Marching On - Macro Horizons

Ian Lyngen:

This is Macro Horizon's episode 263, Marching On, 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 March 4th. And as we leave February behind, we're reminded that March has been a particularly volatile month in recent years. Perhaps there is something to this Ides of March thing after all.

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 put in an almost predictably choppy performance given the cross currents that investors had to digest. There was supply in the front end of the market that was weighted earlier, because of the timing of month end, but at the end of the day, supply came and went with a reasonable concession.

And ultimately, what set the broader tone was the setup for the core-PCE numbers. Core PCE for the month of January came in at 0.4% and that brought the year-over-year pace down to 2.8%, the lowest since March of 2021. Now, while the monthly pace of 0.4% was a marked acceleration from December's 0.1%, the reality was that the market largely priced that in ahead of time. Now, given that we had CPI and PPI, expectations if anything were skewed for a slightly higher than consensus number. So, we're content to characterize this as little more than the passage of an event risk that allowed dip buyers to come back in the market, and 10-year yield subsequently slipped below 4.25%. Now in the context of the broader price action during the last several weeks, we do consider what has been playing out in the Treasury market to be very much a consolidation in the traditional sense.

We're establishing a volume bulge between 4.25% and 4.35%, which should continue to serve as the upper end of the range as we contemplate the next several months. It goes without saying that at this stage the debate has shifted to how long the Fed can avoid cutting rates with a marginal conversation about whether or not the Fed might actually consider hiking rates another quarter point or two. We're certainly not in the rate hike camp, nor do we think that it will be materially priced in, certainly not in any tradable way. That being said, the combination of the passage of time and the resilience of the economic data will continue to push forward later and later into 2024, the timing of the first Fed cut. We're certainly sympathetic to this dynamic, and we'll note that it is very typical once the Fed has reached terminal for the market to be eager to price in the next leg of the cycle.

The recent official fed commentary has been very consistent with a wait and see stance and a collective unwillingness to respond to the strength in January's inflation data, unless and until there is confirmation from February, March, maybe even April before the Fed would really reconsider whether or not it should change its messaging of on-hold for this foreseeable future. And while risk assets might have retraced modestly from their recent peaks, we remain impressed with how well the equity market has managed to hold its recent gains. Now, this is somewhat of a double-edged sword, particularly for the Fed, because overall financial conditions have remained relatively easy. So even as real policy rates increase with the moderation of the year-over-year gains and core inflation, the prevailing financial conditions only reinforce the need for the Fed to continue to delay rate cuts.

Vail Hartman:

January's 0.416% monthly gain in core-PCE was traded as the passage of an event risk, as the inflation update was viewed as largely commensurate with the strength seen within January's core CPI and PPI data. The monthly gain marked the highest in a year and represented a sharp acceleration versus December's 0.1% monthly gain. Still, the inflation figures were remarkably in line with consensus and the year-over-year rate of core PCE ticked down by 0.1 percentage points to 2.8%, which is the lowest since March 2021, as high base effects from early 2023 continue to support the downward trend in annual inflation.

Ian Lyngen:

And that downward trend at annual inflation is important, particularly in the context of the fact that the Fed has no intention of lowering rates anytime soon. So in practical terms at least, the real policy rate is going to continue to edge higher over the course of this year. Now, in light of the fact that we have seen a strong showing on the inflation front during January, it follows intuitively that the Fed has no near term urgency to cut rates in an effort to real policy rates where they had been during the second half of last year. That being said, we are entering a potentially pivotal moment for the Fed between the March 12th release of the February CPI numbers, as well as the March 20th FOMC decision, and the opportunity to update the dot plot and the forward guidance for how many rate cuts the market should be expecting in 2024.

Ben Jeffery:

And the question on how the dot plot will or won't be revised gets at a dynamic that was especially relevant during the hiking cycle last year, specifically that as the Fed was doing its best to move rates as high as possible as quickly as possible, the Committee was extremely reluctant to use one good month of inflation data as justification to lay off their hawkishness. And instead, it was the longer term trajectory of what at that time was accelerating core consumer prices as the most important factor in setting monetary policy, and what kept the Fed hiking through July of 2023. Extrapolate that logic onto the current paradigm, and it still applies, even after taking into consideration what we saw in CPI, PPI, and PCE in January. We still have five or six months’ worth of encouraging inflationary data that's showing the effectiveness of policy rates that are well into restrictive territory.

So just as the Fed wasn't going to stop hiking in response to a single month's worth of data last year, they're not willing to meaningfully shift their wait and see stance after just one month worth of data to start this year. And indeed, we saw Bostic and Goolsbee both come out after the PCE numbers themselves and say precisely that. It would be premature to call January's data in and of itself the start of a new trend, and they still see policy rates coming lower later this year. Bostic went as far as to specify summer in particular.

Ian Lyngen:

And I do think that this entire process has rekindled the debate among market participants as to whether or not inflation is structurally higher, as a result of everything that occurred during the pandemic. Now, recall that those making the argument for a structural shift higher in inflation had very little to contribute to the broader market discourse during the second half of last year, as realized inflation began to come in line with the Fed's objective. So with this one data point, the conversation has once again shifted back to debating whether or not monetary policy works, and if it does work, how much of a lag does it occur with in an environment where R-star is arguably dynamic, or at best a moving target?

Ben Jeffery:

And even if R-star is dynamic and dynamically higher in the context of this conversation, that certainly doesn't imply that the Fed needs to keep rates well above 5% in perpetuity. And in fact, in making the rounds with clients this week, while there was relatively lighter conviction in terms of the direction of the long end of the curve for supply considerations given where breakevens are, and the overall uncertainty on the appropriate level of term premium, in the front end of the curve, as we saw two-year yields back up beyond that 4.70% level, and the entirety of cut pricing for the balance of this year dropped down to below 80 basis points, even if R-star is a bit higher, and perhaps the Fed won't cut as deeply as they otherwise would have.

The outright level of the front end of the curve has reached levels from an outright perspective, but also on the curve that are simply becoming too attractive for investors to pass up. We've also heard of some asset allocation shifting, moving out of riskier assets and taking advantage of this latest backup in yield. And I would argue even though the results of this week's front end supply was mixed, the auction results resonated with this dynamic.

Vail Hartman:

And on the topic of taking advantage of the latest backup in front-end yields, we saw a solid result at this week's two-year auction, that stopped effectively on the screws with a 0.1 basis point tail, and an above average allocation to non-dealers and indirect bidders. The five-year auction needed a bit larger of a concession, with a 0.8 basis point tail and softer bidding statistics. And then on Tuesday, we saw the seven-year auction stop through by 0.3 basis points with decent bidding statistics. All things considered, despite the dueling narratives currently at play in the rates market and the event risk posed by Thursday's core-PCE data, the results speak to still solid demand in the front end, despite the prevailing inflation uncertainties.

Ian Lyngen:

And to a large extent, one could argue that we're still in an environment with front end rates so linked to monetary policy expectations and the Fed on hold at least for the foreseeable future, that outright yields in the front end are just so attractive that they're bringing in otherwise sidelined money, which is a dynamic that isn't that surprising given everything that is going on in the broader market and the global economy. Eventually, however, one should expect that the closer we get to the first rate cut, the lower front end yields will edge. And once we do finally see the Fed choose to begin the normalization process lower, that will be an essential inflection point for the bull steepener that so many investors have been awaiting this year.

Ben Jeffery:

And also on the topic of supply more broadly, it's also worth highlighting that unlike the bulk of the second half of last year, supply and digestion worries, and the uncertainty around the marginal buyer of treasuries, given the fact that outright auction sizes are so large, have not subsided completely, but have certainly dropped on the list of factors that are dictating the outright level of treasury yields. Remember at the August refunding announcement last year, it was those larger than expected auction size boosts that kicked off the bear steepening of the curve, and ultimately got 10-year yields above 5%. And then, now that we saw in November a smaller than expected increase, and then in February a bump to supply sizes in line with expectations, and more importantly, confirmation from the Treasury Department that they don't see the need for more increases, has now left the path of fed funds, the state of the labor market and inflation as more in the driver's seat to the overall market.

Because on that question of the marginal buyer, particularly as it relates to foreign demand and the official sector, the question of when to begin taking advantage of yields at these levels was really mostly an unknown around when exactly it would be that the Fed stopped hiking, and really began to lay the groundwork for the first rate cut. Even after the data we've seen to start this year, the communication we've heard is definitively of that variety, and that represents an important inflection in terms of investor behavior from waiting on the sidelines, or maybe even selling rallies, to now looking at dips in the Treasury market as buying opportunities.

Ian Lyngen:

And there's really little on the horizon that would suggest that is going to shift anytime soon. Now, of course, we could see a re-acceleration of inflation during February and March as well, and one should expect that that would contribute to upward pressure on breakevens, that pushes nominal yields higher, perhaps to the point that potential sideline buyers simply take a step back and see how far the price action itself can move.

Now, given the price action that occurred in the wake of core-PCE, it seems relatively clear that, Vail, as you pointed out, it was more about the passage of an event risk than it was particularly defining to the broader macro narrative. We know that inflation had a strong start to the year. There are some quirks in the series. There are some reasons to expect that it might be a one-off, and until the market is convinced that inflation is re-accelerating, the path of least resistance is going to be to continue to trade the range in treasuries. And anytime we see 10-year yields back up against that 4.35%, or even 4.50% level, one would expect a reasonable amount of demand to quickly develop.

Ben Jeffery:

And overall, what the data to start this year has really reinforced is a fair amount of optimism around the durability of the soft landing narrative and the fact that the Fed will be able to deliver a series of fine-tuning rate cuts, as the labor market maybe softens on the margin while the inflation outlook continues to improve. And unquestionably, thus far, all the information we've received on the jobs front has shown very few signs of an impending inflection. However, to look at some of the underlying statistics around consumer loan delinquencies, credit cards, and autos specifically, along with what we saw in terms of consumer confidence this week, I would argue one of the only pillars, and it's an important pillar keeping the idea of a soft landing intact, is the fact that jobs growth remain solid and wages are still in relatively good shape.

It won't be until we see that dynamic really come into question, that we'll start to see the fallout of higher rates on the household basis, to say nothing of the housing sector and what remains a constrained supply environment, given that no one wants to sell a home into a mortgage rate that's now multiples of where they were a few years ago. And it won't be until the impetus of presumably a softer jobs market, that forces households to make those tough decisions to sell a home, that will start to see the more significant and unfortunately, economically ugly side of rates that are this high.

Ian Lyngen:

At its essence, Ben, you're saying that jobs are doing their job for the time being.

Ben Jeffery:

And not a bad job at it.

Vail Hartman:

So even if I show up late after the clocks change this weekend, would I still be doing a good job?

Ben Jeffery:

Vail, that's next weekend. Good job.

Ian Lyngen:

In the week ahead, the treasury market will have two primary inputs with which to contend, the first being the economic data in the run-up to non-farm payrolls on Friday, and the second is Powell's semi-annual congressional testimony. On Wednesday, the Chair speaks in front of the House and then on Thursday in front of the Senate. Now, we're not anticipating any significant divergence from the recent messaging. However, simply communicating that the Fed is on hold for the foreseeable future and not willing to look at January's inflation data as anything more than a one-off in this environment, will most likely be interpreted as less hawkish than one might would've otherwise expected. Now, keep in mind that there is certainly a contingent in the market that is drawing parallels between the first quarter of 2023 and the first quarter of 2024, and suggesting that we might be in for a re-acceleration of core inflation.

Now, in the event of such an outcome, of course, the Fed would need to recalibrate its messaging, and presumably that would come in the form of a shift in the dotplot. Recall that in December, the Fed messaged that they intended to cut rates by 75 basis points this year. If that signaling is reiterated on March 20th, it's safe to assume that the Fed is interpreting the risks of a re-acceleration of core inflation as relatively low. There's certainly the chance that the Fed could increase the Fed funds rate estimate for the end of 2024, thereby signaling 50 basis points rather than 75 basis points worth of rate cuts. And frankly, given that it's only a couple dots that need to be changed, that's a risk that should at least be on the radar. Although ultimately, we expect that it will be the February CPI series that pushes the Fed in either direction when it comes to the dotplot.

And let us not forget the series of job proxies that bring us to the BLS data. There's Tuesday's release of ISM services and the employment component, followed by ADP on Wednesday, and Wednesday morning we also see the JOLTS data. As far as payrolls itself, expectations are for roughly 170,000 jobs added to the US economy in the month of February, the unemployment rate is seen unchanged at 3.7%, and average hourly earnings are expected to post a benign 0.2%. Recall that January's average hourly earnings increase was 0.6%, which was certainly outsized given the recent trajectory, but it also served as a reminder of the potential for a wage inflation spiral.

That has been a concern for monetary policymakers and the market more broadly. It then followed that the emphasis on the super core measure, i.e. CPI  core-services ex-shelter came under scrutiny, given the fact that the jobs market remains as resilient as it has. And while employment has historically been a lagging indicator, there's nothing to suggest that the broader trajectory has begun to change.

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 for anyone else who might be looking forward to the beginning of Daylight Savings Time, March 10th is the day to spring forward. It sounds so much better than it is in practice.

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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