Early Spring? - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 259, Early Spring, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring your thoughts from the trading desk for the upcoming week of February 5th. Friday was officially Groundhog Day, again for Bill Murray, and as Punxsutawney Phil didn't see his shadow this morning, we are looking forward to early spring and fewer opportunities to injure ourselves on the slopes.

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 had a vast array of new information to digest, starting with a refunding announcement from the Treasury Department that showed as-expected auction size increases and suggested that these will probably be the last for the foreseeable future, the 10-year is now at $42 billion and the 30-year is at $25 billion. We also saw some increases in TIPS and front-end coupons.

It was interesting to note that the Treasury market rallied into the event and out of the event suggesting that at least to some extent the auction increases were fully priced into the market. Although the proximity to Wednesday afternoon's FOMC events surely muddied the water of interpretation to some extent. The Fed came out in-line with expectations; they didn't cut the fed funds rate and as a theme, Powell's press conference suggested an emphasis on flexibility and delaying the first rate cut of the cycle as long as possible. He very specifically said that a March rate cut was not their base case scenario. We then saw a very strong non-farm payrolls print on Friday, which only served to reinforce this notion that the Fed won't be cutting rates next month. In terms of the details of the employment report, headline payrolls gained 353k. That is the highest since January of last year.

Recall that there are strong seasonal factors at play in the January data. We also got the benchmark revisions, which included bringing December notably higher, which now shows a gain of 333k jobs. That was revised up from the prior 216k. The unemployment rate was unchanged at 3.7% compared to expectations for an increase to 3.8%. And overall it was a convincingly strong jobs update, which primarily served to reinforce the notion that the employment landscape remains resilient and that affords the Fed a great deal of flexibility in delaying rate cuts. In addition, we also saw a stronger than expected average hourly earnings component within the BLS data. For the month of January, wages gained six tenths of a percent. That's the highest since March of 2022 and compared to the consensus, which was just three tenths of a percent. As a result, the year-over-year pace increased to 4.5% from the prior level of 4.3% and well above the 4.1% consensus.

On the margin at least we would not be surprised if this rekindled concerns about a wage inflation spiral. Now with the backdrop of all of this potentially bond bearish information, it remains notable that 10 year yield is effectively anchored to 4%. The one set of bond bullish developments that define the week just passed came in the form of a renewed concern regarding the regional banking crisis. There were write-downs taken by a couple smaller banks that reiterated the notion that there might still be trouble to come in the commercial real estate sector. Now in drawing the comparisons to the current environment versus where we were in March of 2023, it goes without saying that the Fed is in a different place. We've seen more significant progress made on the inflation front, and in the event of a comparable event to March of last year, the Fed might find itself more willing to offer a policy response. That being said, there's little to suggest at least thus far that this issue is poised to spiral into the broader banking sector and requires such a response from the Fed.

Vail Hartman:

The week just passed contained no shortage of critical developments for the outlook for Treasury issuance, the economy, and monetary policy. On the supply front, there a funding announcement ushered in another quarter of growing coupon auction sizes at a pace that mirrors that which was seen in Q4. The Treasury also said it doesn't anticipate it will have to make any further increases in nominal coupon auction sizes, at least for the next several quarters. On the policy front, the FOMC walked back some of the market's aggressive rate cut pricing with the statement saying the committee does not anticipate it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%. And then at the press conference, Powell doubled-down on the no rate cut messaging by saying he doesn't think it's likely the FOMC will have reached a level of confidence by the time of the March meeting to deliver a rate cut.

And on the data front, we saw a very strong payrolls print on Friday with headline hiring gaining at the fastest pace in a year at 353k jobs versus the 185k consensus, with an unchanged unemployment rate at 3.7%, and average hourly earnings at 0.6% and the highest since March 2022.

Ian Lyngen:

Vail, you make a great point. There's a lot of strong economic data that came out coupled with a less dovish than anticipated takeaway from the combination of the FOMC and Powell's press conference. However, we did see a solid rally in the middle of the week based largely on a revisit of the regional banking concerns that were so topical in March of 2023. So it's unsurprising in the context of these cross currents to see the 10-year yield close to 4%, but what remains to be seen is just how sustainable that level actually is. We do have supply on the horizon, and while this might be the last quarter of auction size increases that we'll see for a while, that doesn't mean that there won't be some degree of a concession priced in to accommodate the supply. What I think will be interesting is to see how that translates into the shape of the yield curve.

All else being equal, we'd expect a bear steepening to price in a little bit more of an auction concession, but with the backdrop of the very strong employment report combined with less reluctance on the part of investors to roll forward rate cut expectations into the second quarter, one should expect some further weakness in the two-year sector. So as a marginal offset to the steepening pressure that we typically expect, we'll be watching the front end of the curve and the variety of Fed speak that will be on offer at the beginning of the week, to say nothing of Powell's interview on Sunday with 60 Minutes.

Ben Jeffery:

And to think about what was obviously one of the big trends in 2023 in the return of term premium given the larger than expected increases at the August refunding announcement. It wasn't just supply in a vacuum that caused that bearishness, which at the time happened to be steepening in nature, but we’ll argue just as important as the supply increases themselves was the macro backdrop at the time and what was unquestionably hopes of a soft landing, still strong jobs growth, and a policy rate environment that was expected to remain elevated for an extended period of time. Fast-forward to the start of this year and what we heard from Powell on Wednesday combined with an unquestionably strong payrolls print along with a strong conclusion to 2023 in terms of growth, and there really hasn't been a great deal that's changed in terms of the optimism around the potential for a soft landing.

Even the flare up of banking concerns that you touched on, Ian, is probably not as consequential as it was last year if only given the fact that the Fed has an impressive track record of containing financial risks. This all means that along with the front-end of the curve that still has room to price out rate cuts, there's probably capacity for marginally higher rates from here given how far we rallied during January.

Ian Lyngen:

On the topic of the front end of the market, it was interesting that we didn't hear a great deal from Powell regarding the potential for tapering QT. Now, ultimately I expect that we'll get more details regarding the balance sheet and the potential for slowing the runoff of SOMA via the minutes from this meeting. That will provide the perfect communication tool for the Fed to outline in a bit more detail how they see slowing the process. Now, whether or not that becomes a March announcement or later to some extent depends on the data, but it also depends on how the very front of the market continues to function. We've been watching RRP, which is now down to just $503 billion as a key indicator for the timing of a QT tapering announcement. Our assumption is that the Fed will have increasing funding urgency once the RRP dips below $200 billion.

Ben Jeffery:

And on the topic of QT tapering and when that might ultimately play out, also within the details of the refunding announcement, we saw an explicit emphasis by the Treasury Department on the reality that changes in the Fed's balance sheet are going to have issuance implications. And while given the overall size of the deficit, $200 or $300 billion in additional SOMA rollover is not necessarily the variable at the top of the list that's guiding the Treasury Department’s decision making. But now that the groundwork is clearly being laid for a slower pace of the balance sheet rundown, the Treasury Department was comfortable delivering an as-expected round of auction size increases with that specific forward guidance that you touched on, Vail, that they don't see the need for further coupon auction size increases.

So really what this means is that as a feature of the overall composition of the Treasury market, bills occupying a larger share of the overall market will be here to stay. And while on the margin that might stoke supply concerns in the front end of the curve, there's been nothing we've seen in terms of bill auction results or performance in the secondary market that implies there's any material indigestion in the shortest part of the curve.

Ian Lyngen:

On the topic of supply indigestion, we were just looking at the investor allocation data from the Treasury Department for the 10 and 30 year auctions. What struck me in this regard was the fact that there had been a perception that as the Treasury Department's borrowing needs increased, that the primary dealer community would be called upon to underwrite an increasing share of the overall supply. And the fact of the matter was that while there were a few auctions that saw strong dealer participation, as a theme it was the investment fund category that grew in terms of overall awards. So in practical terms, this dovetails well with the narrative that 2022 and 2023 were spent chasing the marginal buyer in the Treasury market. And that went from being less price sensitive official money to some of the most price sensitive and sophisticated investors in the market, which explains to some extent why the conversation around term premium has become so topical.

Vail Hartman:

And despite any concessionary implications from the growing auction sizes, there are several factors that point to solid demand in the week ahead. First, the significant backup in rates on the back of NFP could help emboldened dip buyers at the events themselves. And there's also a very light data calendar in the week ahead, and the lack of event risk could help leave enough room for an intraday concession leading up into the events themselves. And there's also the fact that regardless of which meeting the Fed ultimately delivers the first cut this year, the fact that it's effectively a foregone conclusion that the Fed will be lowering rates in 2024 could help bring stronger demand to the auctions themselves. And on the bullish side, the renewed concerns over lingering contagion from the series of bank failures seen during March 2023 could bring stronger demand after we've already seen those developments disproportionately benefit tens and thirties in the week just passed.

Ian Lyngen:

There's also another event in the week ahead that's worth at least putting on the radar, and that's the CPI revisions that come out on Friday morning. Now, typically these type of revisions are not a very big deal to the Treasury market, particularly given the fact that they're dated. But given the focus on inflation during this stage in the cycle and the perception that the Fed has been successful in their campaign to reestablish price stability, any evidence that inflation is either decelerating more quickly than the market currently perceives or some aspects of the core inflation series are stickier than the current prevailing wisdom implies, that could in and of itself be a catalyst for a new conversation around a Fed rate cut in March or a delay beyond even the May meeting, putting June squarely in focus. Again in light of the fact that it is a definitively data light week, CPI revisions will be afforded a larger role.

Ben Jeffery:

And as we continue to think about the timing and form of the ultimate rate cuts that are delivered this year, the outright level of inflation, including the upcoming revisions, is a critical component of the Fed's rationale around bringing policy rates lower even before we've achieved the 2% inflation target. And that's purely a function of the real level of policy rates that as inflation continues to moderate the level of restrictiveness of effective fed funds at 5.33% goes up. And so, especially as the Fed becomes cognizant of just how long rates need to stay this high, if for example, inflation was lower last year than we thought it was, that means that real policy rates were that much more restrictive. And so in contemplating the motivations behind fine-tuning rate cuts, given such a strong economy, the impact that moderating inflation has on the real level of restrictiveness, real wages, and real growth all need to be taken into consideration as a derivative of the trajectory of consumer prices over the next few quarters.

Ian Lyngen:

Well, Ben, way to keep it real.

Ben Jeffery:

Only way I know how.

Vail Hartman:

Wait, there's no TIPS auction this week.

Ian Lyngen:

In the week ahead. The treasury market will have a lot of incoming information to digest, not least of which being Powell's interview on 60 Minutes over the weekend. We also have Monday's release of the Fed's senior loan officer opinion survey. Recall that in the wake of the regional banking crisis last year, investors anticipated evidence of tighter credit conditions to be revealed by this survey. The fact that that didn't materialize, certainly not in any meaningful way, has to some extent de-emphasize the relevance of the release. That being said, the recent pickup in regional banking concerns will at least make the senior loan officer opinion survey a market event, even if it ends up providing no tradable information. We also hear from a variety of other Fed speakers, which we anticipate will only serve to reinforce Powell's messaging at the press conference, i.e. a March rate cut is very unlikely.

In fact, the January payrolls data makes a March cut all that much less likely. Let us not forget that we do see a fair amount of supply hitting the market. We have $54 bn 3-years on Tuesday. We have $42 bn 10-years on Wednesday, and there's $25 bn new 30-years hitting the market on Thursday afternoon. As a theme. We continue to like the flattening trades, particularly in 2s/10s in the wake of the payrolls data. This spread got to -40 basis points going through our initial target of -35 bp. As we continue to anticipate that monetary policymakers will push back against the March rate cut odds that are being priced in which at this point are less than 25%, it's difficult to want to buy the two-year sector, even though we're cognizant that investors are simply shifting their focus of the rate cut from the March meeting to the May meeting, we remain in the June rate cut camp.

And that suggests that the passage of time and continued confirmation that the employment market remains resilient will simply serve to roll forward investors' expectations for the beginning of the rate cut cycle. In terms of next levels for 2s/10s, it is very reasonable to expect a retest of negative 40 basis points with the potential to settle in a range of negative 40 to negative 50 basis points. We are hesitant to suggest that the January payroll's number was a game changer per se. Instead, it simply extended the runway that the Fed has to engineer a soft landing.

In terms of outright yield levels, the 10-year sector is comfortably anchored to 4%, and while we do see the potential for a backup in yields to accommodate supply, which would be a marginal curve steepener, or serve to offset that inversion momentum that we see, at the end of the day, it will be very difficult to get 10-year yields back to 4.20% or 4.25%. And in that event, we would expect investors to view such a backup, particularly on supply concerns as a buying opportunity. 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 the refunding expected to be the last auction size increases for the foreseeable future, we reminded that auctions bring out buyers and the days of assuming that they'll make more are coming to an end, although there are still trillions in certified pre-owned inventory in the market.

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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