Don't Look Now - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 268, Don't Look Now, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery and Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of April 8th. And as the light rapidly dims, shadows become sharper, and the air chills, don't look now, or at least not directly into the sun. After all, it's only a partial solar eclipse.

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 Treasury market came in with a decidedly weak tone to start the second quarter. Part of that was a function of unwinding quarter-end demand and frankly, the initial sell-off represented repositioning in a core bond-bearish fashion as the balance of risk continues to suggest that we might see higher rates before dip buying interest ultimately overwhelms the bearish market sentiment. We remain on board with a push of 10-year yields to four and a half percent, but we think it's unlikely that 10-year yields will ultimately get back above 5%. That being said, in our recent pre-NFP survey, we asked clients where they believed 10-year yields would peak for 2024, and the answer was roughly 4.65%. That suggests that we are not alone in leaning a bit bearishly at this stage. However, it also implies that there is limited upside in yields beyond 4.50%.

The week just passed also contained a marquee data release in the form of non-farm payrolls. The jobs report was universally strong. Headline payrolls growth was 303,000 compared to the 214,000 consensus. The unemployment rate dropped to 3.8% from the 3.9% prior level and average hourly earnings increased three-tenths of a percent, matching expectations and bringing the year-over-year pace in nominal wage growth to 4.1%, down from the 4.3% seen in February. The wage component is of particular relevance given the high correlation between nominal wage growth and the supercore measure of inflation. As a result, the Treasury market sold off in the wake of non-farm payrolls but not sufficiently to truly redefine the overall trading plateau for yields. Our biggest takeaway was that the March payrolls report did nothing in either direction for the Fed. It doesn't suggest that the Fed can't cut in June, but it certainly suggests that there's no urgency, at least not in the context of the prevailing labor market momentum.

This implies that the June decision is ultimately going to come down to what happens with CPI over the course of the next three prints. Recall that we get March, April, and May's data before the June 12th FOMC decision. We came into 2024 expecting that the combination of the passage of time and the resilience of the economic data would continue to push rate cuts further and further out on the horizon. And to a large extent that is what has occurred. The caveat being that Powell continues to signal that we will have three rate cuts this year and therefore from the market's perspective, the debate really has become about the departure point for those three rate cuts and to a lesser extent whether or not the Fed will ultimately need to revise three cuts into two cuts, which will allow them to start later in the year.

Vail Hartman:

For any apprehension that may have been instilled on the outlook for the labor market as a result of the FOMC's more balanced approach to the dual mandate, the March payrolls report certainly may have alleviated some of that anxiety as payrolls growth grew at the fastest pace since May 2023 and the unemployment rate ticked back down to 3.8%, leaving the onus on this week's CPI data to offer the next critical piece to the policy puzzle. Although we're doubtful the information will completely resolve the ongoing debate about the timing of rate cuts in 2024.

Ian Lyngen:

It certainly won't completely resolve the timing of the first rate cut for this cycle, but it could offer convincing evidence that June might be too soon. It wouldn't be unreasonable to see another 0.4% or even a 0.5% on core-CPI and in such an outcome, it will be very difficult to justify assuming that the Fed is going to cut in June unless there is a concerted effort made on the part of monetary policymakers to talk the market back into that assumption. All that being said, the consensus is for a 0.3%, there's a chance we get a 0.2% and if it comes in that range, that leaves the door wide open for a June rate cut. It's also important to keep in mind that as we contemplate the first move of the cycle, one needs to be cognizant of the timing of the election. And while that doesn't necessarily leave June as the only option, the Fed could also go in July, the reality is it'll be very difficult for Powell to justify cutting in September immediately ahead of the presidential election.

Ben Jeffery:

And as the jobs numbers hit, there was really something for everyone and nothing for anyone. Within the figures themselves, sure, headline hiring was very robust, as you touched on, Vail, but average hourly earnings matched consensus. We had a higher participation rate with a lower unemployment rate along with some of the revisions that frankly, didn't do much to change the prevailing assumption both within the market and on the FOMC concerning the state of the labor market.

And so in keeping with the idea that it's going to be CPI, that's really the next important input to consider, all NFP did was buy the Fed another month of a solid jobs landscape and further diminish any urgency to quickly start bringing rates lower. Now that doesn't negate the messaging we've heard from Powell and others, some of the political aspects that you've touched on, Ian. But as we watched 10-year yields reach new year-to-date highs this past week, the push and pull between continuing to press rate cuts out while also grappling with the question of if this latest sell-off is a buying opportunity has left 10-year yields higher, sure, but not meaningfully so.

Ian Lyngen:

And that does lead us back to the current debate whether or not the 10-year yield is going to push above 4.50%, and if it does, how far it can extend. We're certainly on board with leaning into the seasonality in the Treasury market, which favors higher rates during this period, but ultimately expect that we will reach a plateau that brings in buying interest and eventually rates will grind lower into the end of the year.

That being said, and to return to an observation that you made, Ben, the solid jobs data certainly pushes out the timing of presumed rate cuts. It doesn't put a rate hike on the table, but it does beg the question, what happens if inflation proves stickier over the course of the next three months, but the jobs market remains just as resilient? Will the Fed actually need to cut at all in 2024 and more specifically, how would the Treasury market respond to such an eventuality? Our assumption is that if both inflation remains sticky and the jobs market remains strong for the first half of the year, we will find ourselves in an environment where we have a renewed focus on supply, deficit spending, and positive term premium, and this will trigger a bear steepening comparable to what we saw during the third and fourth quarter of last year. Now, this isn't our base case scenario by any means, however, it's notable that it would nonetheless be a steepener.

Ben Jeffery:

And the steeper curve argument in the bull and bear case is also reflected by what we saw in terms of the price action in the front end of the curve this week. Specifically that even as rate cuts are priced out even in response to a solid jobs print and the other uncertainties and unknowns that are currently driving the price action, two-year yields really haven't moved all that much, remaining well within striking distance of that 4.70 level as we now have fewer than 75 basis points of cuts priced in for this year with another 75 give or take next year.

And as long as the data for the time being conforms with the soft landing narrative and allows the Fed to continue pushing out rate cut assumptions month by month along with each new two-year note month by month, what this translates to is an increasingly durable level of yields in the two-year sector, even as tens and thirties have become far more responsive to the incoming new information. So to say it differently, the shape of the curve has become more of a function of the outright performance of the long-end and a bear steepener, as you touched on, Ian, with flight to quality risk or any slowdown shock that's probably not enough to get the Fed to cut earlier, translating to a bull flattening impulse. And that resonates with the range we're looking at in 10-year yields between, call it 4.10% and 4.50%.

Vail Hartman:

In transitioning to the official communication front, not only will it be another busy week of Fed-speak, in the wake of Wednesday's CPI release, investors will receive the Minutes from the March 20th FOMC meeting. And while the information won't take into account March's NFP and CPI data, the data will nonetheless be factored into investors' forward monetary policy expectations. Now we're of the mind the Minutes will be perceived as more balanced than was implied by the SEP's retention of the 75 basis point rate cut messaging and Powell's dovish tone at the press conference. Recall only one dot made the difference between a 50 and 75 basis point rate cut estimate, and there was a far greater contingent of the committee anticipating 50 basis points or fewer of rate cuts in 2024 as opposed to more than 75 basis points of cuts. Now, this outlay of rate cut estimates this year suggests that any skew in rhetoric within the Minutes will more likely suggest the June FOMC is too soon of a departure point for rate cuts versus the contrary.

Ian Lyngen:

That's a very good point, Vail. The one caveat that I would add is that we can still get to an aggregate of 50 basis points' worth of rate cuts this year starting in June, with the second one in December. That means that the Fed won't be reducing rates immediately ahead of the election as well. That's just food for thought as we think about the debate between 50 and 75 and the fact, as you point out, that there was the downer dot that really got us to 75.

Ben Jeffery:

And policy path is going to be in focus within the Minutes, as it always is. But remember what we also heard from Chair Powell at the March press conference in that the discussion around the form tapering QT is going to take was underway at last month's meeting. And so as a medium to disseminate some of the information and offer some clarity around how the committee is going to approach the first steps of slowing its balance sheet rundown, it's also a reasonable assumption that the minutes on Wednesday are going to shed some light around just how the FOMC is going to want to slow the pace of the balance sheet rundown. The details we're going to be on the lookout for, of course, include size and pace of the slowing. Will it be carried out over the course of a quarter, two quarters, maybe longer?

All else equal, given how well the discussion has already made its way into the market, we'd be biased toward a bit larger and a bit faster slowdown of QT, but we'll hold off on a strong conviction call in that regard until we get the new information on Wednesday. There's also an argument to be made and an idea that's been floating around about the potential for a larger Fed ownership of the very front end of the market. Remember, Governor Waller mentioned he would like to see SOMA hold a greater share of bills. And while that's certainly something that central bankers will probably continue to debate over the next few months, maybe look for something in that regard at Jackson Hole, we think this early in the tapering discussion, broad strokes will probably be what prevails.

Vail Hartman:

And on the supply front, this week the bond market will be tasked with taking down 3s, 10s and 30s. And heading into the liquidity points, I think it's been notable that nominal coupon supply has been generally well received since the March FOMC meeting. Recall the late March two-, five-, and seven-year auctions all saw elevated indirect bidding stats and solidly above average non-dealer participation. These results spoke to strong ongoing demand for treasuries in the primary market, despite the concessionary implications of growing supply and a fair degree of uncertainty that remains on the monetary policy front. Now, as rates continue to trade at the year-to-date peaks in the wake of the NFP release, it will be telling to see if the recent trend in bidding statistics is extended through the coming weeks' supply events.

Ian Lyngen:

So just to summarize. Key takeaways, supply...

Ben Jeffery:

CPI...

Vail Hartman:

Oh my.

Ian Lyngen:

In the week ahead, the Treasury market will have one marquee data point to effectively define trading for the course of the next several weeks. Obviously, this comes in the form of the core-CPI numbers for the month of March. As it currently stands, the consensus is for an increase of three tenths of a percent on a month-over-month basis. Now, this will be an improvement versus the four tenths of a percent seen in January and February, but certainly not back to the 0.2% that would provide definitive confirmation that inflation is back on a trajectory that's consistent with the Fed's objectives. The passing of the event risk represented by non-farm payrolls really does leave the market solely focused on the trajectory of inflation. And so it follows intuitively that the tone for the next several weeks will be set on Wednesday.

We do, however, have supply for the market to contend with, $58 billion 3-years on Tuesday, $39 billion 10-years on Wednesday, and $22 billion long bonds on Thursday. We continue to expect that the auctions will go reasonably well, particularly in light of the outright level of yields at the moment. Said differently, we are anticipating some type of auction concession either outright or on the curve, but even at current yields, the liquidity offered by the auctions will bring in sufficient interest.

Returning briefly to the inflation data, the supercore measure, which is core services ex-shelter, will be the focal point for monetary policymakers, and we suspect to some degree, also for the response in the US rates market. Now, February did show a moderation in the supercore series that we expect will be furthered in the month of March. Part of what's been driving the core inflation numbers has been stickiness in housing inflation, specifically OER in January was much higher than trend and much higher than the market was expecting. It will be notable if those numbers continue the trend of moderation that appears to have started in February.

Let us not forget that on Wednesday afternoon, we'll also get the FOMC meeting Minutes from the Fed's March decision. The fact that there were very few changes to the statement itself really suggests that it was the combination of Powell's press conference and the updated dot plot that drove the market's bond bullish response. The Minutes could reveal a further discussion about the tapering of QT, if there are any thresholds that the Fed is looking for, whether that's in the form of RRP or repo rates on an outright basis remains to be seen. Of course, the market will be very interested in any nuances the Fed is willing to provide in regard to their reaction function to the realized data.

The implicit question is whether or not the Fed views a series of 0.3% core-CPI prints as sufficient to start the process of normalization, or if the committee will need 0.2s or 0.1s. Now obviously, the details of the minutes won't reveal that degree of specificity. However, we will be looking for any insight that will allow us to better gauge how close we are to the Fed truly being convinced that inflation is back on track to reach target.

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. Ahead of the upcoming auctions and in the spirit of spring-cleaning, we decided to dust off the classic adage, there's no such thing as a bad bond, just a bad price.

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:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For a full legal disclosure, visit bmocm.com/macrohorizons/legal.