Debating December - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 302: “Debating December” 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 December 2nd. And as we head into Thanksgiving, we're looking forward to debating all the hot issues of the moment: flat or sparkling, coffee or tea, pumpkin or apple, red or white, and of course, The Nightmare Before Christmas or Home Alone.

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 past, the most interesting developments came from Washington DC with the incoming administration's nomination of Bessent as the Treasury Secretary, a choice which is widely considered by financial markets as adding another adult in the room, and the Treasury market traded this appropriately.

We saw a bullish tone to start the holiday shortened week and 10-year yields drifting back toward 4.25%. Now, ultimately we do expect that we're in for a period of consolidation, even as Trump posted on social media that he intends to increase tariffs on Chinese goods by 10% and add a 25% levy to goods from Mexico and Canada. All of this to look at the response in US rates falls into the category of as expected.

And we anticipate that similar messaging will be absorbed by the market between now and the point when Trump takes office in late January. Now, this isn't to suggest that there are not going to be ramifications from a renewed trade war, but rather that the market has largely priced it in at this point. Now, as we think about 2025, we find ourselves focused on the traditional seasonal patterns, which imply that there will be a bearish tone in the first two quarters resolving in a bid over the summer.

And it's reasonable to envision 10-year yields ending 2025 at 3.75%, not 2.75%, not 5.75%, but effectively moving through the cycle with inflation coming back in line with expectations and the Fed delivering on at least a couple more rate cuts. And we're truly looking forward to seeing the updated SEP on the 18th of December to see the degree to which the Fed is willing to signal that the trajectory and perhaps ultimate target of their normalization campaign could change as a result of the incoming administration.

Everything that we've heard from Fedspeak thus far confirms the notion that monetary policy won't be adjusted based on what could happen in 2025, although that by no means suggests that the Fed will be indifferent towards what actually comes out of Washington. And to a large extent that's the current market debate at the moment, whether or not Trump's policies are ultimately going to rekindle inflation to the extent that it will limit the amount to which the Fed can normalize rates lower.

It's an active discussion that we don't expect will ultimately be resolved until we're well into 2025 and have a much better sense as to not only the initiatives coming from Washington, but also the extent to which the changes on the international trade front translate through to the real economy in the US.

Ben Jeffery:

Well, it was a short week with Thursday's market holiday and Friday's early close condensing trading and Treasuries, but that didn't mean there was no new relevant information for the market, as we came in from the weekend with an impressive bid to Treasuries, 10-year yields falling roughly 50 basis points on the news that President-elect Trump has selected Scott Bessent to become the next Treasury Secretary.

What made the move especially interesting was that despite Bessent's previously offered opinions around the merits of terming out the maturity profile of Treasuries, the curve actually bull flattened in a somewhat counterintuitive move. Our takeaway was that on the one hand, it was the Monday before Thanksgiving and that naturally is going to lend itself to more outsized moves. And on the other, the incoming Treasury Secretary is concerned about the deficit and is something of a fiscal hawk as it relates to the outright level of government spending. So bullish across the curve led by the 5- to 10-year sector, which we'll argue is also illustrative of a steepening bias in terms of positioning that continues to drive the price action as new information is revealed.

Ian Lyngen:

Let us not forget that Trump then subsequently posted on social media that he intends on day one to increase tariffs on Chinese goods by 10% and to levy a 25% tariff on goods coming from Canada and Mexico. This obviously had implications for the FX market, but from the perspective of Treasuries, the more interesting dynamic was the lack of sustainable price action from those headlines.

Now, to some extent, one can argue that this is simply Trump following through on campaign promises and therefore was not only priced in, but also holds limited surprise or shock value as it were. There's also the argument that the market has gone through the process of accepting that tariffs are coming, comprehending that tariffs provide a one-time increase to realized inflation, and are now considering the global growth and inflation implications from a renewed effort on the trade war front.

All of this, we'll argue, is relatively supportive for Treasuries over the course of the next several months. Now, we'll stop shy of suggesting that this means that 10-year yields are on a one-way journey back to three-handle territory. But the price action suggests that if nothing else, there remains previously sidelined demand to buy duration in the event of a backup in rates.

Ben Jeffery:

And part of that has to do with what we've seen in the market over the course of the last month or two. Obviously before the election, the increase in Trump's odds of being victorious in early November translated through to the impressive sell-off we got in 10s that reached 4.50%, more or less, and this was a no small part of function of what was widely expected to be a renewed focus on tariffs.

And if the rhetoric thus far is any indication, the incoming administration is planning on following through with that initiative. And so if we think about what tariffs are worth in terms of additional bearish pressure, particularly in the 10-year sector, the argument can be made that we priced a lot of this in the days following the election when we saw 10-year yields reach that local high.

And now that the ‘sell-the-rumor’ phase of this particular political cycle has played out, we're approaching the ‘buy-the-fact’ point that's becoming increasingly driven by the longer-term fundamentals of the performance of the economy, some lingering concerns on the resilience of the labor market, and let's not forget, the global growth backdrop that is not looking all that optimistic at the moment.

All reasons for a dip buying bias. And I totally agree, Ian, this doesn't mean it's going to be a straight shot back to 3% 10s, but the moves and yields have exemplified that there is still demand for Treasuries at these levels, despite the ostensibly inflationary risks that may be coming next year.

Ian Lyngen:

One of the more unique aspects of the price action that has been somewhat perplexing is the fact that a lot of the bid occurred as a bull flattener. The two-year sector remains anchored to effectively 4.25% to 4.30%. Now, the reason that this is so remarkable is assuming that the Fed delivers another 25 basis point rate cut on the 18th of December, that will bring Effective Fed Funds to 4.33%. In a typical cutting cycle, one can assume that Effective Fed Funds will function as a ceiling for nominal two-year yields.

For context, we tend to think of two-year yields as nothing more than a 24-month rolling window of policy expectations. So if we find ourselves in an environment where two-year yields are trading on top of Effective Fed Funds, the market is either saying that it doesn't anticipate any more rate cuts this cycle, that there's a lot of term premium built in in 2s, or that any rate cuts over the course of the next year will be followed by rate hikes that bring policy rates back above 4.33% on average during year two.

All of these potential justifications for two year yields at 4.30% we struggle with, frankly. We do anticipate that the Fed is going to cut rates in December and signal via the SEP that there are more rate cuts in 2025 yet to be delivered. Now, whether that ends up being 50 basis points in aggregate, 75 basis points, or as they signaled as recently as the September dot plot, a full 100 basis points next year will be a function of data.

It will also be a function of policy changes coming out of Washington DC. Now, returning to the earlier observation about the market's willingness to look past the near term reflationary implications from a trade war, it's also safe to assume that the Fed would take a similar approach. The Fed has a long history of characterizing one time increases in realized inflation as a tax on the consumer as opposed to representing the type of demand driven inflation that would warrant a policy response.

Said differently, we could find ourselves in the middle of 2025, tariffs beginning to flow through to the system impacting headline and in some cases, core inflation, but that not being sufficient to derail the Fed. It's also worth adding that the Fed has done an admirable job of reframing the conversation around inflation to focus on the super core measure – super core defined as CPI core services ex-shelter. Note that goods are not included in the Fed's definition of the important type of inflation at this cycle. So that means that in the event that Trump follows through on a wholesale increase in tariffs across the board, that the Fed will likely be willing to look through any increases in core-PCE as a result of tariffs as, dare we say, transitory.

Ben Jeffery:

And if there was any shortage of factors to consider in terms of framing the appropriate level of yields, there's also some optimistic news as it relates to the ongoing conflict in the Middle East with what that means for energy prices and obviously the flight-to-quality ramifications that will always surround geopolitical events' influence on the Treasury market.

In the vein of transitory, it's also worth acknowledging that we've reached a far different point in the cycle than when Russia initially invaded Ukraine, oil prices spiked, and the Fed started hiking to combat inflation. In that instance, the Fed was already going to be hiking to combat inflation, and it just so happened that the surge in oil costs, with what that meant for headline consumer prices, coincided with the surge in core prices as well. So Powell didn't need to make the distinction between energy price-driven and demand-driven inflation. Fast-forward to today and we've heard from the FOMC that they've gained enough confidence in terms of their cooling core consumer prices and the labor market has softened enough to justify rate cuts that we're not in the same situation.

And so on the one hand, that means a drop in oil prices is not going to be enough to speed up the pace of rate cuts, but nor is any upside in energy prices going to be sufficient in and of themselves to derail the Fed's bias at this stage, which is still for more rate cuts. Sure, they might be at a slower pace in 2025, but nonetheless, the committee is still intent on bringing rates lower, regardless of what's happening in the geopolitical realm.

Ian Lyngen:

And this brings us back to one of the core assumptions that we continue to apply to the market, and that is that from the Fed's perspective, there's a very significant difference between cutting and easing. The Fed is currently in a rate-cutting campaign to bring policy rates back closer to neutral as opposed to easing, which would be predicated on a weaker labor market and slowing economic growth, none of which are readily apparent.

Now, that certainly doesn't ensure that this dynamic will remain in place for the next several quarters, but it does, for the time being, suggest that as long as the Fed remains convinced that inflation is on the sometimes bumpy path back towards the Fed's objective, that it has the needed justification and cover to lower rates at least a few more times before the middle of next year.

All of that being said, we do anticipate that the Fed will transition from cutting every meeting to cutting once a quarter, and we expect that that will occur in the first quarter. So this translates into skipping January and lowering rates in March when they have the opportunity to offer another updated SEP and dot plot to further guide investor expectations. This timing will also afford the Fed the opportunity to incorporate any of Trump's day one policy initiatives after he takes office in late January.

Ben Jeffery:

And coming back from Thanksgiving week will be, what we'll argue, is the most critical input for the Fed and for the market before the end of the year via November's payrolls data. We've heard from Kashkari and others that a December cut should certainly be on the table, and that leaves our bias heading into the jobs numbers that it's going to be anything consensus or softer that would clear the way for the Fed to deliver another 25 basis point cut.

In fact, even a modest upside surprise probably wouldn't be sufficient in and of itself to completely take a cut off the table. For that we'll also need to see CPI. But as we think about the remaining inputs for the FOMC, it's difficult to overstate what Friday's payrolls numbers will mean in terms of the likelihood of not just a 25 basis point cut in December, but also the cadence of easing that will follow in 2025.

Ian Lyngen:

Well, Ben, I appreciate how you managed to work in ‘upside surprise in December’. I appreciate the optimism.

Ben Jeffery:

I gotta rock.

Ian Lyngen:

In the week ahead, the Treasury market will appropriately be focused on the payrolls report. Expectations are for a 180,000 headline print with a slight uptick in the unemployment rate to 4.2%. Now, there will also be plenty of information on offer in the run-up to the payrolls print, including the October JOLTS figures. Recall that in September, the quits rate printed at 1.9%, notably low given the perception that the labor market remains on strong footing, certainly as it has been characterized by the Fed.

Now, we also see the ADP figures for November, as well as the ISM Services and Manufacturing prints, all of which will contribute to the market's understanding of the trajectory of real growth during the fourth quarter. And for context, we'll note that the Atlanta Fed's GDPNow tracker puts Q4 at roughly 2.5% as we move through the data cycle. On top of the growth already seen in 2024, it's a very impressive run and one that has given the Fed sufficient flexibility in its efforts to reestablish price stability.

It's also notable in the week ahead that we're transitioning into the final month of the year, which has historically been characterized by subdued risk-taking appetite as positions are squared and books are closed. As such, it's reasonable to expect choppy price action and limited conviction moves. All that being said, the December Fed meeting will be an important tone setting event for the market as a whole.

Investors remain focused on the 2025 and 2026 dots in the SEP and any hints that the Fed might already be considering increasing its target for neutral based on the GOP sweep. All else being equal, we do not think that that's ultimately going to come to fruition, but it certainly is a key risk that's out there in the market at the moment, and one that we expect will make the November payrolls as well as the November core-CPI series that much more of a tradable event.

Modest payrolls growth and a benign CPI print should solidify the odds of a 25 basis point rate cut on the 18th of December. In the event that there are upside surprises in either releases, it will be notable how the Fed chooses to frame such upside. It's not difficult to envision the Fed being biased to cut rates even in the event of an upside surprise in payrolls and sticky core inflation.

While a direct hurricane impact on payrolls in the month of November is unlikely, we could see the series give back some of the downside in October, thereby distorting the data that much further. One of our core assumptions based on the impact from the hurricanes was that the data would be distorted and the Fed, for all intents and purposes, would be flying blind into the last two meetings of the year. Now, as the BLS has highlighted, that might be the case for payrolls, but the Unemployment Rate was still relatively unimpacted by the storms. So we'll be watching closely to see where November's Unemployment Rate prints as a precursor to any justification that the Fed could have to err on the side of a dovish cut.

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 with the holiday shopping season upon us, we're reminded that it truly is the thought that counts, assuming that the thought comes in platinum.

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.

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