Inflated Expectations - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 260, Inflated Expectations, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery and Vail Hartman, to bring you our thoughts on the trading desk for the upcoming week of February 12th. And with CPI released on the eve of February 14th, the only question remaining is whether investors will see a sweetheart print or a Valentine's Day Massacre. 1929 was a very bad year, particularly for bootleggers in Chicago. Google that, Vail.

Each week, we offer an updated view on the US rates market, and a bad joke or two. But, more importantly, this 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, it was largely expected to be a placeholder of a week, at least from a macro perspective. We did get supply, and the benchmark of all benchmarks, the 10-year auction, came with a modest stop through, which was constructive if for no other reason than it was a record large $42 billion issue. Now, it's important to keep in mind that the Treasury Department has made it clear that this quarter's auction size increases will most likely be the last for the foreseeable future. Now, that doesn't mean that by necessity the next move is going to be lower, but if nothing else, we have several quarters in which we can expect this to be the status quo.

This contributes to the broader theme of market participants awaiting a moment of stability, both in terms of monetary policy expectations as well as Treasury issuance. Now that it's clear that the Fed has done hiking rates, and if anything, the debate is an active one about when to start cutting, and Yellen has told us that auction sizes are done increasing, it follows intuitively that many investors are viewing this as an all clear to add duration exposure. Now, we'll argue that such a dynamic was what was responsible for the absence of a more meaningful supply concession. Particularly as we didn't see any massive buying immediately following the auctions.

With the backdrop of ongoing concerns related to the regional banking crisis, attention was paid to the release of the Senior Loan Officer Opinion Survey on Monday. Interestingly, the survey showed no compelling evidence of tighter credit standards. And, in fact, 85% of respondents said that credit conditions were effectively unchanged. Now, this certainly bodes well for monetary policymakers as it shows little need to potentially respond to any of the headlines or concerns related to the regional banks at this moment. Now, this will remain a background factor as we move through 2024. But for the time being at least, investors appear content to view the situation at the New York Community Bancorp as idiosyncratic. And therefore assume it doesn't pose a systemic risk, which has generally been the takeaway from monetary policymakers.

In terms of the incoming Fed rhetoric, one of the more notable shifts has been the reintroduction of the notion that r-star might, in fact, be higher post-pandemic. Now, this was floated by a few Fed speakers, none of them being Powell. And if anything, we're simply viewing this as another touchstone for monetary policymakers to point to as a reason to delay cuts as long as possible. We have seen the probability of a March cut be reduced significantly over the course of the last several weeks. And we're certainly on board with that. We remain in the June rate cut camp, with a nod to the fact that May might come to fruition in the event that we see a far more material deceleration of the economic data than any sign of material weakness on the jobs front. That being said, the magnitude of the January upside surprise on non-farm payrolls has bought the Fed a significant amount of leeway in terms of pointing to the resilience of the labor market as a reason to avoid cutting rates.

Now, with this backdrop, the inflation profile is, and will remain, relevant. However, the trajectory of the real economy gives Powell a great deal of flexibility. And, therefore, we expect that that will be utilized to keep fed funds at the terminal rate well into the second quarter.

Vail Hartman:

The range trade remain largely intact over the past week in the Treasury market, as supply, and a variety of Fed speak, took center stage. The largest 10-year auction on record was well received, with a 0.9 basis point stop through, and elevated non dealers and indirect bidding stats. And the offering showed virtually no sign of supply indigestion. On the Fed communication front, there was an array of policymakers who reinforced the prudence of awaiting confirmation that inflation is on a decided downward trajectory before commencing the cutting phase of the rate cycle.

Ian Lyngen:

And, Vail, when you say array, you do not mean a ray of sunshine, particularly for the bond bulls. In fact, what we got was a reintroduction of the debate regarding whether or not r-star is actually higher in the wake of the pandemic. Now, from one perspective, we're certainly sympathetic to the idea that the Fed would like to reintroduce this conversation. Because it makes it much easier for Powell to delay rate cuts if, in fact, there is uncertainty about precisely how restrictive policy has been over the course of the last 12 or 18 months. On the other hand, and this is the more troubling aspect of the shift in tone from monetary policymakers, some investors are interpreting this as potentially opening the door to revisit the 2% inflation target. Our baseline assumption is that, for all intents and purposes, there is no way that the Fed opens the conversation about raising the inflation target until Powell proves that he can reestablish 2% for a protracted period of time. So in practical terms, that means any real conversation about revisiting the inflation target won't be until 2026 or beyond.

Ben Jeffery:

And the r-star debate, whether or not it actually is higher on the other side of the pandemic, was certainly something that was making the rounds last year, as the Fed hiked through a regional banking crisis. And the market struggled with the question of whether or not higher rates would actually be effective at curtailing demand and bringing core inflation lower. Now, I think all three of us would agree that we have enough disinflationary evidence over the course of the last six months or so that the effectiveness of higher rates is no longer really in question. So this then leads to the line of thinking of, if, in fact, r-star is higher on the other side of the pandemic, what does that mean for the shape of the curve, steeper or flatter?

I'd make the argument that we can't really have that debate without taking into consideration where policy rates already are. And what I mean by that is had the Fed acknowledged that maybe r-star is 25, 50, 75 basis points higher from a departure point of policy rates at 2.5% or 3%, that would put rate hikes back on the table as the actual restrictiveness of policy came into question and probably be a flattener. However, we know policy rates are at 5.50%, and the Fed has aims to keep them there for as long as possible. And I would argue there is no one on the committee that thinks r-star is multiple percentage points higher, which means that fed funds well above 5% is still very restrictive. And that means we're not going to be talking about rate hikes. Cuts, yes. Hikes, no. And that means the r-star conversation is probably more impactful for the long end of the curve, given what it means about inflation, as you touched on, Ian.

Ian Lyngen:

One complicating factor is the balance sheet. And I'll argue that the Fed has done a bit of a disservice to the market by focusing on r-star, rather than broadening the conversation to include a combination of the size of the Fed's balance sheet, the trajectory of SOMA, as well as real policy rates. Because as we saw in 2023, during the first half of the year, the debt ceiling debate left the Treasury Department in a position where, as it ran down TGA, it was effectively doing QE, thereby offsetting the Fed's QT. Add on top of that the regional banking crisis, which triggered a new funding facility, and the Fed itself was engaged in QE at a point when, more broadly, QT was warranted. Fast-forward to the middle of the year, and everything shifted in favor of QT. We had a rebuild in the TGA, which led to an increase in bill issuance. SOMA runoff continued apace, and utilization of the Bank Term Funding Program stabilized.

It's not wasted on us that during the last six months of 2023, that's when inflation finally started to move in the direction that the Fed wanted to see. And while recent commentary from Powell, and other Fed members, suggest that six months of good inflation won't be enough to start rate cuts, the fact that it did correspond with what I’ll characterized as supercharged QT, means that the r-star argument might be a moot point. Especially when you put this all in the context of ongoing equity market performance, which has weighed on equity volatility, and put easing pressure on financial conditions, more broadly.

Ben Jeffery:

And, Ian, you touched on the BTFP and what the balance sheet means for the banking sector. This week also offered another reminder of the Treasury market's sensitivity to banking sector headlines. And what volatility, within regional lenders, means for the path of yields, even if the volatility was relatively well contained within the current trading range. Recall, coming into this year, Dallas Fed President Logan was talking about the potential for an earlier taper of QT, given the fact that the Fed is going to want to err on the side of more reserves, rather than less. And the fact that we're starting to see funding rates, such as SOFR, begin to pick up on calendar dates and begin to behave in a more historically normal way, AKA not a super abundant reserves regime, has been the primary motivator behind the earlier QT tapering conversation. And an extension of the general theme we've seen, which is that the Fed wants to do its absolute best to separate the stance of monetary policy, and the tools that are in place, and have an impact on the financial system.

And we also heard from one of the directors of SOMA this week, Julie Remache, that there's no reason RRP balances need to fall to zero. And it's unlikely that the balance sheet is going to return to pre-pandemic levels. So while SOMA will surely continue to attract a lot of the market's focus, and much investor discussion, it's probably never going to go back to its previous size. And that's going to be a semi-permanent feature of the central banking landscape for the foreseeable future.

Ian Lyngen:

And let's face it, the balance sheet was never going to be its pre-pandemic size, simply because nominal GDP grew as much as it did in the wake of the pandemic. But even as a percentage of GDP, it does appear that the Fed is content to allow the balance sheet to run at a higher level than it has previously. Now, it will be notable to see if and when the Fed attempts to make any adjustments to the composition of its balance sheet.

We know that the Fed doesn't want to be in the business of owning bonds, but we certainly know that the Fed doesn't want to be in the business of owning mortgages. The Fed has clearly been a reluctant buyer of mortgages in the past. And while in an emergency environment, it does follow intuitively that the Fed's attempt to add liquidity to the market would include mortgages. But in a more normal, or in a normalizing environment, that composition can be open for debate. That being said, we don't think that that's going to be adjusted in the very near term, although it wouldn't be surprising to hear that conversation start to make the rounds, at least on the margin.

Vail Hartman:

And after the recent regional banking drama, this week, we received another reminder of a potential risk off trigger, after Yellen mentioned that the commercial real estate sector poses significant financial stability risks, due to the combination of lofty borrowing costs and high vacancy rates in commercial real estate. It is notable that Yellen and Powell agree this is a sizable issue, but a manageable one, leaving this an important space to watch in the coming weeks and months.

Ian Lyngen:

Manageable, yes, up until a point. Recall that the nature of the commercial real estate market is that the maturity profile tends to be chunky. And we know that it's weighted heavily in 2025. So as long as we are able to find some semblance of stability between now and the middle of next year, it's manageable. But if we still have very high vacancy rates, combined with elevated real borrowing costs, we might be in for a bigger issue in the commercial real estate market than we've already seen. To a large extent, operators are able to keep valuations where they are, as long as there's not a transaction that causes a large portion of commercial real estate holdings to be marked to market. That's the biggest risk.

And while we haven't seen that come to fruition yet, the Signature Bank holdings highlight what is appropriately being characterized as an idiosyncratic risk, specific to rent controlled apartments in and around the New York City area. That was what caused the bulk of the hit to the Signature Bank portfolio. And that proved to be a microcosm of the mark to market pricing that the broader commercial real estate market is, rightfully, nervous about.

Ben Jeffery:

And all of this with the backdrop of 10 year yields that have pulled off the earlier extremes, in no small part as a function of the Fed's pushback against the rate cut in March, along with the payrolls report that confirmed another month of a still strong labor market. But, nonetheless, in thinking about some of these risks, and the fact that the next policy rate move is going to be lower, not higher, this all suggests that a critical difference between 2023 and 2024 is the fact that the global investor base in treasuries is shifting from a disinterest in increasing Treasury exposure toward a greater willingness to buy dips. After all, we know supply is going to remain steady for the next several quarters, at least, if not beyond.

And for those that missed the buying opportunity presented by 5% tens, and then 4.50% tens, we don't think it's likely the market will pass up on an opportunity presented by another selloff. So 4.25% 10-year yields, very achievable, maybe even something slightly beyond that. But given the change in the prevailing macro wins from last year versus this year, it seems unlikely that we're going to, once again, get a wholesale shift higher in the level of rates and deepening inversion of the curve. It doesn't mean it won't be a choppy path to get there, but it increasingly appears that bull steepening is going to be the longer term path of least resistance.

Ian Lyngen:

So our takeaway from the last couple of weeks of price action is, if you liked them at 4.50%, you'd love them at 4.25%, but you're indifferent at 4%.

Ben Jeffery:

Is 2s/10s positive – Yet?

Ian Lyngen:

Staying positive.

In the week ahead, it all comes down to Tuesday's core CPI numbers. Expectations are for the core CPI to have increased three tenths of a percent on a month-over-month basis in January. Now, this mirrors what we saw in December. And as with December, the consensus is for a low 0.3% or a high 0.2%, which means that there could potentially, once again, be downside risk on the year-over-year numbers. All of that being said, conversations regarding real monetary policy rates remain relevant. And the base effects that are going to be evident in the inflation series over the course of the coming months will put further upward pressure on real policy rates. Begging the question of whether or not this will function as an offset for the Fed's stubborn policy stance at terminal. Our baseline assumption is that it will not. However, it will serve as an offset to the fact that overall financial conditions remain markedly easier than they were in the third and fourth quarter of 2023.

If nothing else, monetary policymakers can take solace in the fact that overall financial conditions might remain easier than they would've otherwise anticipated because of the equity market performance. But real policy rates have, and will continue to do, a fair share of the heavy lifting for the Fed.

Other events in the macro horizon include Thursday's release of retail sales. Consumption is seen up two tenths of a percent on a monthly basis, which falls squarely into the category of good, not great. Although, in light of the overall strength of consumption that we saw in the fourth quarter, even a modest give back in the first quarter would be easily explained away as spending having been brought forward to the end of last year at the expense of the beginning of 2024. More importantly, monetary policymakers, and the market more broadly, would be reluctant to extrapolate anything meaningful for 2024 as a result of a softer consumption profile at the beginning of this year.

There's plenty of Fed speak on the docket for the week ahead, including Kashkari, Goolsbee, Barr, and Daly, as well as Bostic. We do expect that we will see a reiteration of the ongoing messaging regarding delaying rate cuts as long as possible. And as we get closer to month-end, and the release of the February employment data, it will be useful to see how the incoming official commentary characterizes the Fed's apathy towards any weakness on the data front in the context of having already, for all intents and purposes, taken a March rate cut off the table. Surely, the Fed would like to be viewed as data dependent at the moment. But in light of Powell's comments that a March rate cut is not their base case scenario, the bar is very high to get the Fed to move on the 20th of March.

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 as we prepare to watch the 49ers and the Chiefs meet on the gridiron, we'll confess that it's really the beloved Clydesdales that we expect to gallop to victory.

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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