Practicing Patience - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 283, Practicing Patience, 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 July 22nd. And as the Fed appears unlikely to shift policy rates in late July, we're reminded of the prudence of patients, at least in some circumstances. When it comes to the institutional investor survey, however, time is of the essence and the polls are still open. Please support us with five star rankings in the categories of US rates, technical analysis, fixed income, and short duration.

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 a solid performance with 10-year yields, drifting as low as 4.14% this despite the fact that both retail sales and import prices surprised on the upside. This suggests that there is an underlying bid for duration that is likely to persist even as the Presidential election comes into focus and the market anticipates that the Fed will delay cutting rates until the September meeting.

At the end of the day, underlying the demand for Treasuries is the notion that while the Fed might not be cutting immediately, they are transitioning from the period of being on hold at terminal to beginning the campaign to normalize policy rates. If nothing else, one of the key lessons that the market has learned from the response to the pandemic and the subsequent spike in inflation is that even when faced with decades high levels of realized inflation and the potential to lose the price stability assumption, the highest the Fed deemed necessary to increase policy rates was to 5.5%. So as investors think about the course of the next 10, 20, or 30 years, it's a reasonable assumption that as long as we don't see another global pandemic inspired spike in inflation, that we're unlikely to go above 5.50%, if we reach 5.50% at all in fed funds over the course of the next few cycles.

We make this observation because it contributes to our term constructive outlook on treasuries. As the cycle turns. Breakevens will begin to contract, nominal rates will drift lower. And while we have yet to see flows leave the very front end of the market as investors look to lock in higher rates for five, 10, or even 30 years, the reality is that that rotation will begin at some point and we expect that while the bull steepening trend will eventually emerge. One of the factors that will slow the steepening will be investors moving further out the curve. This more constructive take also dovetails with the realities of the economic data recently with initial jobless claims surprising on the upside, and once again, bringing into question the resilience of the labor market and the risk that while the Fed has been successful in reestablishing price stability, there nonetheless remains the possibility that they have overstayed their welcome at terminal, and there's still greater economic fallout yet to be realized.

It's within this context that we're approaching the next several weeks of trading in the Treasury market with an apprehension about the prospects for a range break. This is typically a point in the year where there are constructive seasonals, which we do anticipate will play out. But given the proximity to the Fed's July 31st rate decision, we anticipate that the market will continue to consolidate in the prevailing range, and the long awaited bull re-steepening in the curve will be delayed until investors have the bulk of the August data by mid-September, and that will provide the Fed with sufficient evidence to follow through with the quarter point cut on the 18th of September.

Vail Hartman:

Fed commentary in the wake of June's inflation updates has played a key role in readying the market for the cycle's first rate cut in September. And looking back over some of the recent comments from some of the core members on the committee this week, we heard New York Fed President Williams say we're actually going to learn a lot between July and September, and if we get more data like the last few months, he will find himself with the confidence that inflation is moving sustainably to 2%. Fed Governor Waller said he does believe that we are getting closer to the time when a cut in the policy rate is warranted. Fed Governor Kugler said she anticipates that it will be appropriate to begin easing monetary policy later this year. And while Powell hasn't offered any obvious hints on the timing of the cycle's first rate cut, it's clear the chair's confidence on inflation is increasing and the downside risks to the employment side of the dual mandate are just as relevant as restoring price stability.

Ian Lyngen:

And while we're cognizant that the September 18th FOMC meeting is by far the most likely departure point for the rate normalization cycle, we've also heard the argument that the Fed should begin cutting rates as soon as July. Now we don't think that the Fed is going to cut rates when it meets on the 31st of July, but nonetheless, given the trajectory of inflation that's already in place, combined with some of the weakness that we are starting to see in the employment anecdotes, there is a compelling case to be made that there's no time like the present for the Fed to begin cutting rates. At the end of the day, however, we suspect that the more hawkishly inclined members of the FOMC will require further evidence in the form of the inflation prints for July and August to get behind cutting rates. The more germane debate at the moment is how far will the Fed cut rates in the event that Trump is reelected to the White House and a significant round of fiscal stimulus is on offer in 2025 or 2026.

Our operating assumption is that the results of the November election won't impact the first three or four rate cuts by the Fed, and it's not until we get to the second half of 2025 where there's a potential for the Fed to pause and reassess the trajectory of inflation and the real economy in the context of some of the changes that might come out of Washington.

Ben Jeffery:

And similar to the cliche around monetary policy being akin to driving while looking in the rear view mirror, this represents another challenge that Powell faces in terms of the current inflection point of the stance of policy while also needing to weigh potential, not certain, fiscal policy outcomes that might be associated with the changing of the guard in the White House, and also Congress. Clearly the official rhetoric is going to continue to remain as apolitical as possible. And frankly, regardless of what happens in November, a rate cut in September and or December was probably always going to happen anyway, but it's once we look out into the middle and later parts of 2025 and into 2026 that that calculus becomes a bit more challenging. The Fed may have tariffs to consider, tax cuts to consider, a far different labor market to consider.

And this means that from the current departure point, with effectively two cuts priced this year and another a hundred basis points or so reflected in next year, that the market is priced more or less where the Fed wants it. And this means that even though the Fed has not yet cut, the market has already done a fair bit of easing for the Fed as monetary policy makers have been successful in laying the groundwork for the initial steps of the policy normalization campaign. All one needs to do is take a look at 10-year yields below 4.20% to see the influence on borrowing costs that's come along with the softening economic data and the Fed's response to it.

Ian Lyngen:

The same argument can be made by simply glancing at equities, which are still near record highs, as a contributor to easy overall financial conditions. So to your point Ben, the market is in fact easing for the Fed to some extent, and now it's incumbent on the committee to follow through with rate cuts in September and December. Now the fact that the October 24 fed funds futures contract is fully pricing in a rate cut does strike us as somewhat premature because the Fed isn't going to cut by 50, and therefore the market is assuming that at some point over the next eight weeks, there won't be either a data point or an event that triggers a wholesale rethink of whether or not the Fed will cut in September. So while we do believe that the path of least resistance for monetary policymakers is to cut in September and we're very much in the September rate cut camp, it's challenging to imagine that there won't be some event or data release that doesn't lead investors to revisit that assumption, at least momentarily.

Ben Jeffery:

And that same underlying logic holds in the opposite direction as well. Obviously, as we saw during the last cutting campaign, there is nothing that is going to make Powell's first cut be 25 basis points. And while hopefully it's not a pandemic this time around, there's always the risk of some outside shock, whether that be economic, geopolitical, or some other type of black swan event that inspires the Fed to deliver an even larger rate cut. Obviously the probability waiting on that outcome is relatively low, but nevertheless, as we look further and further out in terms of near term futures pricing, some small premium around that risk is probably warranted. And so that means that 26 or 27 basis points of a rate cut price at each meeting going forward probably isn't all that unreasonable, although it is certainly predicated on the inflation data continuing to cooperate with the disinflationary trend.

It's also worth mentioning that while there is still some underlying angst on the state of the consumer, obviously jobless claims moved higher once again this week, the fact that this week's retail sales data was nothing if not solid, and generally speaking, even if the economy is slowing in outright terms, it's still very strong, it's probably too soon for the recession alarm bells to start ringing, just yet anyway.

Ian Lyngen:

And in keeping with that theme, when we contemplate the Fed pausing in the second half of 2025 based on something that comes out of Washington on the fiscal side, that's also predicated on this Goldilocks economy persisting for the next 18 months without any evidence of downside risk. So while that might be an ideal outcome for most participants in the markets and the real economy, the reality is even if the Fed is able to cut by 75 or 100 basis points, monetary policy will still at least in outright terms be in restrictive territory. So depending on where one estimates the neutral rate for policy to be in this current cycle, that implies that the Fed will have been restrictive for at least 24 months.

Ben Jeffery:

And on the topic of just how restrictive the Fed is going to be, let's not forget one of the other main monetary policy events of the summer in the Jackson Hole Symposium, that is quickly approaching on the other side of the FOMC meeting. With the topic of this year's conference, the effectiveness of monetary policy and R-star continuing to feature prominently in the overall conversation this year, the issue being tackled the Jackson Hole is probably going to be exactly around that question, Ian. Just how much has R-star changed on the other side of the pandemic, and just how restrictive is monetary policy? Does this mean that maybe the Fed can get away with just 50 or 100 basis points of cuts before stopping at a higher terminal rate, or is the evolution of the real economy going to bring investors to the realization that the post COVID economy looks an awful lot like the pre-COVID one did? And maybe neutral is a bit higher, but that doesn't necessarily justify policy rates at, call it 4% or 4.5% over the medium or longer term?

Ian Lyngen:

Well, given that conversation, this strikes me as the perfect time to hear from R-star, Vail?

Vail Hartman:

Thanks, Ian. And as the market readies for the data cycle for the second half of the year, to help set the stage, this week we heard Fed Governor Waller lay out three possible scenarios for inflation in the second half of 2024 that are factoring into his hawkish monetary policy stance. Now, across all three scenarios, Waller makes the baseline assumption that there is no significant deterioration in labor market conditions, and employment remains in its current sweet spot.

Now, in the first scenario over the next several months, we continue to receive very favorable CPI and PCE readings, and Waller characterize this outlook as the optimistic one. And in this instance, the Fed governor could see a rate cut in the not too distant future. Said differently, Waller would likely support a rate cut in September if we receive two very good inflation prints in July and August, but he doesn't see a high probability of this scenario occurring.

In the second scenario, the inflation data comes in uneven and isn't as good as the previous few months, but still consistent with overall progress to 2% inflation. Waller said this scenario is probably more likely to occur. And in this case, he believes a rate cut in the near future is more uncertain. And as a result, the timing of the first rate cut will be more data-dependent. Because of this, we're hesitant to assume that a hawk like Waller would endorse a cut in September if the inflation data is uneven in the next two months. But it's notable that in both of these scenarios, regardless if the inflation data is good or uneven in the coming months, rate cuts are still a part of the near term policy discussion, even among the more hawkish leaning members on the committee.

And in Waller's third scenario, which he labeled the pessimistic one, there is a significant resurgence in inflation in the second half of this year. Now, this is certainly something Waller doesn't want to see, but he says it's something he has to worry about. He ascribed it a low probability of occurring given the experience of the second quarter, but it's nonetheless possible. And in this scenario, as one would imagine, Waller didn't mention rate cuts. Taken together, the bar for Waller to cut appears to be a bit higher than the other members on the committee whose guidance more closely aligns with a rate cut in September, assuming two more good inflation reads in July and August.

Ian Lyngen:

Our biggest takeaway from Waller's recent speech was that while pessimism might be a low probability event for Waller, it certainly isn't here on Micro Horizons.

Ben Jeffery:

Is the bond market after all.

Ian Lyngen:

In the week ahead, the Fed will be in its radio silence period ahead of the July 31st FMC meeting, so we won't see any tradable headlines as it relates to monetary policy. On the other hand, we do get the first look at Q1's real GDP figures. And the current consensus is for an increase in real terms of 1.7%. That's a reasonable pace, particularly in light of the fact that Q1 increased 1.4%. Focus will be on the pace of consumption as well as the quarterly core PCE figures. It's important to keep in mind that on Friday, we receive the monthly core PCE figures for June, which are expected to increase two-tenths of a percent. So on Thursday, the core PCE numbers will include the June data, but it won't break it out specifically. So said differently, we could see a surprise on Thursday that preempts what would otherwise be the biggest tradable event of the week, i.e., the June core-PCE figures on Friday.

There's also supply with which the market will have to contend. We have $69 billion two years on Tuesday, followed by $70 billion five years on Wednesday, and capped with $44 billion seven years on Thursday. We are reaching the point of the calendar where constructive seasonal patterns tend to hold, so that leaves us bias for a downward drift in rates between now and Labor Day weekend. That being said, we're cognizant of the relevance of the next few weeks in terms of calibrating monetary policy expectations, as well as investors gaining a better understanding of what to expect in November. And the market remains very much in the mode of repricing based on big macro events, and then transitioning to a period of consolidation before repricing and consolidating again. The combination of the data on Thursday and Friday will potentially trigger one of those repricings with the subsequent consolidation period only lasting a couple sessions, given the proximity to the Fed, and of course, the April 2nd release of non-farm payrolls.

The shape of the yield curve has been somewhat perplexing, given the fact that a September rate cut is now effectively a 100% priced in. One would've otherwise anticipated more persistent bull steepening to be the story. However, while the prospects for a Trump presidency were initially traded as a bear steeper, that has since transitioned to being a bear flattener as expectations have shifted to anticipating that any reflationary surge will limit the degree to which the Fed chooses to cut rates in the latter half of 2025.

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 the II campaigning season continues, if this is the first that you're hearing of it, all we can say is congratulations. Whatever you're doing, you're doing it right. 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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