Vote Monday, Vote BMO - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 281, Vote Monday Vote BMO, 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 8th. Monday marks the beginning of this year's Institutional Investor Global Fixed Income Research Survey, and we truly appreciate your support and a five-star rating 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 holiday-shortened week just passed, the primary focus in the Treasury market was the chances of a Trump victory in November. Coming into last week's debate between Biden and Trump, expectations were apparently lower than even odds that Trump retook the White House. In the wake of Biden's performance at the debate combined with the Supreme Court decision regarding presidential immunity and how it might apply to Trump's situation, the takeaway has been a net positive for the probability of a Trump victory. Now, there's still a lot that can happen between now and early November, but if the price action is any indication, investors are viewing a Trump victory as a bear steepener. Now, we anticipate that that would be exaggerated further in the event that there was a GOP sweep in which the Republicans ended up with the White House, the Senate, and the House of Representatives.

Now, when we put this in the context of 2016, which is when Trump won and it was accompanied by a GOP sweep, it's difficult to attempt to not at least use the price action in 2016 as the archetype for what one might expect. We'll caution against doing this, however, because in 2016, a Trump victory even immediately ahead of the election was considered a relatively low probability outcome. Fast-forward to 2024, particularly in the wake of the recent debate and the shifting political tides, a Trump victory at this stage could arguably be the consensus. The week just passed also offered comments from Powell, which were non-committal but skewed toward the dovish side, that follows intuitively given the inflation numbers that we saw in May and how that translated through to a Core-PCE print of just 0.1%. The other incoming information also showed ongoing weakness in the ISM manufacturing survey as well as stabilizing claims at an elevated level.

238,000 claims is what we saw for the final week of June. When we put this in the context of what had been routinely one-handle prints or slightly above 200,000 initial filers a week, there does seem to be something new unfolding in terms of the trajectory of the labor market. The combination of Wednesday's early close and Thursday's market holiday has broken up trading in the Treasury market and for a period in the calendar that has notoriously been characterized by low volumes, limited liquidity, and an overall absence of conviction, choppy price action has clearly become the new norm, although we do not expect that that will persist indefinitely.

Vail Hartman:

The growing prospect of a Trump presidential victory in November, in the wake of the Biden-Trump debate has refocused the market on the potential for greater fiscal stimulus and ballooning Treasury issuance, which has renewed concerns about the need for higher term premium in the long end of the curve. And in light of the market's renewed focus on election risks, political headlines have become another source of volatility potential that investors will need to be mindful of during the summer months in addition to the economic fundamentals.

Ian Lyngen:

It has been a notable shift in sentiment. The bear steepening that accompanied the increased probability of a Trump victory was certainly a welcome development, at least from the perspective of a steeper curve, given that this year's macro trade was always expected to be a re-steepening of the yield curve with particular emphasis on 2s/10s. The fact that this trend began as a bear steepener does bring into question whether or not it will ultimately be sustainable. We're certainly open to the idea that ten-year yields at 4.40% can maintain the range between 4.25% and 4.50% up until the Fed's first-rate cut. And in the event that the Fed delivers a September cut, that means that to a large degree, politics would have functioned as the initial trigger of the steepening with the Fed following on with rate cuts pushing 2s/10s back into positive territory.

The caveat is that we expect that as the data evolves over the course of the summer months, what we'll see is that the Fed is reluctant to commit to a September rate cut until monetary policymakers have seen the August inflation data. As a result, any bond bullishness will be expressed further out the curve with the two-year remaining largely range-bound until there's indisputable evidence that the Fed will start cutting in September. All of that being said, there has been some chatter around the potential for the Fed to delay rate cuts based on the prospects of a Trump victory and what that might imply on the fiscal side. We think that the market is overstating this risk at the moment. The Fed has a long history of downplaying potential future changes on the fiscal side in favor of the realized economic data and the trajectory of the real economy. Said differently, it's highly unlikely that the Fed is going to anticipate an election outcome and anticipate changes on the fiscal side, and base the decision of a September rate cut on those factors.

Ben Jeffery:

And part of that underlying logic has to do with the fact that one, the market's departure point is increasingly looking like the consensus is increasingly becoming that former President Trump will be back in the White House or at a minimum it's much closer to a coin toss than was expected to be the case in 2016. And at the end of the day, regardless of if it's a Republican or a Democrat in the executive branch, fiscal support and higher government spending are policy platforms of both parties. So that means in terms of the actual differential between whatever the outcome of the election ultimately ends up being, the actual difference in terms of inflationary implications might not be as large as would otherwise be expected, and the market will likely not react, at least not to the same scale the same way it did in 2016 when obviously Trump's victory was an extremely underpriced risk.

And then there's the uncertainty around the composition of Congress and what we'll argue is really the biggest wild card around this year's elections, which is whether or not we see a red sweep and both the House and the Senate under GOP control. It's this scenario that's probably the most market moving, and as has been the case over the past several elections, really the most market-friendly outcome would be a split Congress and something of a status quo as it relates to Washington's ability to get things done.

Ian Lyngen:

Well, there's no question that gridlock is good. It will be interesting to see whether or not there's any credence to the notion that the Democratic Party is going to attempt to replace Biden as the presidential candidate. Everything that we've gathered suggests that it will be very difficult to execute such a change, especially in the event that the party wants to remove Harris as well. The full rewriting of the ticket at the moment seems like a very low probability event. Nonetheless, the market will have some clarity in this regard over the course of the next week and a half. And as you pointed out, Vail, this means that there will be greater emphasis on the political headlines and the potential fallout for financial markets

Ben Jeffery:

And away from the political landscape, even if that does promise to dominate the discussion over the next few weeks, beyond June's payrolls report, let's not forget we also have CPI on the docket this week. And as one of the crucial inputs for the data dependent paradigm, the fact that we've seen Core-PCE drop to its lowest level since 2021, and generally speaking, the inflation data as a whole continue its grind lower, an extension of that dynamic is instrumental in keeping the current paradigm and the rates market intact. Specifically what you mentioned as it relates to the shape of the curve, Ian, and the fact that two year yields at 4.75% more or less represent something of a fair value point, assuming the Fed is on track to more or less follow through with two 25 basis point cuts this year, that assumption is predicated on ongoing progress in the inflation fight, and given the timing of CPI's release, as has been the case throughout this year, it's really up to the inflation data. For more hawkishness to be reflected in valuations, we would need to see more concrete evidence of a re-acceleration and inflation, and that goes beyond just this week's data given we know the Fed is reluctant to make any decision around a single month's worth of fundamental information, but especially as we talk about base effects from last year and the market that's become fairly optimistic that this inflation is going to continue, it's challenging to overstate the relevance of Thursday's consumer price update.

Vail Hartman:

And in the context of policy expectations, this week we heard Powell chime in on the inflation discussion, and it was notable that the chair said recent inflation data suggests that we're getting back on a disinflationary path, but the Fed still wants to see more data like what we've been seeing recently before it decides to lower policy rates. Now, with the consensus for a 0.2% month-over-month Core-CPI gain in June, the final month of inflation data in Q2 is expected to show another month of favorable inflation data for the Fed, especially when considering the downward implications for the three- and six-month annualized rates, even if the annual rate of Core-CPI stays steady for another month.

Now, a 0.3% gain isn't the favored outcome, but it's still within the range of foreseeable outcomes. And in the event the rounded figure comes in at 0.3, the unrounded number will be of particular relevance given that such a gain would fall on the upper end of what we've heard policymakers deem as a good inflation reading over the course of the cycle. Said differently, a high 0.3 would make it difficult for the market to characterize the inflation print as good, whereas a low 0.3 could more easily be interpreted as a favorable inflation print.

Ian Lyngen:

That is particularly true in the event that PPI, which follows on Friday combines with the low 0.3% CPI to yield a 0.2% Core-PCE estimate. That's a dynamic that we've seen play out in the past and wouldn't be particularly surprising given all the moving parts within the CPI series and how that has historically translated through to Core-PCE, which is the Fed's favored measure. Shifting gears slightly to returned politics, domestic politics are not the only focus of the US rates market at the moment. The second round of the French election occurs on Sunday, July 7th, and expectations are somewhat mixed in regard to whether or not Le Pen's party will emerge victorious with an absolute majority. In the event that it doesn't go in Le Pen's favor, we'd expect a risk on response as it lowers the probability of any dramatic change in French politics, at least for the foreseeable future.

Vail Hartman:

And transitioning to the supply front, in addition to the top tier data that will be on offer, this week we'll also have the 3-, 10-, and 30-year auctions, and especially for the sale of the longer dated Treasuries, given the sharp politically inspired bearish repricing we've seen over the last week or so, the setup for the auctions will be of particular relevance, and we'll be curious to see whether the almost universally strong demand that we saw in the primary market in the month of June is carried into July, now that the renewed focus on domestic politics has been occupying a greater share of the macro narrative.

Ian Lyngen:

Well, one thing is very clear. There is a potential for fireworks.

Ben Jeffery:

Get it?

Ian Lyngen:

No.

Ian Lyngen:

In the week ahead, the US rates market will once again be offered a variety of fundamentals from which to derive trading direction. The marquee release comes on Thursday in the form of the CPI report. Headline inflation is seen increasing just one tenth of a percent in the month of June, while core inflation is seen up two tenths of a percent. It goes without saying that the market will take the bulk of its trading direction from the inflation figures, and when combined with Friday's release of PPI, expectations for the Core-PCE series should be pretty well established by the end of the week. We remain squarely in the September rate cut camp, but we'll note that the June Core-CPI numbers could challenge the notion that the disinflationary trend has been reestablished in the second quarter.

It's clear that the Fed is very much in a data-dependent mode, and it follows intuitively that market participants are as well. As a result, it's difficult to overemphasize the importance of Thursday's core inflation figures to the monetary policy outlook. The market will also be tasked with taking down $58 billion 3-year notes on Tuesday, followed by 39 bn 10-years on Wednesday, and capped by 22 bn 30-years on Thursday. The fact that the 10-year auction comes on the eve of CPI should marginally reduce any aggressive bidding at the auction, although ultimately we continue to see the outright level of Treasury yields at the moment as sufficient incentive to bring in otherwise sidelined buyers. We're also reminded that while this is a very important week for monetary policy expectations, there is a seasonal bias in the Treasury market that favors lower yields in July and August. All else being equal, we would expect that any bearish repricing that occurs as a result of the inflation figures will ultimately end up being a fade, particularly further out the curve as yields conform to the more traditional seasonal patterns.

And there's also a variety of Fed speak on offer. We hear from Powell, Goolsbee, and Bostic. And while we're not anticipating a major divergence from the recent Fed messaging, any nuance that monetary policy makers are willing to offer as it relates to the comparative weighting of the dual mandate will potentially create a trading impetus, particularly if it implies that the bar for disinflation to drive a September rate cut is lower.

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 arrives, we'd like to, once again, thank everyone who shows us support in the survey, and for those who haven't voted in the past, make this the first year. After all, it's too late to change the candidate.

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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