Lyngen/Kohli BMO Closing Call, November 15 - Fixed Income Strategy

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Nov 15, 2017 - inflation report to convince the market that inflation is poised to ratchet sustainably higher. To be fai
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15 November 2017

Lyngen/Kohli BMO Closing Call, November 15 Ian Lyngen, CFA, MD, Head of US Rates Strategy, Aaron Kohli, CFA, Director, Rates Strategist US Market Comments WEDNESDAY'S LEVELS: 2s: 99-21 168.30 bp, 5s: 99-27 + 2.037%, 10s: 99-08 2.335%, 2s/10s: 64.71 bp, EDZ7: 98-15, TYZ7: 125-02+, USZ7: 154-0, S&P: 2568.        »

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CPI, Oct – matched expectations at +0.1% MoM vs. +0.5% Sept. Core-CPI came in as-expected at +0.2% MoM vs. +0.1% Sept. YoY core CPI increased to 1.8% vs. 1.7% Sept and 1.7% anticipated. Unrounded coreCPI was 0.225% MoM. Used car prices gained +0.75% in a clear hurricane impact. Real Average Hourly Earnings, Oct – dropped to 0.4% vs. 0.6% Sept. Lowest level since April 2017. Empire Manufacturing, Nov – declined to 19.4 vs. 30.2 Oct and 25.1 consensus. Prices paid slipped to 24.6 vs. 27.3 Oct. Prices received gained 2.2 pts to 9.2. New Orders improved to 20.7 from 18.0 Oct. Shipments dropped to 18.4 from 27.5 prior. Number of employees declined to 11.5 from 15.6 prior. Retail Sales, Oct – slightly above expectations at +0.2% vs. +1.9% Sept and 0.0% forecast. Control group was +0.3% MoM vs. +0.3% consensus and +0.5% Sept. Business Inventories, Sept – 0.0% vs. 0.6% Aug and 0.0% expected. Corporate deal pricings were limited to a Citadel 5s, TransCanada Pipelines 2s, and an HSBC Holdings 6 nc 5s. Stone McCarthy showed real money slightly longer at 100.1% of the duration-weighted benchmark vs. 100.0% prior. Smaller accounts were also longer with the arithmetic gauge at 100.0% vs. 99.9% prior. Curve flattening remains the most identifiable trend in the Treasury market and one that we see no reason to fade at this juncture. We’re certainly wary of the potential for an in-range steepening that would ultimately offer better placement to scale into the flattener; however, the Fed’s demonstrated commitment to tighten monetary policy is arguably the strongest force in the market at this moment. Today’s +1.8% YoY core-CPI print will only reinforce the Fed’s resolve and in doing so leaves us biased for an extension of the flattening – don’t fight the Fed (some idioms are truly timeless). We’ve been hearing a great deal about how ‘consensus’ it has become to expect ‘two more hikes and a pause’ and that sentiment has conjured up images of the Fed Funds futures curve during the 2004-2006 tightening campaign. For those of us who recall that episode first hand, that particular series of rate hikes had a similar dynamic in forward pricing – the market would price in two additional hikes and then the probability of further moves fell off sharply. For context, that tightening process brought rates from 1.00% to 5.25% by way of a series of seventeen 25 bp hikes – slow and steady at a measured pace. It strikes us as somewhat intuitive that investors are confident with pricing in the Fed’s demonstrated pace of rate hikes for the foreseeable future – which we’ll argue extends to about six months. While that is far beyond our own ability to predict the future (we’re better in the 6 second zone and that’s typically just momentum based), we understand the logic however – the Fed has communicated its plan and until they blink and tell us otherwise, the data would need to materially deteriorate to trigger a Fed rethink. It’s notable that this aspect of the tightening cycle mirrors the most recent one so closely, although in terms of the 2s/10s curve the market is

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors; The views expressed in this report may differ from the views offered in BMO Capital Market’s debt research reports prepared for retail investors; This report may not be independent of BMO Capital Markets proprietary interests. BMO trades the securities covered in this report for its own account. Such trading interests may be contrary to the recommendation(s) offered in this report. Please refer to the last page of this document for Important Disclosures, including the Analyst's Certification.

• BMO Capital Markets Fixed Income Strategy • Margaret Kerins, CFA, Global Fixed Income Strategy Head • https://strategy.bmocm.com

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November 15, 2017

ostensibly much further ahead – although we’ll challenge that assumption. The last time 2s/10s had flattened out to this degree was in April 2005 after the Fed had hiked to 2.75% and core-CPI was 2.2% YoY. This is where we start to see more similarities than the market chatter indicates. 2s/10s last dipped below 65 bp in April 2005 at a point when the FOMC had delivered seven 25 bp rate hikes (with two more and a pause priced in) compared to five 25 bps hikes and a taper – assuming a December move. This difference doesn’t really stand out in our minds and, in fact, only suggests that there is more flattening to be seen if the Fed continues on its forecasted path for raising rates. It’s worth emphasizing that the period from 65 bp to inverted in 2005 was just seven months. We’d love to hear your thoughts on the subject of flattening. Wednesday’s bullish price action was accompanied by elevated activity and cash volumes ended at 160% of the 10-day moving-average. 5s emerged as the most active issue, taking a 30% marketshare while 10s trailed at 26%. 2s and 3s combined to take 30% at 18% and 12%, respectively. 7s managed 9% while the long bond took a more normal 6%.

Tactical Bias »

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The grinding flattening bid in the Treasury market persists and we remain onboard with the move and unwilling to fade it -- content to view any steepening as an opportunity to scale into the trade. That said, we’re certainly not of the mind that it will be a direct shot of 5s/30s to 64 bp (a reflected channel bottom), but the Fed’s commitment to normalization means any countertrade will be short-lived. We’ve drawn the parallels between now and the 2004-2006 Fed tightening with the biggest eyebrow-raiser being how quickly the 2s/10s curve went from its current level (65 bp) to inverted – i.e. roughly seven months. As for the 5s/30s curve, that timeframe was a bit longer from current levels (75 bp), taking effectively twelve months. We offer these as both grounding for the current price action as well as a defense for our call for a flatter curve in 2018 – with a risk of inversion. We’ll table the discussion for now about the correlation between an inverted curve and a recession – after all, we need something to write about tomorrow. Nonetheless, our outlook is certainly at odds with calls for a triumphant return of term premium. If we learned anything from Wednesday’s response to the stronger-than-expected core-CPI print, it was that it’s going to take a lot more than a consensus inflation report to convince the market that inflation is poised to ratchet sustainably higher. To be fair, it was a strong +0.2% at +0.225% and relatively broad based – although the increase of +0.75% in used auto prices indicated some hurricane influences similar to what was seen in PPI. At the risk of going too far off topic, we maintain that the only way to get term premium sustainably priced back into the Treasury market is with a rally of the belly of the curve as the market prices out future rate hikes. That isn’t a new position for us and rather simply reflects the current stage of the hiking cycle. It comes down to the market’s perception of the Fed’s ability and willingness to combat inflation – both of which are elevated, if for no other reason than the Fed has been raising rates despite the lack of inflation. As an aside, one of the overlooked details in Tuesday’s inflation report was the drop in real average hourly earnings – now at just +0.4% YoY. While this is above the +0.1% low seen at the beginning of the year, the fact that this series has fallen during each of the last four months is troubling – even in light of the hurricane related spike in AHE seen in the September data. This isn’t an inflation story as much as it is yet another indication that the current pace of consumption might be on weaker footing than otherwise assumed. We’ve been tracking the development of a potential head and shoulders formation in 10-year yields and the post CPI price action is consistent with the construction of the right shoulder. The longer the market consolidates in the 2.30% to 2.40% range, the more compelling this particular technical pattern becomes. We would be reluctant to target anything