5-Handle 10s - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 245, 5-Handle 10s, 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 October 23rd. With Halloween quickly approaching, the annual costume selection debate is at hand. Powell, Yellen, Bernanke, or Greenspan. Never Burns. Nope, never Burns.

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 sold off rather dramatically with the long end of the curve leading the move. 30-year yields above 5% and tens making overtures toward the same. The new fundamental information that was received included better than expected retail sales, including the control group, which surprised on the upside and contributed to strong Q3 GDP expectations.

Now, this also added to the no-lending argument or the notion that the real economy can sustain higher policy rates and more restrictive financial conditions. Whether that ends up being a reality for an extended period of time remains to be seen, but in the week just past, the clear takeaway was that investors anticipate that the real economy will continue to grow well into 2024, without any obvious ramifications from the cumulative rate hikes that have already occurred.

On the monetary policy front, this was the last week for the Fed to contribute to the pre-FOMC meeting pricing, i.e. currently a hike is seen as a very low probability event, and if the Fed was anticipating it would hike in November, we would've heard by now. This sets up the November 1st meeting to be largely a non-event or a bit of a placeholder until we have more information to inform the December 13th meeting.

We also saw a constructive jobless claims print, which did little to dissuade the market from assuming that the October non-farm payrolls data will continue to show a tight labor market. The combination of retail sales and employment figures have again reinforced the notion that the US economy will continue to post healthy growth figures.

On the supply side, we saw a solid concession for the 20-year sector that led to a 1.1 basis point stop through for the $13 billion offering. Now, given the outright level of yields, we're not particularly surprised that an additional concession was able to bring in marginal buyers, but the auction performance did little to prevent a broader sell-off in Treasuries. The $22 billion five year tips reopening tailed 2.2 basis points, which is really rather telling, given where we are in the cycle.

Specifically, the absence of a particularly strong bid for inflation protected securities suggests that we might be nearing the end of peak investor angst as it relates to the inflation outlook. That being said, it still remains too soon to declare victory on inflation, at least according to the vast array of incoming Fed speak. The consistent messaging on the part of monetary policymakers is they are in a wait and see mode, but there is absolutely nothing on the horizon that would suggest that they are going to be interested in bringing forward the process of normalizing rates lower, compared to what was signaled in September, i.e. 50 basis points of rate cuts next year as opposed to the 75 that they were suggesting in June.

Now obviously, as is so much the case with financial markets, monetary policy expectations are, and will ultimately remain, data dependent and as was noted earlier, the market seems very content with the no-lending narrative as do monetary policymakers until we have evidence to the contrary. There doesn't seem to be any clear indication of such evidence being in the offing, and as a result, we're content to go with the selloff in Treasuries with a target of 5.10 to 5.15 in the 10-year sector.

Vail Hartman:

It was a week that saw milestone price action in the Treasury market and tens look poised to achieve a five handle after we saw 30-year yields trade above 510 and close above 5% for the first time since 2007. This all happened while 2s reached as high as 5.25 before rallying back to roughly 5.15 in the wake of Powell's speech in New York. As far as curve shape, 2s/10s traded above negative 20 basis points and to the steepest level since September 2022.

Ian Lyngen:

The shape of the curve really is fascinating in this environment. As you point out, Vail, we're not quite back to positive territory for 2s/10s, but the reality is this year's big trade was always going to be the re-steepening in the yield curve. Now admittedly, most market participants were anticipating that that occurred in the traditional end of cycle style, which would've been bond bullish as opposed to bond bearish, but nonetheless, we're effectively where most market participants anticipated we would be at the end of the year.

The question quickly becomes, however, can we transition from a bear steepener to a bull steepener without an interim bull flattener? Now we expect that the short answer to that question is no. We will have a point where flight to quality benefits the longer end of the curve as the Fed proves to be stubborn in keeping policy rates anchored at terminal for in a typically long period of time, or at least that's the intention of monetary policymakers.

For the moment, there's no reason to expect that that won't be the case, especially as we approach the balance of the year and the real economy appears to be on more than sufficiently strong footing to withstand tighter monetary policy conditions for the foreseeable future.

One of the interesting aspects as we contemplate five handle tens that comes to mind is the fact that with effective Fed funds at the moment at 5.33, and the path to let's call it 5.10 or 5.15 in 10-year yields relatively straightforward from here, it's interesting to contemplate what the market is telling us in this context. For all intents and purposes, when looking at 10-year yields as nothing more than the geometric average of overnight rates for the next 10 years, it looks like Goldilocks is here to stay. The market is saying that the Fed won't have any material reason to cut rates, or the Fed's future rate hikes and rate cuts are going to be centered at effectively 5%.

That's interesting when we put it in the context of what monetary policymakers have been telling us over the course of the last several years, specifically that the neutral nominal rate is 2.50. Moreover, not only has the Fed told us that they're cutting rates next year, but they're cutting policy rates the year after that, and the year after that, and still the market seems determined to continue to push nominal rates higher even from current levels, which we'll argue are already very lofty.

Ben Jeffery:

There's a component of this conversation that we've had several times this week in the context of the relative attractiveness of Treasuries versus risk assets. After all, as portfolio plans are laid out and investment decisions are made, there's an aspect of simply the fact that one can guarantee a 5% annualized return for the next 10 years or even 30 years without needing to take on any credit risk or whether the volatility associated with say, owning equities. Not to mention the fact that in inflation adjusted terms, the fact that real yields are still so high also introduces this idea that as investors take a step back and evaluate allocation decisions, it's not unreasonable to expect that we'll see some meaningful demand come in for bonds.

Now the extent to which that comes at the expense of risk assets is the operative question, but certainly based on the sentiment we've heard this week, rates at these levels seem to imply a lot goes right for the Fed over the next two, five and even 10 years, exactly as you touch on, Ian. Now, the one counterpoint to this, and it's precisely what we've seen over the past several weeks, is that supply dynamics and Treasuries have shifted, and maybe positive term premium really is warranted, and that's how one gets to the conclusion that nominal rates need to be more elevated than simply overnight rates over the next 10 years.

Ian Lyngen:

But the question embedded in that, and I do agree with what you're saying, Ben, quickly becomes how much higher should 10-year yields be than the average assumption for overnight rates? If we use the New York Fed's ACM model for term premium, we're now at roughly 27 basis points. Historically, a range of zero to 35 basis points has represented what I'll characterize as the peak plateau by this measure. Using this as a guide, we're running up against the aggressiveness with which the market is willing to price in positive term premium over the course of at least the next 10 years.

Now, this creates a very interesting setup for the November 1st FOMC meeting. Since we're now in the Fed's period of radio silence and there's no economic data that will materially change the prevailing narrative on the horizon, we are content with the market's pricing out of any rate hike in November, rolling forward the possibility to the next meeting, which is December 13th. This means that the combination of the Fed's rate announcement, i.e. no change, and the subsequent Powell press conference are unlikely to yield anything remarkable in terms of policy expectations.

What makes Wednesday, November 1st so unique however, is the fact that in the morning, we have the refunding announcement. The market is expecting $48 billion 3s, $41 billion 10s, and $25 billion 30s. Said differently, auction sizes are continuing to increase and the appropriateness of the amount of term premium being priced in will come into question yet again. It's very rare indeed that the refunding announcement will overshadow the FOMC rate decision, but that's precisely what we're expecting to occur on the 1st of November.

Ben Jeffery:

There is also some information to be gleaned from the survey of primary dealers around the refunding process as it relates to the bill market, and specifically the Treasury Department's questioning about how aggressive they can continue to be in terms of growing bill sizes and increasing bills as an overall share of marketable debt outstanding, given the fact that despite some of the weakness we've seen in long end auctions and the bear steepening of the curve, generally speaking, even record large bill auction sizes have been met with very solid end user demand.

Now, bills as a percentage of the overall market have climbed above the 15% to 20% band that the Treasury Department has previously communicated they're comfortable with. However, remember in August, TBAC suggested that for a period, it may be appropriate for bills to represent a larger share of overall debt given precisely that dynamic. Obviously, we still have over a trillion dollars in the reverse repo facility, and generally speaking, the front end of the curve is still awash in cash in search of a place to be invested and bill rates at five and a half percent are clearly attractive enough to warrant leaning into to help the Treasury Department's borrowing endeavors and fund the deficit.

Along with larger coupon auction sizes, it's going to be interesting to see any communication around the refunding that suggests an overall larger bill market, maybe a near and medium term reality in terms of the issuance landscape.

Ian Lyngen:

When we put this in the context of how the Fed has changed some of the dynamics in the very front end of the market over the course of the last several years, it's difficult not to point to the RRP. Now, the magnitude and the relevance of the RRP are frankly difficult to overstate. Ben, as you point out, RRP balances are down notably, but that was always going to happen as investors saw the opportunity presented by higher bill rates, and that also answers one of the key questions, who's going to fund this increase in Treasury issuance?

If the reality is that bill issuance is going to absorb a disproportionate amount of the financing for the deficit, then a continued drawdown in RRP certainly resonates. It's also not wasted on us that a period of reserve scarcity comparable to what we saw in 2019 is now much less likely, given that the Fed has introduced the standing repo facility.

Now, this isn't particularly relevant for 2023 per se, but as we roll forward into 2024, and the balance sheet runoff continues apace from SOMA, one might have otherwise expected periods of potential reserve scarcity. But as Powell has said a number of times, even if the Fed chooses to start normalizing rates lower next year, the balance sheet will continue to run off in the background, affording the Fed the ability to get the balance sheet back at least closer to what they've identified as an ideal level.

Vail Hartman:

Transitioning to the topic of Fed speak, even as we had begun to see policymakers concede a lesser need for further hikes as bond yields have risen, this week we heard from Richmond Fed President Barkin, who acknowledged that even as long-term rates have risen, the challenge with depending on them is that they can move. This certainly resonates given how much realized volatility has risen in the long end of the curve, but it's notable that on Thursday, Powell acknowledged that financial conditions have tightened significantly in recent months and higher long-term rates have been an important driving factor behind this tightening. The fact that two-year yields resolved roughly 10 basis points lower in the wake of Powell's speech, and the odds of a hike in Q4 were similarly reduced, suggests that the net takeaway from Powell's comments were dovish, despite the Chair leaving the door open to further hikes and acknowledging that there are still plenty of risks that could ultimately resolve in another hike.

Ben Jeffery:

The Fed has been able to deliver a somewhat elegant solution and allowing themselves the opportunity to gather that more information before needing to make a policy decision in December. Two more NFPs and two more CPIs will mean that the Fed will be able to be data dependent in terms of the December decision.

Now, of course, the risk to that is that Congress can't come to an agreement to avoid a government shutdown, which may delay or distort the data in the lead-up to the December decision. It's still too soon to have a truly high conviction opinion on exactly what that would look like, but nonetheless, over the next several weeks, it's something to consider in terms of what it might mean for the clarity of the economic picture in the fourth quarter.

Ian Lyngen:

On the topic of clarity, and seeking clarification, did either of you know that Monday was National Boss's Day?

Ben Jeffery:

Vail, did you?

Vail Hartman:

I'm actually not sure who my boss is.

Ian Lyngen:

In the week ahead, supply will once again be on the radar for the Treasury market. We have $51 billion two years on Tuesday, followed by $52 billion five years on Wednesday, and then capped with $38 billion seven years on Thursday, which will represent the final nominal coupon auction for the month of October.

The economic data slate is relatively limited until we get to Thursday's release of Q3 GDP. Expectations are for a solid number across the board with the consensus putting Q3 real GDP above 4%. When we put that in the context of the Fed's estimates for growth this year, it would certainly be erring on the high side. That being said, given the numbers that we saw on the retail sales front, we wouldn't skew the consensus any lower.

The big question quickly becomes how much of that is already priced in, and was the backup in 10-year rates that the Fed is now viewing as the equivalent of a rate hike, if not more, in anticipation of a strong GDP print on Thursday? Or was it simply the process of accommodating the upcoming supply with an increase of term premium further into positive territory? That question will surely be answered on Thursday morning.

Then we have Friday's PCE and personal spending and income data. It's important to keep in mind that the PCE data is for September, and therefore will already have been incorporated in the third quarter's GDP numbers. As a result, we'll be looking for greater clarity in the trajectory of inflation within the third quarter, but not necessarily the outright numbers.

Quickly turning to the Treasury market itself, the backup in rates has been notable, as has the dis-inversion of the yield curve. A move in 2s/10s back to positive territory by the end of the year seemed to be the path of least resistance, and one that frankly we're unwilling to fade. We're on board with a continued backup in yields as the market explores the degree to which risk assets can handle higher nominal and higher real rates in an environment of heightened geopolitical and economic uncertainty.

While the US economy appears to be on strong footing, that's not necessarily the case for all developed economies, and as the impact of cumulative rate hikes continues to flow through the system, we remain wary that at this moment, the safe haven premium typically associated with US Treasuries is being undervalued. Said differently, in the event of a more material downturn in Europe or the UK or north of the border in Canada, the flow through to lower US rates could be rather dramatic.

That being said, that certainly isn't our near term outlook, and while eventually, we do anticipate that dip buying will emerge and 10-year nominal rates will drift back into a very familiar range, in the short term, the process of price discovery will continue to dominate trading in US rates, as there appears to be very little appetite to step in front of a move that has, by all accounts, been not only unanticipated, but very dramatic from a historical perspective.

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 in the wake of the apparently forgotten National Boss's Day last week, and as year-end approaches, there's really only one thing to say. Ben, Vail, thanks for making hard decisions much, much easier.

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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