38 Days Later - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 270, 38 Days Later, 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 April 22nd.

With 38 days left until the Memorial Day holiday, we're now in the middle of one of the longest stretches between market closures, second only to the window of Independence Day to Labor Day, but that period includes August, which let's face it, is a market holiday, just food for thought as the five-day work week becomes a norm and SIFMA is doing its best to give us plenty of full weeks. Thanks.

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 most notable development came in the form of the price action itself. Now we know that the combination of this strength in the labor market, particularly seen via the March non-farm payrolls print, combined with the stickiness of inflation, as evidenced by CPI and PPI, has led the market to seriously consider no or one rate cut from the Fed this year.

Now we're pricing in more than one full cut at the moment, but there's a very reasonable conversation to be had about as the data continues to demonstrate this degree of resilience, rate cut expectations will be pushed further and further into 2024 and eventually into 2025. Now, that's not our call at the moment at least, and instead we are focused on the June FOMC and the updated SEP for better guidance as to what we should expect.

We certainly don't think that there's a path to 75 basis points worth of cuts this year, at least not anymore. But it's very conceivable that by the time we get to the June meeting, the Fed is marginally convinced on the inflation front and they lay the groundwork for two rate cuts, whether that starts in July or September remains to be seen. On the flip side, if the data continues to come in strong, then there will be little urgency on the part of monetary policymakers to begin cutting rates.

Now at present, no one is seriously entertaining the idea of a rate hike. The assumption is that 5.50% will be the upper bound, i.e., terminal, for this cycle, and eventually the Fed will begin normalizing rates lower. Now, it goes without saying that given the Fed is very much in a data-dependent mode, we will be closely tracking any changes in Fed rhetoric.

Powell's comments on Tuesday were very much in keeping with the data-dependent mode narrative. They were more hawkish, but that translates into delaying rate cuts not revisiting the right level for terminal. One could argue that all Powell was effectively doing was marking-to-market the Fed rhetoric to the realities of the economic data. That's a process that we expect will continue over the second and into the third quarter as investors and the Fed respond to the realities of the data.

The week just passed also saw a decidedly bond bearish response, which brought ten-year yields as high as 4.69%, and started conversations about whether we're going to get beyond 4.75% and retest 5%. 4.75% seems like a very obvious line in the sand. And while we do think there's a high probability that level is tested, what will be interesting to see is how, if at all, the equity market responds to another surge in Treasury rates.

All else being equal, we would've expected to see more damage done to the stock market at this stage. But the S&P 500 is still in positive territory for the year, which means that a much more significant correction could be absorbed without compelling the Fed to deliver a policy response. To a large extent, the Fed would in fact like to see an increase in realized volatility, which will tighten financial conditions and serve to offset some of the upward pressure on inflation.

With core services CPI sticky to the upside and the unemployment rate sticky to the downside, it's not surprising to see headlines about how rent and housing costs remain the Fed's biggest obstacle to re-anchoring inflation.

Vail Hartman:

The month of March has turned out universally strong on the economic data front with a 303,000 payrolls gain, a 3.8% unemployment rate, a 0.4% core-CPI gain. And in the week just passed, we saw a very robust showing on the consumer spending front via the Retail Sales report, in which the control group jumped by 1.1% showing the largest monthly gain in consumption since January 2023, and that move nearly tripled the 0.4% consensus.

We also heard from Powell who said that the recent data has indicated it will likely take longer than expected to achieve confidence on, and this all served to push ten-year yields north of 4.65%. And now the question has become, does anything further need to be seen by investors in order to push benchmark rates to 4.75% and beyond?

Ian Lyngen:

And I think that that is the fundamental question in the market at the moment. We have taken the new information received via the economic data, as well as Powell's effective acknowledgement of the realities of the data, and we have repriced, we've repriced the market to such an extreme, however, that the combination of short covering and dip buying interest has defined the upper bound for the trading range for the time being, and that comes in at 4.69%, let's call it 4.70% to 4.75%.

So setting aside the technicals for a moment, if we have another bond bearish episode, it follows intuitively that we could go above 4.70% with the target of 4.75% without really needing to see anything change fundamentally. That would be achieved simply by a period of consolidation in which positions are squared, the decidedly bond negative momentum measures are able to work themselves back to some version of neutral, and then we would, for all intents and purposes, be re-trading the same narrative.

Getting ten-year yields to 5%, however, is an entirely different story. For that, I suspect that we would need to see an acceleration of inflation, another impressive employment report or two, and the Fed, once again, concede that they're going to need to spend an even longer period with terminal policy rates in place before they can start normalizing.

Ben Jeffery:

And to talk a little bit about the reaction in terms of investor behavior we've seen across the Treasury curve, what started a few weeks ago as a general skepticism that the data warranted as many rate cuts as we saw priced into this year. Now that we have all those data points that you mentioned, Vail, in hand, and Powell's acknowledgement that progress on inflation has stalled, what we've seen is that cut pricing in 2024 has fallen to just north of 40 basis points with next year's easing at just 60 basis points.

So in conversations with clients this week, and as we saw two-year yields briefly cross 5%, the question has become how much further can the front end of the curve sell off if in fact we know that the Fed wants its next move to be a cut, not a hike. And at this point, the hawkish reaction function is still simply delaying cuts and not introducing hikes back onto the table. So to zoom out a bit in terms of what we've seen in outright rates, but also the shape of the curve this week, it's been relevant to see some steepening progress in what was widely thought to be this year's big macro trade, although I'll argue this steepening is playing out not because the economy is rolling over and a recession is at hand, but rather that yields in the very front end of the curve have simply backed up too far for real money investors to pass up the opportunity of a 5% two-year yield for a second time.

Remember last year in the lead up to the November refunding announcement, we only had a week or two of 2s as cheap as they are right now. And given what a compelling buying opportunity that ultimately ended up being, I think the bull case for the front end of the curve from here is growing increasingly strong, even as the long end may remain a bit more susceptible to the arguments around higher term premium, a soft landing, and higher Treasury issuance.

So as we think about the case for a steeper curve from here, I would argue that barring a meaningful tone shift from the Fed, a larger sell-off from here will probably be of the steepening variety, given that two-year yields at 5% reflect roughly no cuts at all this year, and just 75 basis points of easing between now and early 2026.

Ian Lyngen:

And I think the key part of the narrative underlying the support for two-year yields at the 5% level is this idea that if the Fed needs to avoid cutting rates throughout all of 2024, that increases not decreases the probability of a soft landing. So said differently, if inflation proves to be so sticky for such an extended period that the Fed ends 2024 at 5.50% for the upper bound, then the probability of a significant downturn increases every quarter that goes by.

Now, one could argue that Powell's been very fortunate to not see the type of excess demand destruction that one would typically associate with the tight policy that's in place. But this does return us to the persistent question of how long can it last?

Ben Jeffery:

And implicit in the how long it can last discussion is the reaction we're starting to see in risk assets. Equities come to mind, and the modest widening, emphasis modest, that we've begun to see represents a reaction function across markets that the Fed probably wanted to see play out sooner. Sure, the S&P 500, 5 to 7% off all-time highs, is hardly a correction that's material enough to justify a swift reaction from the Fed.

And nor is a modest credit widening an alarm that we're about to see a massive tightening in credit standards. But it is surely, at least marginally encouraging for Powell to see that equities are at least marginally starting to pay attention to the rhetoric that's being delivered. And financial conditions have begun to tighten slightly.

To look at the pullback in stocks, to look at the increase in real yields, the Fed's hawkish communication is a bit more effective than it has been over the past month or so. And so despite what it means for the wealth effect or maybe because of what it means for the wealth effect, the Fed would like to see another few weeks, maybe even another few months, of a gradual grind, lower in risk asset valuations as long as it doesn't take place in dramatic fashion.

The Fed is fine even if most others are not, but stocks need to be 20% lower over the course of several months, not over the course of several days. It's that variety of pullback that doesn't echo of market dysfunction, that is exactly what Powell and the Fed are pursuing. Whether that's ultimately what plays out will probably be more of a function of the economic data we get between now and the June meeting.

Ian Lyngen:

On the topic of market dysfunction, it is notable that the Fed has continued to ready investors for QT tapering. Now as we see the utilization of RRP well below 400 bn, it does bring to mind whether or not the Fed will ultimately be comfortable with QT starting to work into bank reserves once we get RRP down to zero. Our baseline assumption, and I think it's largely shared by the market, is that the Fed wants to get RRP to the lower bound, whether that's $50 billion or zero remains to be seen. And they'd prefer not to risk a reserve scarcity event comparable to what we saw in 2019.

Recall, the balance sheet is still very large by historic standards. However, some of the residual regulatory changes that occurred because of the regional banking crisis have added a new layer of uncertainty and the Fed simply wants to preserve the functioning of the market.

In terms of the precise timing of the announcement, we're anticipating it occurs at the May FOMC meeting. So next month we will learn that the Treasury component of QT will be halved to $30 billion from $60 billion, while mortgages are generally expected to be unchanged.

Vail Hartman:

In returning to the supply front, we do have the Treasury Department's financing estimates and quarterly refunding announcement coming up in just under two weeks, which brings another potential source of volatility back into the limelight as investors remain concerned about the potential for lofty borrowing needs and supply indigestion at a moment where we've already seen a substantial spike in Treasury volatility throughout the month of April.

For context, after the MOVE index reached the lowest since February 2022 just three weeks ago, the volatility gauge has quickly shot back up to the highest since early January. So on top of the many cross currents currently factoring into the price action and Treasuries at the moment; including choppy data, geopolitical tensions in the Middle East, cross asset flows with earnings season now in full swing. The potential for poor auction takedowns to continue as a theme is another factor that could add to the volatility in the Treasury market in the coming weeks and months.

Ian Lyngen:

Well, Vail, based on your comments about vol, I think it goes without saying that you're a strategist on the MOVE.

Ben Jeffery:

I can VIX that.

Ian Lyngen:

In the week ahead, the market will get its first look at Q1 real GDP, where expectations are for a solid print above 2%. Perhaps more importantly is that within that series will be the extent to which inflation played an instrumental role. Recall that for the same amount of nominal GDP growth, the lower inflation is, the higher print one would expect in real GDP.

If in fact, as we've seen in Q1 inflation is airing on the upside, we could see a weaker growth update as inflation continues to plague the US economy. Whether the market is quick to trade that as a stagflation narrative is a meaningful unknown. But we don't think that stagflation will actually become truly topical with just one missed GDP print. The flip side is, of course, that real GDP comes in stronger than expected, which reinforces the no-lending narrative, and if nothing else would give the Fed an extended runway to continue its battle against inflation.

Let us not forget that on Friday we see the core-PCE numbers for March. The upside seen in core-CPI at 0.4% did trigger concern on the part of market participants that we would see a comparable 0.4% for core-PCE. However, once we had PPI in hand and the translation of core-CPI into core-PPI became more certain, the market consensus has settled on 0.3% with an expected downtick in the year-over-year pace.

One certainly won't be able to take the core-PCE number at 0.3% and make an argument that the Fed should be content with the progress on inflation. But that being said, it's certainly more benign than a 0.4% or even a 0.5% print would've been. Certain aspects of inflation have proven to be stickier than the market, and certainly the Fed would've expected at this point in the cycle.

When we look at the housing sector and the high correlation between the unemployment rate and rents, the economic cycle is entering a very precarious stage at which the long overdue spike in the unemployment rate could be needed to re-anchor inflation. The issue then becomes whether or not that spike is 75, 100, 150, or 200 or 300 basis points, which would take us from 3.8% to something well above, let's call it 5%.

Now, obviously, the trajectory of such a move is as key as the ultimate magnitude, and this is going to be even further complicated by the fact that it's occurring in a presidential election year. Powell has gone out of his way to distance the conversation about rate cuts from the looming election, but at the end of the day, the Fed still faces a degree of credibility and independence risk as November approaches.

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 the NBA and the NHL playoffs starting this weekend, we'll be looking forward to a post-game NAP.

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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