Lyngen/Kohli BMO Closing Call, October 24

A daily focus on fixed income markets, trends, and trades

24 October 2017

Lyngen/Kohli BMO Closing Call, October 24 Aaron Kohli, CFA, Director, Rates Strategist, Ian Lyngen, CFA, MD, Head of US Rates Strategy US Market Comments TUESDAY'S LEVELS: 2s: 99-27 158.10 bp, 5s: 99-27 2.039%, 10s: 100-0 2.414%, 2s/10s: 82.84 bp, EDZ7: 98-16, TYZ7: 124-20, USZ7: 151-19, S&P: 2570. • • • •

The 2-year auction had a weak showing with a 0.5bp tail and bid/cover was the lowest since March at 2.74x compared to a 2.93x average. Dealer takedown was at 37.7% (highest since January) vs. 31.4% norm with directs and indirects both light at 14.1% and 48.2% vs. averages of 15.1% and 53.5%, respectively. Markit US Manufacturing PMI for October beat expectations at 54.5 vs. 53.4 consensus and 53.1 in September. Service PMI also surprised on the upside at 55.9 compared to 55.2 expected and 55.3 prior. The Composite PMI came in at 55.7 vs. 52.8 in September. Richmond Fed Manufacturing for October disappointed at 12 compared to 17 expected and 19 in September. Within the details, order backlog and capacity utilization were the biggest headwinds with both coming in at 7 compared to 8 and 16 in September, respectively. The corporate deal calendar for Tuesday included Goldman Sachs $7b 5nc4s/21nc20s, Export-Import Bank of Korea $2b 3s/5s, Boral Finance $950m 5s/10s, CPPIB Capital $1b 10s, Kingdom of Sweden 3s, BNG 2s and CCDJ 3s. The fact that a Bitcoin split and a spat between President Trump and Senator Bob Corker occupied much of the early session today speaks volumes about the market’s lack of focus as we await more from central banks and the fundamental data prints ahead. One headline that did get some attention late in the day was that Trump had asked congressional members for a show of hands at a GOP policy lunch today on who they would prefer as Fed chair (Bloomberg stated that Taylor won). This led a sizable jump in yields late in the session with 10s closing about 4.5 bp higher on the day. We’re not sure this means anything for whether Taylor eventually gets the nod, though it does at least suggest that Trump is considering the favorability of his potential pick amongst Congressional Republicans as a factor in his thinking. Another headline suggested that three Senators were already leaning against Trump’s tax cut plans with a fourth likely to oppose.

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10-year yields managed to break over 2.40% and held that level through much of the session with 2.42% tested and rejected prior to the close. The last leg of the selloff came after rumors that Republicans favored Taylor in an informal poll at a lunch with Trump. It’ll be important to see how the overnight session evolves and whether investors push yields to even higher levels or if Asian investors see this as a broader dip-buying opportunity. Should we push higher still, it’ll offer more convincing evidence of a clear break in the psychologically important 2.40% level with 2.50% likely in the crosshairs shortly thereafter. The 2-year auction tailed, but did so after a sharp rally at 1pm which was mostly responsible for the miss. The markets didn’t really react to the tail despite the facts that the stats were soft and in our view, the implications for the 5-year as a result were somewhat limited. While it’s clear that the risk of a tail at the 5-year increased marginally, the outright and relative concession in 5s means we’re likely to see some buying there. 5s are

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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October 24, 2017

arguably just as (if not more) affected by a hawkish Fed pick, and that stands as the largest risk for owning 5s ahead of the announcement of Yellen’s successor. »

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Tuesday’s volumes were slightly below average with cash trading at 89% of the 10-day moving average. The 5year was the most active capturing 31% of total market share with 10s following close behind at 28%. 2s and 3s took a combined 24% at 14% and 10% respectively. The 7-year received 9% and the long bond was at 8%.

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We’ve seen the 2.40% level break in 10s and while we’d be apt to write off the move as noise, given that it came without heavy trading (10s were running at 94% of the 10-day MA) and on the back of Taylor rumors, experience has taught us that price action has to be respected. We’re content to keep letting yields rise for the moment, but are more willing to join a rally than push for a selloff as levels get even higher. 2.42% held in the immediate aftermath of the headline and 2.50% is strong support beyond that as we wait for a more convincing turn in momentum to go long. The easiest read of the market’s reaction to a possible Taylor nomination would be to simply offer that the 5s/30s curve would flatten with the 5-year likely leading the move to higher yields while a Powell or Yellen nomination would have the opposite effect. Rumors of Congressional Republicans favoring Taylor late in the day drove the 5s/30s curve nearly a full 1.5 bp flatter. The choice of Fed chair won’t materially alter our longerterm fundamental growth view given what we see as the lack of wiggle room for the new Fed chair in demographics and the focused strength of US inflation (heavily housing centered). For us, the question really comes down to one of timing and while we’re open to the notion that the Treasury market will react initially to a Taylor nomination with more pessimism than to a Powell or Yellen nod, our longer-term view leaves us as dip-buyers in Treasuries. Even if we do receive a “hawkish” nominee from Trump, and that is by no means a certainty, we’re less convinced that it does anything meaningful to the dynamics driving global rates. We might even expect such a nominee to offer more soothing words during the process of Congressional approval and in any event will be looking for an optimal time to buy long-end Treasuries on any such result. The belly and front-end are likely to be most heavily impacted on the knee-jerk move accompanying any Fed chair nominee move and for now, the market is only pricing roughly 34 bp worth of hikes into 2018. We’d argue that a Taylor nomination is likely to make that at least two full hikes more likely though any push past that could well be an over-reaction. An astute investor asked us how much we might reprice the front-end and belly in the event of two full hikes being priced in alongside a December hike. That repricing of 2s from the current levels would be worth roughly 12 bp while it would be worth roughly 20 bp in 5-year yields from the current close assuming we fully price a single hike into December and two full hikes into 2018. Since we’re still dubious about the prospect of three full hikes in 2018, we’d be buyers at anything past these levels. We’d expect the curve to flatten and the 10-year to sell off less than 5s in such a move. - Aaron Kohli and Ian Lyngen

Impending Events • • • • • •

MBA Mortgage Applications, week ending October 20th – prior week +3.6%. Durable Goods Orders, September – consensus +1.0% compared to prior of +2.0%. Cap Goods Orders, September – expected +0.3% vs. +1.1% in August. FHFA House Price Index, August – seen +0.4% vs. +0.2% prior. New Home Sales, September – consensus 555k vs. 560k in August. $34bn 5-year Treasury auction.

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October 24, 2017

BOC statement and MPR will be released on Wednesday.

Technical Analysis •

2s – A broad upsloping channel in 2s that started after the Trump election is nearby in a selloff and offers strong support at 1.658% which also coincides with a very tight channel that started in September. Past that level, we also see 1.733% as a support that held in a few instances in 2002 and 2003. A Bollinger band top provides first support at 1.564% which is very close to nearby levels. On a rally, we have the first significant resistance at previously conquered support of 1.448% which was major resistance in 2003 and 2008. Levels past that include the 50, 100 and 200 day moving averages at 1.397%, 1.373% and 1.310% respectively. 1.310% also is the aforementioned channel bottom and will provide very stiff resistance in a large rally. RSIs and stochastics both look well into oversold territory but have looked oversold for some time now.

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5s – 5s broke a downward sloping yield channel of their own and the prevailing trend is to higher yields though the break appears still only slightly tentative. The next material support for 5s lies at 2.146% which is the yield peak from early 2017 and will be difficult to cross even in a sustained selloff though we do have some minor support at 2.05%. On a rally, the previously broken channel top of 1.985% becomes resistance and past that, we have a cluster of averages between 1.824% and 1.858% with the 50-day MA at 1.824% crossing the 100-day MA at 1.819% from below. Momentum isn't as positive for 5s as it appears for 2s, but is still broadly oversold. RSIs for 5s are just a bit more neutral and outside of oversold territory after the sideways chop of the last week pulled us out of very oversold territory.

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TY – The front-month December contract is in a tight trading range topping out at 125-25+ and a bottom at 124-22+. We'll look to mostly trade this range for the contract though the drop below 125 does offer a hint that further losses are to come. We've got much stronger support below that at 124-14 should a break occur and momentum looks less bullish for TY than it does even for 5s. Stochastics are well out of oversold territory again suggesting a slight steepening ahead.

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10s – Friday’s price action has undoubtedly shifted the tone in the Treasury market and the 10-year sector is no exception. Stochastics have crossed in favor of higher yields and the momentum seen via MACD tells a very similar story. For immediate support we have the recent yield peak that comes in at 2.402% and a break of that level points to 2.421% with very little between there and 2.50% -- a move that we expect would bring in sidelined buyers, particularly ahead of month-end. For resistance, we like the cross of the 200- and 21-day moving-averages that comes in at 2.310% with a volume bulge beyond there at 2.30%. Through there is the low yield-close at 2.277% before the 74-day moving-average of 2.25%. The weekly chart tells a similar, and much more bearish, story with momentum decidedly in favor of higher rates.

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30s – The long-bond didn’t escape the massive selling pressure seen on Friday and has recast momentum in the sector more bearishly. There is a stochastic cross and a spike in MACD that points toward higher yields as the path of least resistance. The 200-day moving-average at 2.912% is the most immediate support and followed shortly by an isolated yield peak at 2.933%. Beyond there is 2.945% before the 2.95% level – both we expect to be difficult to sustainably break, but if we do, the 3.00% handle-change comes into play. For immediate support we’re focused on the 21-day moving-average at 2.846% and then that volume bulge at 2.816%. In a more meaningful rally we’ll be targeting 2.80% which is both a familiar level and the 40-day moving-average. The weekly chart remains decidedly bearish with momentum in a position to extend further following the break of a downward sloping channel that had been in place since March.

Attached • • • •

5-year Auction Stats MBA Mortgage Apps US New Home Sales Average-Median Spread New Homes Sales vs. FHFA House Price Index

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Inventories to Shipment Ratio vs. Durable Goods New Orders 10-year BEIR Daily 10-Year Yield Daily 5s30s Curve

October 24, 2017

24 October 2017

A daily focus on fixed income markets, trends, and trades CONTACTS Margaret Kerins, CFA, MD, Head of FI Strategy [email protected], 312-845-2687

Michael Gregory, CFA, MD, Dep. Chief Economist [email protected], 416-359-4747

Ian Lyngen, CFA, MD, Head of US Rates Strategy [email protected], 212-702-1703 Aaron Kohli, CFA, Director, FI Strategy [email protected], 212-702-1252

Sal Guatieri, Director, Sr. Economist [email protected], 416-359-5295 Jennifer Lee, Director, Sr. Economist [email protected], 416-359-4092

Dan Krieter, CFA, Vice President, FI Strategy [email protected], 312-845-4015

Benjamin Reitzes, Director, Sr. Economist [email protected], 416-359-5628

Dan Belton, PhD, Associate, FI Strategy [email protected], 312-865-5068

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5yr Auction Stats - Fixed Income Strategy

Aaron Kohli 212-702-1252

3/25/2015 4/28/2015 5/27/2015 6/24/2015 7/29/2015 8/26/2015 9/23/2015 10/28/2015 11/24/2015 12/29/2015 1/27/2016 2/24/2016 3/29/2016 4/26/2016 5/25/2016 6/21/2016 7/26/2016 8/24/2016 9/27/2016 10/26/2016 11/22/2016 12/28/2016 1/25/2017 2/22/2017 3/28/2017 4/26/2017 5/24/2017 6/27/2017 7/26/2017 8/28/2017 9/27/2017

$35 bn $35 bn $35 bn $35 bn $35 bn $35 bn $35 bn $35 bn $35 bn $35 bn $35 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn $34 bn

6 Auction Avg $34 bn

1.387% 1.380% 1.560% 1.710% 1.625% 1.463% 1.467% 1.415% 1.670% 1.785% 1.496% 1.169% 1.335% 1.410% 1.395% 1.218% 1.180% 1.125% 1.129% 1.303% 1.760% 2.057% 1.988% 1.937% 1.950% 1.875% 1.831% 1.828% 1.884% 1.742% 1.911%

2.35x 2.56x 2.46x 2.39x 2.58x 2.34x 2.57x 2.43x 2.52x 2.32x 2.44x 2.44x 2.38x 2.41x 2.60x 2.29x 2.27x 2.54x 2.39x 2.49x 2.44x 2.72x 2.38x 2.29x 2.37x 2.34x 2.67x 2.33x 2.58x 2.58x 2.52x

0.9bp -1.1bp -0.5bp 1.1bp -1.0bp 0.9bp -0.6bp 1.6bp 0.9bp 1.6bp 1.1bp -1.4bp 0.7bp 0.4bp -0.4bp 1.3bp 1.4bp -0.4bp 0.4bp 0.0bp 0.3bp -1.1bp 1.1bp 0.5bp 0.4bp 0.7bp -0.8bp 0.5bp -0.9bp -0.8bp 0.1bp

39.6% 33.2% 31.6% 37.9% 27.2% 42.5% 31.5% 37.2% 33.2% 36.5% 37.8% 22.7% 38.9% 29.8% 21.8% 39.1% 41.6% 25.1% 34.1% 35.4% 35.7% 24.5% 32.1% 33.3% 26.4% 37.4% 22.7% 25.6% 24.1% 17.5% 23.3%

4.7% 5.6% 10.0% 5.6% 5.3% 7.5% 5.0% 3.8% 10.1% 11.0% 8.6% 10.0% 7.2% 6.8% 11.6% 3.7% 4.7% 6.2% 4.4% 4.9% 4.5% 4.1% 4.6% 8.4% 4.8% 5.3% 8.6% 9.2% 6.2% 13.5% 7.1%

55.7% 61.2% 58.5% 56.6% 67.5% 50.1% 63.5% 58.9% 56.7% 52.5% 53.5% 67.3% 53.9% 63.4% 66.6% 57.2% 53.6% 68.7% 61.4% 59.7% 59.8% 71.4% 63.3% 58.2% 68.9% 57.3% 68.7% 65.2% 69.8% 69.1% 69.6%

23.8% 19.4% 19.1% 23.5% 16.3% 26.1% 18.6% 22.5% 19.5% 23.0% 22.6% 14.6% 23.7% 18.5% 13.1% 23.9% 25.4% 15.0% 21.0% 20.5% 20.8% 14.9% 19.9% 21.3% 16.8% 22.9% 13.5% 17.8% 15.0% 11.4% 15.2%

97.2% 91.5% 94.6% 95.0% 92.8% 93.0% 92.0% 95.7% 95.2% 97.7% 98.3% 94.6% 91.6% 93.0% 85.7% 99.5% 99.8% 89.0% 89.7% 90.1% 95.0% 71.6% 93.4% 97.6% 97.3% 95.3% 79.4% 86.4% 80.5% 79.9% 80.2%

$0.0 bn $0.1 bn $0.0 bn $0.0 bn $0.0 bn $0.0 bn $0.0 bn $0.0 bn $0.0 bn $0.0 bn $0.6 bn $11.4 bn $8.1 bn $9.0 bn $8.7 bn $5.0 bn $2.4 bn $2.3 bn $2.1 bn $2.1 bn $3.6 bn $4.5 bn $2.2 bn $4.7 bn $4.1 bn $4.6 bn $4.1 bn $4.1 bn $3.5 bn $1.1 bn $4.2 bn

43.3% 46.7% 44.9% 45.3% 54.4% 45.1% 47.7% 43.4% 42.3% 45.1% 38.5% 60.0% 40.0% 48.7% 49.3% 39.2% 44.2% 53.8% 46.0% 47.4% 46.6% 62.8% 44.4% 49.5% 52.8% 45.9% 57.2% 53.1% 57.1% 55.2% 62.4%

14.2% 17.3% 21.4% 13.1% 15.3% 9.2% 17.6% 14.5% 21.6% 15.3% 20.5% 13.8% 17.2% 18.2% 26.0% 19.0% 11.1% 18.1% 16.9% 12.4% 13.5% 8.8% 18.5% 12.5% 18.1% 13.7% 16.0% 17.0% 13.4% 22.8% 9.5%

1.845%

2.50x

-0.2bp

25.1%

8.3%

66.6%

15.9%

83.6%

$4 bn

55.2%

15.4%

MBA Mortgage Apps 125

100

75

50

%

25

0

-25

-50

-75 W1

W14

W27 2016

W40

W1

W14

W27

W40

2017 Refinancings YoY Purchases YoY Market YoY Source: BMO CM & Macrobond

US New Home Sales Average-Median Spread 400 350 300

200 150

Thousands

250

100 50 0 70 60

40 30

Thousands

50

20 10 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

0

US New Home Sales Average [m.a. 1 year] US New Home Sales Average - Median Spread [m.a. 1 year] US New Home Sales Median [m.a. 1 year] Source: BMO CM & Macrobond

New Home Sales vs. FHFA House Price Index MoM 1300

1.00

1200

0.75 1100

0.50

1000

0.25

800

0.00 700

Percent

Thousand

900

-0.25

600

500

-0.50

400

-0.75 300

200

1992

1994

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1998

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2002

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2010

2012

2014

2016

-1.00 2018

US New One Family Houses Sold, lhs [m.a. 1 year] FHFA US House Price Index MoM, rhs [m.a. 1 year] Source: BMO CM & Macrobond

Inventories to Shipment Ratio vs. Durable Goods New Orders 3

1.9

2

1.8

1

1.7

1.6

Ratio

Percent

0

-1

1.5 -2

1.4

-3

-4

1994

1996

1998

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2002

2004

2006

2008

2010

2012

2014

2016

1.3 2018

US Manufacturers Inventories to Shipment Ratio, rhs US Durable Goods New Orders MoM, lhs [m.a. 1 year] Source: BMO CM & Macrobond