Marking Milestones - Macro Horizons

Ian Lyngen:

This is Macro Horizons Episode 300: Marking Milestones, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of November 18th. And as we've finally reached our 300th episode, we're tempted to start rolling the odometer backwards, making next week's episode 299. Alas, that didn't work in Ferris Bueller's Day Off, and we're skeptical that it will afford us that new podcast smell.

Each week we offer an updated view on the U.S. 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 got a lot of new information from which to derive a trading direction, and nonetheless, the primary theme that emerged was one of consolidation with 10-year yields between, let's call it 4.35% and 4.48%. Now obviously this is an important range because it also encompasses the response to the election and the modest bid that occurred in its wake. Core CPI came in largely in line with expectations. There was perceived to be the potential for an upside surprise that didn't come to fruition, and when combining core CPI, core PPI, and the import price data, the market appears comfortable with the estimate of a 0.3% increase in core PCE for the month of October. Now, this is relevant given that PCE is the Fed's preferred measure of inflation and frankly, a 0.3, even if it ends up being a low 0.3, isn't necessarily the type of move in core PCE that the Fed would like to see as the FOMC ponders cutting rates by another 25 basis points next month.

At the risk of oversimplifying it, futures pricing suggests that the market is roughly 50/50 on whether or not the Fed pauses in December or chooses to deliver another quarter point cut. We anticipate that there will be a stronger market bias the closer the event becomes, if for no other reason than we will have the updated payrolls report for the month of November as well as November's CPI figures in hand before the Fed actually decides. This will allow the market a better understanding of the evolution of the real economy during the fourth quarter. The week just passed also included the comment from Powell that the road back to 2% inflation will be bumpy at times, and this is consistent with what we're seeing in the realized data. But, for the time being, at least, the Fed remains convinced that inflation is trending back towards its objective and therefore they feel comfortable messaging that more rate cuts are on the horizon.

Now we'll argue that by emphasizing that the Fed is not in a hurry to cut rates, Powell is, in essence, laying the groundwork for a pause sometime during the first half of 2025, not a pause on the 18th of December. Even in this context, the two-year sector remains relatively cheap overall and we expect that as the data unfolds between now and the December meeting, that the two-year sector will outperform on the curve if nothing else, simply because the amount of hawkishness implied with two-year yields at 4.30 is unlikely to persist indefinitely.

In fact, in December, assuming that the Fed cuts again, this will bring effective fed funds down to almost precisely where the market is trading in the front end. And if one believes that effective fed funds should serve as a ceiling to where nominal two-year yields trade, then this should also create some downward pressure on front-end yields as well. Keeping in mind that we tend to think of the two-year sector as nothing more than a 24-month rolling window of monetary policy expectations, and the Fed has confirmed that the direction of travel for rates will be lower, the only question is the pace and perhaps the final objective. It's difficult not to want to lean long into the two-year sector as year-end approaches.

Ben Jeffery:

It was another short but important week for the Treasury market with October's CPI and PPI data along with Powell's speech on the economic outlook on Thursday. What we ultimately saw in terms of the inflation data was an as-expected core inflation print, but to look in the details, perhaps slightly softer than the market was looking for, with core CPI up 0.28% month over month, and especially considering there were many in the market that were looking for something between 0.3 and 0.4, that number was enough to give a passing bid to the Treasury market and pull 10-year yields momentarily back from that 4.49 level we've been watching as support.

But the balance of the week saw that rally reversed, aided in no small part by Powell's optimistic comments on the state of the economy and reiteration of the fact that the Fed doesn't need to be in a rush to continue lowering rates, given the resilience of the performance of the real economy. So despite all the new information, that netted to 10-year yields being in a remarkably similar place to where they were coming out of the election in what is this new, slightly higher, trading range.

Ian Lyngen:

I think one of the more interesting aspects of the price action was the implied probability of a December rate cut. On Tuesday, ahead of the CPI data, the market was pricing in roughly a 55% probability that the Fed delivers a 25 basis point rate cut in December. After the data, the odds increased to roughly 85%. Following Powell's comments, however, on Friday morning, the market indicated roughly a 58% chance of a cut. So we'll argue that investors are interpreting Powell's comments as laying the groundwork for a pause. Now, we don't think that that ends up being a December pause, but we are open to the Fed skipping January to shift the cadence of rate cuts from every meeting to every other meeting or 25 basis points per quarter. That would provide the Fed the opportunity to accompany each rate cut with an update of the SEP.

The SEP in December will be particularly impactful, if for no other reason than there's been a significant divergence between what the Fed is signaling the end goal for normalization is, i.e, an upper bound of policy rates at 3%, versus what SOFR is pricing in, which is effectively an upper bound of 4%. That hundred basis point divergence can't persist forever. And the question then becomes: is the Fed going to follow through on their recent pattern of simply shifting the dot plot to more closely mirror the market's pricing, i.e. marking to market the dot plot, or in December, will we learn that the Fed is more comfortable with that divergence between market expectations and their own projections of where they anticipate terminal will ultimately be? We struggle to imagine that the Fed will increase its terminal estimate by a hundred basis points in December, if for no other reason, Powell has been very clear that the Fed won't respond to any future potential changes on the fiscal side or anything that might happen in regards to tariffs or trade war escalations.

It's also important to keep in mind that the market has been very eager to trade the GOP sweep from a reflationary-only lens, particularly as it pertains to tariffs. Tariffs are not only inflationary. In fact, when we look at the episode of 2018 when Trump was levying specific targeted tariffs on some of the US' major trade partners, we didn't actually see that translate into a sustainable rise in CPI. Now, this is due primarily to the fact that the tariffs hit the intermediaries and effectively caused price compression as opposed to an incentive to attempt to pass along price increases on a one-for-one basis to the end user.

Taking the tariff discussion a bit further, we'll also observe that even a blanket increase, let's say a 10% tariff on all imported goods, would only be a one-time increase in realized inflation. As long as tariffs are not perpetually escalating, then there'll be nothing more than a one-off price reset, which will, yes, flow through to CPI. However, the Fed will be more likely to view that as a tax on the consumer as opposed to true demand-driven inflation, the latter being the type of inflation that the Fed would be more apt to respond to.

So, making a long story even longer, Powell and the Fed are likely to continue the process of normalization at least until the middle of next year until we see any potential flow through into the real data from what the incoming administration does in the first half of the year. More immediately, if the Fed is unwilling to close the hundred basis point gap between the market's estimate of terminal and the SEP, then we expect the two-year sector will be the primary beneficiary and that will bring two-year yields lower and further drive the 2s10s curve steeper.

Ben Jeffery:

And that divergence between where the market has terminal and where the Fed does is an implicit acknowledgement of the uncertainty that still persists around the level of R-star on the other side of the pandemic and even after 75 basis points of rate cuts, just how restrictive monetary policy still is, if in fact the neutral rate has crept higher. And this goes beyond the conversation about tariffs, which to your point, Ian, and at the risk of using a bad buzzword, are transitory in terms of their influence on the overall level of inflation. It's not an ongoing increase in prices, it's just a one-time boost, that, combined with the fact that tariff policy can change far more quickly than the structure of the real economy can, really means that we're less convinced the incoming Trump administration has a material impact on the level of R-star and what will be the Fed's target in terms of refining policy rates and their proximity to neutral.

And in talking about valuations and the outright level of yields currently, there's also the simple but important factor to consider, which is the asymmetry around the level of Treasury yields, given the unique position that Treasuries benefit from in the global financial system. And what I mean by that is – something is not going to become suddenly so inflationary or suddenly pro-growth or suddenly question the dollar's status as the reserve currency that triggers a broad-based bearish repricing in treasuries. However, what can suddenly occur is a bad data print as it relates to the strength of hiring in the U.S., some exogenous shock overseas, either geopolitical or as it relates to the economy, or some other unknown unknown that triggers, on the one hand, a flight to quality in the benchmark safe haven asset class, or on the other, would necessitate the Fed to step up and provide more support for the real economy via a dovish policy response. Now, by no means are we suggesting that that's going to be coming imminently, but the probability thereof should be worth at least something in keeping rates relatively contained.

Ian Lyngen:

It's also been very impressive how well risk assets have performed throughout the last several months with stocks at record high prices. The wealth effect should continue to contribute to some of the upward pressure in the inflationary complex. However, as the new policies of the incoming administration become clearer, it will be interesting to see the degree to which the equity market can retain its current bid. This holds a potential for complicating the path forward for monetary policy rates. In the event of a significant downside correction, that would serve to tighten financial conditions and leave the Fed more likely than not to either accelerate the process of cutting rates or at a minimum, avoid pausing for a meeting or two.

On the flip side, however, another 25% plus year in the S&P 500 would continue to serve as something of an offset for the Fed's attempts to undermine demand. All this being said, the performance of the equity market is sure to remain topical into the end of the year. And while not directly a monetary policy influence per se, lofty valuations will remain a cornerstone for the positive economic outlook and one that is accompanied with at least modest reflationary potential.

Ben Jeffery:

And in a completely natural transition to turn the conversation to money markets, we also got some update on the state of SOMA earlier this week and the fact that as it stands, the Fed sees no reason to adjust its lower pace of QT and the fact that the manager of SOMA offered that it's not the Fed's role to remove all volatility from money markets suggests that the repricing we saw over month and quarter end at the end of September did not reach a level from the Fed's perspective that justified any concern on the state of reserves or the appropriateness of continuing to shrink the balance sheet and remove liquidity from the system. We did hear, however, that funding rate spikes on days not related to the calendar or any other volatility that wasn't more, quote, unquote, "traditional" would potentially be a reason for worry or maybe some indication that the Fed should rethink the speed with which it's running down its balance sheet.

So as the end of the year quickly approaches, it means we're probably not going to see any material tone shift from the Fed in response to a garden variety increase in market rates over the end of the year. But something more dramatic could certainly inspire a conversation about the amount of liquidity in the front end and the distribution of it as we get toward the January meeting, especially given the cautious optimism around this episode of the debt ceiling with the new all-Republican government more likely to strike a deal sooner than would have been the case had we had a split Congress. So that means the cash that would've flowed out of the TGA into the system will now not be distorting the front end, and that means that any strains or pick up in funding costs will be on full display around the turn.

Ian Lyngen:

So essentially what you're saying is it's the end of the year as we know it, and the Fed feels fine.

Ben Jeffery:

For now.

Ian Lyngen:

In the week ahead, the Treasury market will have remarkably little new information. There are a few data points – we have Housing Starts, Building Permits, as well as Existing Home Sales. On the supply front, we see 16 billion 20-years auctioned on Wednesday afternoon as well as 17 billion 10-year TIPS on Thursday. The weekly Jobless Claims figures will be notable. However, the broader trend has revealed a pullback in some of the earlier spikes seen in the Initial Jobless Claims figures. Therefore, we would expect that the impact of the hurricanes and the strikes on Initial Jobless Claims has largely run its course. Any uptick from here would suggest that there might be something more troubling developing in the jobs market, but at this moment, there's nothing to indicate that that should be one's baseline assumption.

Instead, we anticipate that the week ahead will be defined by responding to political headlines as the market ponders the late January change in government in the U.S. We also anticipate that the price action itself will become more of a potential trigger. There have been some moments of dip buying interest, but as a theme, 10-year yields remain towards the upper end of the local range. And in the event that we have a breakout to, say, 4.50% or beyond 10-year rates, we could see some meaningful follow-through. The bond bearish narrative remains well-established. Many of the changes that investors anticipate will be accompanied by Trump's presidency are seen as reflationary. Some of that derived from a more economically stimulative stance. Some of that derived from tariffs and the implication for at least short-term isolated pockets of realized inflation. Our concern is that this is essentially re-trading the Trump trade.

Said differently, a further backup in rates without any fundamental backing is probably going to be short-lived as investors choose to take the other side and the opportunity for a 10-year yield above 4.50 to add duration exposure. We'd be remiss not to reiterate the interplay between risk assets and nominal treasury yields. Recall that in September and October of 2023, we had a sharp increase in rates accompanied by a return to positive term premium that ultimately shifted the prevailing sentiment and direction in the equity market and triggered a flight to quality that ultimately managed to contain rates and bring us back to a more familiar rate environment. Now, pondering between now and the end of the year, it's difficult to envision anything that would materially challenge the year-to-date gains in equities, but with perhaps the exception of another spike in nominal yields. At the risk of overstating the concern, we'll be watching for any wobbles in the equity market in the event that 10-year yields manage to break above 4.50.

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 we ponder the approaching holiday season, we're reminded that we have so much to be thankful for. Loyal listeners, good producers, below-average writers, and of course, our frenetic disclaimer.

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 3:

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