Cue for Q2 - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 216, Cue for Q2, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey in Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of April 3rd. With April Fool's Day falling on a Saturday this year, we had an astute client ask us, "How do you keep an idiot in suspense?" An answer was promised on Monday, so we'll wait this one out.

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.

In the week just passed, the primary theme in the Treasury market was one of consolidation. We came into the week with upward pressure on rates as we made it through the weekend without further evidence of contagion from the banking sector, and we have, for all intents and purposes, traded around in a relatively tight range since then. Of the three auctions, the two-year tailed 2.6 basis points, and the seven-year tailed 1.2 basis points. It was only the $43 billion five-year that stopped through, and it did so at a modest 0.8 basis points.

Overall, there was little on offer to change the macro narrative from a data perspective, which came as little surprise given the second tier nature of the economic releases on offer. What was of note that was communicated however came from monetary policy officials. We had a variety of Fed speakers, most of whom emphasized two primary takeaways. The first being that it's still too soon to have a strong opinion on a May rate hike or pause that much followed intuitively given all of the uncertainty that characterized March. The second takeaway was that there's a clear distinction in the minds of monetary policy-makers between macro prudential tools and rate policy, the former being designed specifically to offset any contagion risks in the financial sector, whereas the latter will be used to contain inflation expectations and manage the employment market appropriately.

Now, at some point, if the banking sector woes extend dramatically enough, that will translate into a truly disinflationary impulse for the US economy and eventually result in the Fed revisiting policy rates as a response to a banking crisis. Such an extreme scenario, however, would entail a greater contagion that has yet to become evident. So, for the time being, the market appears content with the current pricing levels in the US rates market and will note two inflection points of relevance from a technical perspective. The first being two-year yields at 4%. That has served as an important focal point. We do think that there's a wide range around a center point of 4%, but both sub four and above four will prove well-worn territory over the course of the second quarter.

The other key pivot point in Treasuries of note is the 3.50 level in 10-year yields. We came into 2023 with the expectation that 10-year yields would hold a range of roughly 110 to 120 basis points, and the center point of that range would be 3.5%. That certainly does appear to be the case now that we are entering the second quarter, and it's worth noting that that doesn't preclude a bearish period for Treasuries in which 10-year yields get back close to 4%. That being said, we're skeptical that 4% 10s will be retested this year and see the path of least resistance biased lower with a two-handle in 10s more likely than a four-handle.

As for the shape of the yield curve, our expectations are that the cyclical re-steepening of 2s/10s and 5s30s has officially commenced. While there will undoubtedly be moments where the curve is flatter, the extremes have been established. In 2s/10s in particular, that's represented by the negative 111 basis point level. We anticipate that by the end of the year, the curve will at least have momentarily shifted into positive territory for 2s/10s, and 5s/30s will continue its march into the realm of above zero spread. Further to the 5s/bonds curve, any dip below zero will be an opportunity to reestablish a core steepening position in 5s/30s.

Vail Hartman:

The sign on the trading desk says that we are now closing in on two weeks without an accident in the banking sector.

Ben Jeffery:

So does that mean it's all clear?

Ian Lyngen:

I mean, to be fair, the two weeks is written in chalk, so my expectations are that while we are in a moment where it appears that there is tranquility and calm in the banking sector, there's still a lot of information that the market has yet to see as it relates to the potential fallout from what has occurred over the course of the last three weeks. Even envisioning a scenario in which there is not another banking failure, at the end of the day, there will be a net-tightening of credit standards as a result of the regional banking crisis which in and of itself will slow the velocity of money and thereby create a disinflationary impulse for the broader economy.

Ben Jeffery:

In Treasury market terms, the sense of calm was certainly evident in the price action. We got a fairly impressive bearish retracement in the 10-year sector, although that 350 level that we've been watching as a tether for the benchmark of all benchmarks definitely exerted its influence, and the bearishness was well contained below 3.65 10-year yields with the curve putting in a solid flattening effort. Now, while our longer term steepening expectations for the curve as the Fed eventually needs to respond more significantly to the damage that's been inflicted on the real economy is intact, we still see 2s/10s far closer to positive territory over the longer term. The flattening response we got over this last week was a reflection of the idea that the volatility in the banking sector has thus far been contained, and maybe that means we will in fact get another Fed hike to bring us to that 5.25 terminal bound, and maybe the committee can make it through 2023 without being forced to cut rates.

Ian Lyngen:

At its essence, the debate comes down to whether or not the Fed's macro prudential tools that they have in place are going to be sufficient to forestall any potential contagion beyond what's already been seen. Recall that after the great financial crisis, monetary policy-makers and regulators rolled out an array of new programs and in that process, established a culture/response function to bank crises that entails the swift creation of new support programs as needed as evidenced by the introduction of the bank term funding program.

Now, given that the biggest question is whether or not that is going to be enough, monetary policy-makers have clearly doubled down on this narrative with the vast majority of incoming Fed speaks, suggesting that the programs which are in place and the potential for new ones will keep the banking stresses out of the realm of rate policy. Then, the logical extension becomes that the FOMC is on track to reach terminal and keep terminal in place for the balance of 2023. Ben, to your point, I suspect that that's a good portion of what has been driving the re-flattening of the yield curve. Now, we still continue to see the negative 111 point in 2s/10s as the depths of the inversion for this cycle, but that's not to say that we can't move deeper into inverted territory from current levels as the market responds to the incoming economic data and skews the risk for another quarter point in May.

Ben Jeffery:

This brings us to a very interesting client question we got this week in terms of what would the Fed's preference be if given the opportunity to deliver either a higher terminal rate for a shorter period of time or a comparatively lower terminal rate for a lengthier period of time. The developments of the past several weeks and what we saw within the March SEP showed a decided preference for the latter, and if we think about the actual economic impact of policy rates at 5.25% or 5.50%, given how far policy is into restrictive territory, what's more impactful than simply an additional 25 basis points is going to be the duration of time that the Fed can keep rates at that level.

So, clearly, the trade-off that the committee has been willing to make is an acknowledgement that given what's happened in the banking sector, maybe we don't need to go to a 5.50%, 5.75%, or even 6% terminal rate. But as it presently stands based off what we heard from Collins, Barker, Kashkari, there seems to be an appetite for just one more 25 basis point hike, accepting that comparatively lower terminal rate, but fighting to hold it for a longer period of time. Related to this conversation is another thing we saw in the dot plot which was that we actually saw the 2024 forecast increase, admittedly, just by 12.5 basis points, but nonetheless, a reflection that everything that's gone on has not yet translated to the official forecasts reflecting more policy easing in 2024.

Ian Lyngen:

So, Ben, what you're saying is that it's effectively like the market's opinion on taxes, lower for longer? That brings us back to the debt ceiling debate. As we think about one of the biggest risks for the amount of reserves that are currently in the system, the debt ceiling is difficult to ignore, principally, because the rundown of the Treasury general account has resulted in what's effectively reserves coming back into the system. This occurred at a point when the Fed was actively engaged in QT, so the debt ceiling is creating a QE impulse while the Fed is attempting to execute QT. This all resolves at some point, presumably this summer, and it will be linked to tax receipts. As the mid-April personal income tax deadline approaches, we'll get more accurate estimates of how long the Treasury Department can keep things functioning without running up against the constraints of the debt ceiling.

Vail Hartman:

On this topic, another variable to consider would be that we've seen bank deposits drop in favor of flows to money market funds.

Ben Jeffery:

You're absolutely right, Vail, and in thinking about what might come in terms of legislation resulting from the situation in the banking sector, before we get any clarity on potential changes to the FDIC or anything along those lines, what has resulted from the risk of uninsured deposits is that individuals are removing cash from their presumably lower yielding checking accounts in search of higher yields elsewhere. Now, money market funds, as you touched on, Vail, are a clear headline example of this, but let's not forget there's also a fairly solid return to be earned in the bill market with policy rates this high.

What this all means in terms of reserve balances, money velocity, and the overall disinflationary impulse that you were talking about, Ian, is that we're seeing cash leave banks in favor of higher returns elsewhere, and ultimately, what that's going to mean, all else equal, is a lower reserve environment that's just going to add another wrinkle in the Fed's decision-making process about the balance sheet and just how much longer they can continue the QT process before the market should be on the lookout for any change. Now, as we've talked about before, that change will probably first come in the form of slowing QT. So, for round number's sake, call it $60 billion of Treasury runoff a month cut to 40 and then 20. But first, we're going to need to see the Fed arrive at terminal and signal that they're shifting to an on-hold stance before amending balance sheet policy.

Ian Lyngen:

What the market has been focused on is a lot of forward-looking implications from the events that are currently transpiring that have yet to make their way through to the realized economic data, and that's one of the biggest divergents between the market's interpretation of current events and what they might or might not mean for the forward path of monetary policy. As we think about the higher than expected February CPI numbers that we saw as well as the resilience of the US labor market, it becomes very difficult for the Fed to quickly pivot without some type of confirmation within the economic data series that justifies such a move.

With this backdrop, the market will be closely following Friday's release of nonfarm payrolls for the month of March. Expectations are for an increase of 235,000 jobs combined with an unchanged unemployment rate of 3.6%. Recall that February marked the cycle low for the unemployment rate at 3.4%. Now, when we look historically, anytime the unemployment rate is more than three-tenths of a percent off of the cycle low, that tends to mark the beginning of a more significant re-basing of the labor market to a notably higher unemployment rate. Said differently, the unemployment rate tends not to stop after increasing by half a percent and instead often snowballs to a 1.5% or 2% increase off of the cycle lows. That's one of the biggest risks facing monetary policy-makers both in the US and abroad during 2023.

Ben Jeffery:

Aside from headline hiring in the unemployment rate, the participation rate and the interplay with wage growth is also going to be an especially important piece of new information that we get on Friday. Throughout most of the post-pandemic period, one of the consistent questions we've received or observations we've heard made is that the participation rate remains stubbornly low versus the 2019 and very early 2020 norms driven partially by those in the workforce who are 55 and older, and a great deal of that set of the population that left the labor force during the pandemic, but has been very slow to return.

Early retirement has been a frequently cited driver of this dynamic as well as health concerns surrounding COVID itself. This week, it's worth highlighting a piece of research published by the New York Fed. We can flip around that link to anyone who might be interested. That emphasized this dynamic has less to do with direct impacts of the pandemic and those relatively older individuals who may have pulled forward retirement and more a result of demographic trends that were always going to be in place regardless of if COVID happened or not. Coming into the early 2020s, a lot of baby boomers were already approaching retirement age anyway, and so what we've seen is that that segment of the population has opted for retirement as they were always going to. Maybe it's a year or two earlier, but really, what it means is that it's going to be very difficult to return the participation rate back to those 2019 levels that we saw, which will just be one more headwind for the Fed to consider in terms of cooling wage growth and containing inflation.

Ian Lyngen:

Now, to be fair, there will be natural upward pressure on the labor force participation rate in a 55 and older cohort as people age into that group and older potential participants run off. Now, clearly, this is a dynamic that will play out over the course of several years, not several months or quarters, making it less of an immediate policy consideration. Instead, we'll be left ponder if April jobs bring May hikes...

Vail Hartman:

Or another bank failure.

Ian Lyngen:

In the week ahead, the Treasury market will start the second quarter and the month of April with a bias to take in new information associated with the state of the labor market. We have the March nonfarm payrolls print, which is expected to increase over 200,000. The consensus currently stands at 235k with an unemployment rate of 3.6%. Impressive by any measure to be sure, but it is notable that that is off the cycle low of 3.4%. In addition, the average hourly earnings numbers are expected to increase during the month of March by three-tenths of a percent, which is an uptick from the prior month's two-tenths of a percent number.

It's also worth noting that this comes in an environment with increased scrutiny as it relates to the overall trajectory of inflation. Recall that on Friday, we saw the core PCE numbers for the month of February, which illustrated a below-consensus three-tenths of a percent increase, which brought the year-over-year inflation numbers below the estimate and consistent with the idea that inflation has peaked for the cycle. While the Fed might still have heavy lifting yet to be accomplished in terms of keeping policy rates on hold for an extended period of time, we're no longer in an environment in which the market believes that the Fed lacks either the tools or the commitment to reestablish price stability within the US economy. Recall that one of the primary concerns during 2022 wasn't necessarily the lack of Fed commitment to reestablishing the price stability assumption, but rather that the tools at their disposal were inadequate to address the type of inflation that was working its way through the system.

While it's no longer a topical debate, it is worth highlighting that the Fed might not have been horribly wrong with their initial transitory estimate of inflation, but rather they missed the timeframe during which that characterization was applicable. It wasn't transitory for 18 months, but it might have been 48 months, and the biggest risk, obviously, then became that during that extended period of transitory, forward wage inflation expectations were able to become embedded in the real economy, and that would subsequently risk a wage inflation spiral. Given the relatively benign nominal wage figures that we have seen so far in 2023, that seems to have taken a backseat for monetary policymakers, especially given the banking sector turmoil that developed during the month of March.

In addition to the BLS's marquee employment release, we also see the ADP figures for the month of March, which will set the stage for pricing in a consensus print on Friday. Let us not forget that Friday is also a recommended early close at noon for cash Treasuries that will compress the timeframe in which the market has to respond to the employment report. All else being equal, we suspect that that will increase the probability of an outside response to either a miss or upside surprise on NFP. It does go without saying that there's clear asymmetry around the risk for Friday's report.

A consensus or better read on the employment market will simply reinforce the market's prevailing understanding of the strength of the employment market and do little to shift forward expectations. In the event of a material disappointment or further increase in the unemployment rate however, the market would be more apt to respond sharply as that implies that the employment market was on the downswing even before any of the future ramifications from the tighter credit environment resulting from the banking turmoil have come to pass.

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. As March closes, we'll note that it's the end of the madness as we know it, and banks feel fine. Maybe.

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 4:

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