Terminal is Nigh - The Week Ahead

Ian Lyngen:

This is Macro Horizon's episode 247, Terminal is Nigh, 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 November 6th. As the week move from Halloween to All Saints Day to the day of the Dead, it only seems fitting that it ended with disappointment payrolls Friday. If nothing else, it was the makings of a bond rally.

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. That being said, let's get started.

In the week just passed, the treasury market was offered a dizzying array of economic fundamentals from which to derive trading direction. The net takeaway was decidedly lower yields. 10 year yields slipped below 450 in what was generally a bull flattening rally, although on Friday, the disappointing employment report led to a parallel shift lower across the curve. The bid in the two year sector implies that the Fed might be closer to cutting rates than was previously assumed. We'll caution against that interpretation, although one thing is pretty evident, the bar is very high for the Fed to hike rates in December at this point, particularly when we coupled the economic data with the fact that there seems to be no obvious way that Congress will avoid a government shutdown in the middle of November.

In addition to the employment report, which showed an increase in the unemployment rate to 3.9%, we also got the Fed decision to not hike rates as well as the press conference in which Powell made it clear that it's obvious, at least to the FOMC, that there's no clear need to hike rates at this moment.

Now that isn't to say that there couldn't be a shift in financial conditions in favor of an easier bias, which would then presumably prompt the Fed back into action in December, or potentially January. But for the time being, our assumption is that we're at terminal and that the Fed's next challenge will be to avoid cutting rates as long as possible.

Let us not forget that Yellen also weighed in via the refunding announcement with smaller than expected increases further out the curve. This is relevant as it's a clear response to the fact that term premium has increased and therefore Yellen gave investors a better understanding of the Treasury Department's reaction function to the recent pricing. The potential for further increases in auction size next year was also left as an open question. While we could still see February auction size increases, the November refunding statement was somewhat non-committal.

There was also disappointment in the ISM, both manufacturing and services sector, as well as ADP, which actually ended up being a reasonable proxy for private NFP growth in the month of October. All this occurred with the backdrop of the yield curve continuing to invert. This is consistent with the trading dynamic that we anticipate will define the balance of the year, i.e., the Fed remains committed to retaining terminal as long as possible, therefore two year yields are comparatively less volatile than tens and thirties and have an anchor, if not precisely at 5%, then somewhere within that proximity. As a result, the shape of the yield curve has effectively become a directional trade, i.e., we will more often than not see one of two price dynamics playing out, either a bull flattener or a bear steeper. This implies that the parallel shift lower in yields that followed the disappointing payrolls report is the anomaly, not the new normal.

Vail Hartman:

It was a bullish week in the treasury market that brought 450 tens back on the radar and the bid was catalyzed by three primary factors. First was the refunding announcement that confirmed smaller than expected increases to coupon auction sizes in Q4 and revealed that just one additional quarter of boost to coupon issuance will likely be needed. Second was the FOMC that held rates steady for the second consecutive meeting this cycle, and Powell acknowledged that financial conditions have tightened significantly in recent months and that the Fed will be proceeding carefully in light of the uncertainties and balance of risks. Third was the soft NFP print where the unemployment rate ticked up to 3.9% and the disappointing 150K headline payrolls gain versus the 180K consensus, and there was also meaningful downward revisions.

Ian Lyngen:

Vail, you're right, it was a fascinating week in the Treasury market. We had a lot of crosscurrents that really netted to lower rates. I think that part of the reason that it was such an eventful week has to do with the fact that all the market's primary concerns had some input during the week. On the supply side, what we learned was not only, as you pointed out, Vail, were auction size increases further out the curve underwhelming versus market expectations, but embedded in that was a glimpse at Yellen's reaction function to the reintroduction of positive term premium to the market. Said differently, it's been revealed that the treasury secretary is unwilling to term out the federal debt given the current market conditions, or at least not as much as previously assumed.

The reliance on the bill market to cover any shortcomings from a funding perspective seems the typical, and quite frankly, most prudent approach at the moment. With that context having taken away some of the supply angst, the Treasury market was allowed to refocus on the fundamentals. The fundamentals at this stage suggests that despite the resilience of the consumer, as evidenced by the strong personal consumption data in the third quarter GDP print, we are starting to see the weight of prior rate hikes in the labor market. That increase in the unemployment rate, while still below 4%, now has the benchmark gauge of the overall health of the labor market, half a percent off the cycle lows. When putting this into a broader context, investors are growing increasingly confident that we will see a more typical re-basing of the unemployment rate to a higher plateau over the course of the next several months. It follows intuitively that treasuries would rally.

Ben Jeffery:

While in a more traditional cycle, this would probably be enough to inspire a more significant tone change from the world's central banks. Instead, what we saw at Powell's Press conference this week was an acknowledgement of the tightening in financial conditions we've seen over the past few months. While that means the FOMC can be more patient in delivering future rate hikes even after the payrolls report, it certainly doesn't mean that the Fed is going to seriously be talking about rate cuts anytime soon. The fact that we saw market pricing pull forward the first cut of the cycle to June from July before the NFP number, and two year yields drop back to roughly 480, exemplifies that after the impressive selloff we've seen, the market's reaction function has swung back to attempting to pull forward cut pricing and a faster monetary policy response to a softening labor market than the Fed has communicated thus far given where inflation is.

Ian Lyngen:

But to be fair, assuming that we are at terminal at this stage, that means that the last rate hike was in July of 2023. If the Fed ultimately does cut in June of 2024, they will have retained terminal for longer than the seven month average. While technically that would be in keeping with the Fed's messaging, I think that we can all agree that that would be much sooner than the committee would like to see at this point.

Ben Jeffery:

Let's not forget, while we have October's employment data, we also get two more very important inflation reads before the December meeting and another one after that before the January meeting where the trajectory of continued decelerating inflation will probably be necessary for a more widespread messaging around the fact that the Fed doesn't need to hike again, even from those more hawkish on the committee. And especially from the departure point we've reached after the jobs report, this introduces the risk that if inflation doesn't cooperate over the next several months and the tightening of financial conditions we've seen as a function of the increase in rates that then gets undone by a rally in treasuries ultimately puts Powell in the precarious position of facing uncooperative inflation and a market that is no longer tightening for the FOMC, but actually making conditions easier. And to close the loop of circular logic, maybe that means the Fed might be forced to hike.

Ian Lyngen:

Well, I've never been accused of linear thinking, so I think it is important to put that reasoning in the context of what the Fed is attempting to achieve. Despite what we might ultimately believe will be the outcome, the Fed is simply trying to reestablish price stability as a forward assumption in the US economy. That dovetails well with a softer landing scenario. In the event that Treasuries rally, let's say, back to 425 by the end of the year, yes, that would undo some of the tightening and financial conditions. However, the time spent with tighter financial conditions remains relevant. While the peak tightening might not be as high or sustained as long as the Fed might have otherwise wanted at the beginning of the cycle, even at slightly easier, but still restrictive levels, it's a matter of timing for the Fed. The longer that they can avoid cutting rates, the more successful they're going to be in reestablishing price stability.

It's within this framework that I'll offer the observation that Powell has a very high incentive to keep another rate hike on the table as long as he can, regardless of whether or not he actually thinks that the Fed will need to execute. Because as soon as the Fed acknowledges that they're at terminal, the market, as we saw in the wake of non-farm payrolls, will rush to price in an aggressive easing campaign sooner rather than later.

Ben Jeffery:

It's very telling how quickly the realized economic data, monetary policy and what we heard from Powell has overwhelmed the bond vigilante higher supply, higher term premium discussions that obviously dominated the direction of rates over the past several weeks leading up to the Treasury Department's financing estimates that were released this past Monday. While yes, a billion dollar smaller increase across the board in the long end of the curve for this coming quarter supply, it still leaves very large auctions that need to be taken down and an environment where the marginal buyer of treasuries is still something of an uncertainty. Add to that the fact that we've seen a 50 basis point rally in 10 year yields over the course of the last 10 days or so, and the question becomes, has the macro backdrop shifted enough to justify a strong round of sponsorship at this week's refunding auctions on Wednesday and Thursday, or will the weight of supply necessitate some auction discount either in terms of some early bearishness in the week ahead or via softer auction results themselves?

Ian Lyngen:

One thing that does seem pretty obvious is with the rally in Treasuries that brought 10 year yields back to within striking distance of 450 in place, if that price action is maintained into Wednesday's 10 year auction, we will need a bigger concession in one form or another. The flip side of that argument is if we get a modest bear steepening into the take down itself, then we could get a more accurate gauge of investors' interest in Treasuries at this particular inflection point for both the rates and the economic cycle.

Ben Jeffery:

In talking about the price action, it's also worth mentioning the positional backdrop. Now that we've seen the generally long bias in the long end of the curve move back to more balanced positioning, and for those in the market who had been waiting for a reason to buy, maybe this past week's, developments are serving as something of a green light to begin adding duration exposure.

Now what this means going forward is that there's an increased capacity among the real money community to take advantage of buying dips once they present themselves, all while the variety of Treasury market participant who's been short throughout most of the last selloff, aka, CTAs, are now faced with what might be an inflection point toward lower yields, which represents an important tone shift in terms of what the pain trade is. It used to be higher rates, but now maybe it's increasingly becoming lower rates.

Ian Lyngen:

On the topic of green lights, as the light turned from green to yellow to red and then back to green, I can't help but think, is life nothing more than a bunch of honking and screaming? Sometimes it feels that way.

In the week ahead, investors focus in the US rates market will be primarily on the refunding auctions. First up, we will have three years on Tuesday, followed by new tens on Wednesday, and then new thirties on Thursday. There's very little economic data throughout the week, so there will be an emphasis on incoming Fed speak. There are currently a few scheduled Fed speakers and any insight on how comfortable the Committee would be simply conceding that terminal at 550 is good enough will be useful as it implies, obviously, no further rate hikes, but also a transition in the discourse around policy toward ensuring that the market isn't too ambitious in bringing rate cut expectations forward.

We also have Monday afternoon's release of the senior loan officer opinion survey from the Fed. This is a quarterly release and market participants will be watching very closely for any evidence of tightened credit standards, presumably as a result of the regulatory changes in the wake of the regional banking crisis. Recall that the prior release showed some tightening, but nowhere close to dramatic enough that the Fed or market participants would begin to worry about more significant ripple effects throughout the economy.

All of this creates an ideal backdrop for the price action itself to be the biggest driver of the macro narrative in the week ahead. By this we simply mean that if the market is able to easily absorb the refunding, even if it does require a concession of some magnitude, then that suggests a refocus on the fundamentals of growth and inflation as the defining drivers of the outright level of US rates. The foray into positive term premium on the supply concerns that defined the last couple of months of trading was allowed to persist, in part because investors had increasing confidence in the no landing or soft landing narrative. Now that we have some evidence in the form of a softer employment situation report combined with a increase in the unemployment rate, it follows intuitively that investors are once again relying on the fundamentals to guide trading direction.

Let us not forget that on Friday we do have one data report of particular note. That comes in the form of the University of Michigan sentiment survey. While the headline number could prove incrementally tradable, investors will be far more focused on the five to 10 year inflation expectations component, which has been around the 3% level for the last several months. Typically at this point in the cycle, we would assume that that number would be biased lower, especially in the context of the Q3 core PCE print at just 2.5% on a quarterly annualized basis. As the Fed finally settles into terminal, forward inflation expectations with an emphasis on the survey-based measures will be of note to monetary policymakers and help the market gauge how successful or not the Fed has been in reestablishing price stability as a baseline assumption for the US economy.

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. With Halloween behind us and the holiday party season quickly approaching, we are reminded of the sage wisdom of an ever insightful colleague, "Two Red Bulls equal one night's sleep."

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.

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Speaker 4:

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