably the most conservative case to 3.50 by the end of the year. And that means that whether or not September is 75 or 50, we're going to continue to get rate hikes throughout the rest of this year, and as we heard from Evans, probably early next year as well. This comes in contrast to market pricing, which in turn continues to hold flattening potential for the shape of twos tens that broke through its flattest level since the year 2000 over this past week. As we heard from some of those Fed speakers that yes, inflation is decelerating, but a core read at 5.9% is hardly enough progress toward the 2% target to warrant anything other than a continued, aggressive removal of accommodation.

Ian Lyngen:

And that actually brings us to what I'll characterize as the essential debate for 2023. And that is how long is the Fed ultimately going to be able to keep policy rates at the terminal level? Are they going to eventually end up cutting rates comparable to the way in which the Fed funds futures market is currently pricing? Or will the Fed push back significantly and ultimately hold fed funds at terminal for longer in this cycle than it has in prior? As with the hard landing versus soft landing question, I think it's safe to say that even the Fed doesn't know the answer at this point. Nonetheless, one thing that we do anticipate is that between now and the beginning of 2023, the Fed will make a concerted effort to emphasize their commitment to fight inflation, and in doing so, imply a willingness to keep terminal in place for longer than the market is pricing.

Ben Jeffery:

And this brings us to Wednesday's release of the minutes from the July meeting. And along with that question of how long at terminal will be appropriate, Ian, another potential topic to be mindful of is how the committee is thinking about the appropriate level of terminal versus what we saw in the September update to the Summary of Economic Projections. After we have seen the belly of the curve outperform so dramatically over the past several weeks, I would argue the hawkish risk here is that the minutes introduce some discussion around the potential for an even higher terminal rate than was forecasted in the SEP, which, given that at this point, it seems unlikely the committee is going to move any faster than 75 basis points a meeting, would reverse some of that belly out-performance and probably offer a bit of a steepening impulse to twos fives or twos threes while pressing fives 30s even flatter from its current level, just slightly above zero.

Ian Lyngen:

Let us not forget retail sales for July, which is expected to come in at 0.2%, not a very inspired number to be sure, particularly given that this number is in nominal terms. However, since we had no inflation in the month of July, 0.2% is in fact a real number, per se. What will be more interesting from the consumption figures will be the composition of spending between necessities and non-necessities. Then as you pointed out, there's been a rotation away from discretionary non-necessity spending to offset higher costs. As a result, consumers are more focused on gasoline consumption and food and basic necessities. If we see this trend continue, one might actually expect further Fed commentary on the issue. After all, it's really the bottom quartile of the consumer base that's been the hardest hit from higher inflation, particularly at the pumps.

Ben Jeffery:

And away from the tax bill, it was also a big week in terms of Treasury supply. We did get the marquee Treasury auction event of the quarter in Wednesday's $35 billion 10-year refunding, which recall was cut by one billion versus the prior quarter's offering. As for the bid that met the August of 32, what we saw was following the knee jerk rally in response to the softer than expected CPI data, a fairly significant intra day bearish reversal that ultimately served as a good concession for a supply. An 8/10 of a basis point stop through with very strong underlying bidding statistics is keeping with the general trend we have seen at new issue 10-year auctions over the past few years. And even though we've seen ten-year yields move back meaningfully below 3%, another solid result in the primary market firmly reinforces our take that the outright level of yields are not going to be set by supply in the Treasury market, but rather auctions afford more short term tactical opportunities. And it's more a question of five to 10 basis point moves, not 40 or 50.

Ian Lyngen:

And this is important context as we come up against September, which is the month in which the QT pace will reach its peak. Now, we've had a lot of questions over the course of the last several weeks about why the balance sheet run down by the Fed isn't forcing longer dated yields higher. 10-year yields reached as low as 2.51 recently. And when we think about the Fed's objective of unwinding its balance sheet, it is reasonable to highlight what one might characterize as a divergence. That said, as we've maintained, what is more relevant isn't the size of the Fed's balance sheet, it's how the US Treasury Department decides to cover any funding gap that results from less participation at auction add-ons. And all we've heard from Yellen thus far in 2022, is that coupon auction sizes are decreasing, and the only sector that is seen any meaningful increase in auction sizes has been the bill market.

Ben Jeffery:

And what I'll argue is the most interesting facet of the issuance landscape currently is the fate of the 20-year Treasury bond. At August refunding announcement, we learned that the Treasury Department opted to cut 20s by more than 10s and 30s, but not materially so. And the information contained within the policy statement revealed that for the time being, Washington remains committed to the 20-year program. So as we approach Wednesday's 20-year refunding auction to the tune of 15 billion, it will be topical to see how investors come in to take advantage of A, liquidity point and one of the most illiquid points on the curve, and B, the substantial yield pickup investors receive given how inverted 20s/30s still remains. And while there may come a point when that curve returns to more "normal territory," we're not expecting that will be a near term development.

Ian Lyngen:

And it's also notable that 20-year auctions tend to perform reasonably well in the event themselves, even if the sector does continue to underperform. And that's one of the aspects of the process that has been so perplexing, and why many in the market were looking for the Treasury Department to take more dramatic action as it relates to the 20-year sector. Alas, it looks like we're stuck with 20s for now.

Ben Jeffery:

And I know wasted 20s.

Ian Lyngen:

You've still got a couple years left. In the week ahead, the Treasury market has second tier data at best. And it's interesting to think of retail sales in that light. Retail sales and the overall consumption profile is obviously essential to growth in the US, given the portion of the US economy that's made up of consumption. That said, because Powell and company have effectively made inflation the one thing that monetary policymakers are focused on at the moment, the consumption profile has taken a back seat, as it were. In fact, the two negative back to back quarters of real GDP, which are not being characterized as a recession, speaks to the fact that the Fed is willing to accept a slower or negative growth profile to ensure that they can retain credibility as a potent inflation fighter. In terms of the spending numbers, the consensus is close enough to zero that a slight drop in retail sales wouldn't be particularly surprising for this market.

Ian Lyngen:

The incoming data also includes an update on housing starts permits as well as existing home sales, which are seen declining 5.3% in the month of July. Now the overall state of the residential housing market is key when we think about the wealth effect and how that flows through to consumers' willingness to spend. What we have seen thus far has been a moderation in the pace of sales, but to a great extent, prices have been flat if not slightly higher. A question that we've received quite often recently is whether or not we expect that the US economy is poised for a meaningful correction in the housing market, comparable to what we saw in 2008 and 2009. The short answer is no. And the logic here is that given the bulk of the run up in housing prices occurred purely as a function of demand, not easier credit, that the current housing landscape means effectively that higher priced homes are in stronger hands.

Ian Lyngen:

Now, if the Fed is successful in increasing the unemployment rate, we might see some incremental downward pressure. But the average borrower is in much better financial condition than what we saw in the 2006 and 2007 period. In addition, overall household balance sheets are in a better position, which implies that the average worker can endure a longer period of unemployment without needing to make difficult choices as it relates to what has historically been one of the biggest stores of value for US workers, i.e., home equity.

Ian Lyngen:

We also see the update of the TIC data. Now, it's data for the month of June so it is a bit dated. However, given the focus on the absence of key overseas investors in the US Treasury market, we'll be looking for any indication that we have seen an increase in demand for US Treasuries as well as agency mortgages and corporate bonds. One of the often cited conundrums at this point in the cycle is who is actually out there buying Treasuries, given everything that is going on with the state of the economy, the amount of inflation there is in the system, and the fact that the US still has a reasonable growth profile? It's a question that we'll look to the TIC data for some insight on, but when we look at the classic surveys, such as the Stone & McCarthy Real Money Survey, what we see is that buy and hold investors, while perhaps participating in the Treasury market, are still running a significant short versus their benchmark. As a result, we expect that a bullish period for Treasuries will bring in sideline investors and push yields even lower as people attempt to get closer to the benchmark.

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. And with average gasoline prices in the US back below $4 a gallon and road trip season at hand, we'll be staying put. What does E stand for anyway?

Ben Jeffery:

Inversion, right? Has to be.

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.

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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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