Trump's Reentry - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 307: “Trump's Reentry” presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of January 20th. And with all the geopolitical change afoot, we can almost hear the chorus of the Kenny Rogers hit ‘The Gambler’ – "Know when to hold them, know when to fold them, know when to walk away, know when to run, know when to buy, know when to sell." Okay, we added those last two.

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 took the bulk of its trading direction from the inflation updates, primarily core-CPI, which came in up 0.225%. Now, that was lower than the consensus, which was 0.3, and lower than the prior month, which was 0.308. In addition, we saw the super core measure, which is core services ex-rent and OER, increase by just two-tenths of a percent compared to the high three-tenths of a percent seen in the prior month. Overall, the inflation profile in the US appears to be moving back in line with the Fed's two-percent inflation target, and as a theme, is consistent with the Fed's efforts to move monetary policy rates back to a more normal level.

Now, there was nothing within the inflation data that suggests that the Fed won't pause in January, which remains our base-case scenario, but it also does afford the Fed enough flexibility to continue the process of normalizing rates lower in March or June depending on how the rest of the data plays out, and of course, what comes out of the White House during the early part of Trump's second presidency. Within the details of the core-CPI report, we saw that rents gained three-tenths of a percent, as did OER. A return to the plus-two, plus-three, plus-four percent range for rent and OER is surely a welcome development for monetary policymakers as it's more in line with the pre-pandemic norms.

Globally, investors also saw a cooler inflation profile in the UK, which added to the stabilizing bid that has developed in Treasuries. 10-year yields reached 4.80 in the run-up to the inflation update and have since staged a pretty significant rally. Not only are we viewing the CPI figures as constructive for the Fed's objective, but also December's inflation profile was a reasonable departure point from which to incorporate any potential new increases in tariffs once the Trump announcements unfold.

The week just passed also contained the PPI and the import prices data series, which rounded out core PCE estimates, which are now seen at a solid 0.2, if anything, on the slightly light side. That's also consistent with the Fed's inflation target. The retail sales report for December confirmed solid growth in the control group, which is the aspect of the report most closely correlated with real GDP. And as we see real GDP tracking above two and a half percent, it's difficult not to assume that the Fed is going to have ample flexibility and leeway to delay rate cuts as long as they see necessary, based on any changes on the trade and potentially immigration front that monetary policymakers might view as potentially impactful for both the pace of inflation as well as jobs growth.

We were encouraged to see the magnitude of the curve re-steepening with 2s10s comfortably above 40 basis points at one point only to consolidate as the longer end of the curve received a modest bid. Our base case scenario remains that we will continue to see the curve grind incrementally steeper, but with the bulk of the price action more likely led by a rally in the two-year sector as opposed to the bear steepening that has characterized much of the recent move.

Ben Jeffery:

Well, it was always going to be a week defined by CPI, and frankly that's exactly what played out. The bearishness we saw resulting from last week's payrolls report has now been more or less undone with the confirmation that the disinflationary trend the Fed is pursuing is intact, a downside surprise in terms of core consumer price growth in December, and this has all been enough to bring ten-year yields more than 20 basis points off the highs. After briefly crossing 4.80, now 10s are far closer to 4.50 as a degree of the higher term premium bear steepening trade has been unwound and we've seen better buying interest come into the long end of the treasury curve.

Ian Lyngen:

Our approach to the week was to view the incoming inflation data as level-setting expectations for incorporating any changes from the incoming administration. Next week's major focus will be any headlines related to tariffs, immigration, and overtures on the trade war front and how those could potentially impact the forward outlook for the real economy with an emphasis on inflation. At issue is whether or not any tariffs are a one-time increase or if they're scaled in over the course of time. In the latter scenario, we expect that that will further complicate the Fed's job in so far as it will put a floor in for realized inflation, which will subsequently make it difficult for the Fed to justify normalizing further.

In the event that Trump's tariffs are implemented immediately or effectively immediately, the Fed would have more than sufficient justification to look beyond the immediate implications for CPI and instead focus on the potential downside for real growth and the tax on the consumer that is represented by increased levies. All that being said, the Treasury market continues to consolidate and it's consolidating in a manner that we’ll argue sets the market up well to incorporate any dramatic headlines that hit early in the holiday-shortened week ahead.

Ben Jeffery:

And let's not forget that this week started with a little bit of moderation in terms of the tariff rhetoric with some headlines suggesting that Trump's economic team favors a more gradual approach to increasing import taxes and what was generally being viewed as a sign of Bessent's influence on the incoming administration and his more markets-friendly approach to the economic policies of the incoming administration. So what remains to be seen is once the keys of the White House are officially passed over on Monday, just how quickly and just how aggressively Trump will act via executive order to start to implement some of his campaign promises.

It's been extremely telling over the course of the past several weeks, and frankly since the election, that investors’ focus is obviously still on jobs and inflation and what that means for the Fed. But, just as important if not even more relevant to the rates outlook has been the question marks around tariffs on the one hand, but also the potential for more fiscal support and what that means for the growth outlook on the one hand and term premium, but also Treasury supply and the potential for auction size increases that are generally being viewed as likely to take place later this year to be pulled forward or pushed back.

This week in his confirmation hearing, incoming Treasury Secretary Bessent was extremely focused on the spending side of the equation as it relates to controlling the deficit, while also affirming that cementing the tax cuts that were implemented in 2019 is near the top of his economic agenda. Now, how that ultimately flows through in terms of policies that are actually able to be enacted, of course will remain to be seen with the new Congress and new executive. But as an early indication of the focus of the new Treasury department, getting the deficit under control appears to be high on the list of priorities.

Ian Lyngen:

Other potential headlines in the week ahead related to the Trump administration will come on the immigration front. Now, there's certainly been a great deal of speculation around what Trump can and will be able to implement once he retakes the White House. Nonetheless, we are anticipating at least some type of announcement on the immigration side. Now, translating that through to the real economy is going to be very challenging because at the end of the day, some of the positive payroll growth that we have seen over the course of 2023 and 2024 was at least partially attributed to immigration. By reducing that influence, one could argue that there could be downside risks on headline payrolls, while at the same time creating upside risk on realized wages as the US could be entering a phase in which there is greater labor scarcity.

Ultimately, at the end of the day, we do expect that the trajectory of the real economy will continue apace at least for the next couple quarters, and any spike in the unemployment rate or shift in the labor landscape won't be realized until at least the latter half of this year. Putting this in the context of monetary policy, we expect that the Fed will skip January in terms of cutting rates and the emphasis will roll forward to whether or not they'll lower by 25 basis points in March. As the trajectory of the real economy currently implies, there won't be a great deal of urgency from the committee to cut rates in March. So this leaves us focused on the second quarter as the most likely departure point for further normalization. Now, of course, monetary policy and the direction of the market is in a particularly data dependent mode at the moment, and as such, the market will be closely monitoring the evolution of the real economy.

Ben Jeffery:

And to bring it back to some of the price action we saw over this past week, it was telling to see that the softer inflation reads, both via PPI and CPI, translated to a rally in the Treasury market. That much makes sense even to us. But the fact that the move toward lower yields was led by the 5 to 10 year part of the curve as 2s and bonds underperformed on a relative basis was indicative of a few things, both from a macro and more tactical positional perspective. First on the fundamental side, the fact that we saw a strong jobs report means that the urgency for the Fed to pull forward rate cuts isn't really there. The only reason that the Fed would feel the need to ramp up its dovishness was if there was perceived to be a more material risk to hiring. Nothing that we've seen to start January has indicated that's the case.

And on the flip side, we saw an inflation print that was hardly alarming and certainly doesn't inspire any realistic conversation about the potential for a return to rate hikes. And so what that translates to is a two-year sector that is going to be increasingly well anchored to a policy bias that is more or less status quo. So what that means is as the market sells off, 2s were quite sticky and the curve bear steepened, and as we saw the market rally this week, 2s were also quite sticky as the market bull flattened. That's from a fundamental angle, and we'll also observe that following CPI, the fact that 2s10s flattened while 5s30s steepened does reveal that there is still something of a short base in the 5- to 10-year sector as a lingering function of the quote-unquote Trump trade and a market that has been apprehensive to be overweight duration exposure in an environment that, before this week, has been so unquestionably bearish.

And so from here, after the rally that we've seen that presumably saw some of those shorts covered, it should leave a bit more balanced positional landscape heading into next week when obviously we'll be getting no Fed communication, but more importantly, the reaction to the changing of the guard in Washington and the setup for the January FOMC.

Ian Lyngen:

As you point out, the fact that we are going into this series of events from a relatively balanced position does bode well for assuming that we're not going to retest 5.25% in 10-year yields, we might see 5% in the event of a continued escalation of the trade war combined with ongoing solid growth, a lower employment rate and sticky inflation. But the path to materially higher yields has become more difficult to envision, especially as we've already seen term premium in the 10-year sector return to +65 basis points, and the conversations about increased Treasury issuance and ballooning deficits have become more and more mainstream, implying that to a large extent this dynamic is effectively priced in.

Ben Jeffery:

And as it relates to the funding market, while Waller's comments were the highlight this week, with him suggesting that there's still a potential for three or four cuts this year, we also heard from New York Fed President Williams as it relates to the Fed’s thinking around QT and the potential change for balance sheet policy, namely that the Fed doesn't see an impending risk of reserves reaching close enough to scarcity to be a concern, and that the front end of the curve is still not really in need of any response from the Fed as it relates to the balance sheet rundown. There was a time in the middle part of last year, specifically around the end of the third quarter where the volatility and repo begged the question of how long the Fed would be able to continue QT. But now that year-end is behind us with the extra standing repo facility operations not being utilized at all, it seems to be the case that the calm in the funding market should keep QT on track, which will continue to drain liquidity from the front end of the curve.

Now, it's not unreasonable to expect that we may see some more discussion around a compositional change of the Fed's balance sheet to more closely mirror overnight rates, so a shift toward a shorter maturity profile in terms of what SOMA holds, but that's likely not a near-term discussion. And as is the case with Fed funds, it seems the Fed’s relative incentive to rock the boat as it relates to their balance sheet is low at this stage. And that should keep the funding market status quo intact, at least for now.

Ian Lyngen:

So the takeaway is, we are anticipating continued fun in the funding market.

Ben Jeffery:

Isn't it always?

Ian Lyngen:

It is until it isn't.

In the week ahead, the US rates market will be focused on any announcements coming out of the White House once Trump once again becomes president. One of the biggest questions at the moment is whether or not he will issue an economic state of emergency, which will allow the President greater latitude in implementing tariffs. It would raise the potential for more broad-based sweeping tariff changes. Another major question is whether or not any increase in tariffs ultimately ends up being a one-time event, or if the recent reports are accurate and the administration is considering ramping up tariffs slowly over the course of several months or quarters.

The latter scenario would be a bit more challenging for monetary policymakers because it would mean that inflation measures would be skewed higher for several months or quarters as opposed to just a one-off shock. The one-time price reset is easier for monetary policymakers to dismiss as not the type of demand-driven inflation that would typically warrant a Fed response. All else being equal, we continue to assume that the Fed's characterization of whatever comes out on the tariff front as being less a monetary policy issue and more an issue for international trade will remain the case.

Considering some of the potential changes on the immigration front becomes even more complex because if the administration's efforts on immigration ultimately translate into a tighter labor market, that could put upward pressure on wages. And the correlation between nominal wages and the super core measure of inflation is so essential to the Fed's thinking about where we are in the cycle that a spike in average hourly earnings could prove much more troubling than an increase in headline tariffs that lead to a one-off spike in CPI.

Embedded within our concerns about what comes out of the administration is this idea that there's so much anticipation of a dramatic Trump reentry that the market might actually be overpricing, i.e. biased towards higher yields, what the administration will ultimately deliver, or at least will be able to deliver in the first several weeks of Trump's presidency. Now, it goes without saying that the market is going to remain very much on headline alert for anything either on social media or through more traditional channels that would clarify Trump's initial agenda.

The data calendar in the week ahead is relatively limited. The biggest highlight being Thursday's weekly Initial Jobless Claims print. We saw a slight uptick in the prior week. However, this week's release will encompass Nonfarm Payroll survey week and therefore presumably be more impactful in investors' estimates of the January payrolls figures. There are two supply events of relevance. There's the 13 billion 20-year auction on Wednesday, followed by the 10-year TIPS auction of 20 billion on Thursday.

Treasury auctions, as a theme, have continued to go reasonably well. There are moments where a concession has been both warranted and delivered. However, the nuances of supply are not a key factor in determining the outright level of rates at the moment. To be fair, there remains a lot of concern and angst around increased deficit spending, how the US is going to fund this deficit spending, and whether or not there'll be a disproportionate increase in longer-dated issuance once the new Treasury Secretary takes the helm of the Treasury Department. For the time being, we continue to see auctions largely as non-events, especially as we've run up against the debt ceiling considerations, and extraordinary measures are the next leg in that saga.

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. A quick glance at the calendar reminds us that after Monday's MLK holiday, SIFMA only has two full-market holidays until Memorial Day in late May. In hindsight, work from home had its upsides.

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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