A Positive Outlook - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 290. A positive outlook, 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 September 9th. And as the 2s/10s curve shifts back above zero, we're thankful the market at least has something positive going for it. It certainly isn't carry.

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 relevant data came in the form of Friday's payrolls report. Here we saw headline non-farm payrolls increased by 142,000 jobs. That was slightly below the consensus of 165,000. Perhaps more relevant, however, was the fact that the net two-month revision was down 86,000. It's also notable that the unemployment rate ticked lower. However, when viewing it on an unrounded basis, what we see is that in August the unemployment rate was 4.221%, versus July at 4.253%. So it effectively went from a low 4.3% to a high 4.2%. We also saw a larger than expected increase in average hourly earnings, which printed at 0.4% versus the 0.3% consensus. That brought the year over year figures up to 3.8% versus the 3.6% level in July. Overall, our takeaway from the payrolls report was that it provided evidence for both the 25 and the 50 basis point rate camp.

So overall, while the market went into the event anticipating clarity in the 20 versus 25 basis point rate cut debate, what we saw was an extension of the period of uncertainty. The results then put the onus on the core-CPI numbers, which are expected to show a monthly increase of 0.2%, consistent with the Fed's broader objective of reestablishing price stability. We'll argue that a consensus core-CPI number combined with what we saw in the employment report sets the stage for 25 basis points in the event that the Fed chooses to take a more measured approach to lowering rates. The same could be argued for a 50 basis point cut, assuming that the Fed would then use the combination of the press conference and the dot plot to communicate that the committee wants to start with 50, but transition to 25 basis points at either every meeting or every quarter.

Another interpretation of the payrolls report is that it increased the probability of a November 25 basis point rate cut in the event that the Fed was approaching the balance of the year with a baseline assumption of 25 in September and 25 in December. There's also the timing of the end of QT. The softer employment profile in July and now August suggests that the Fed could be more comfortable bringing forward the announcement of the end of QT, which argues for 25 basis points in September combined with the end of quantitative tightening. The price action itself was bond bullish and favored a steeper curve, very much in keeping with what the market had anticipated would be the big macro trade of 2024, i.e., the bull steepening. We've certainly taken some solace that it appears that 2s/10s is back into positive territory on a sustainable basis, and we expect that from here we'll see a continued grind back into a positive sloping yield curve environment.

Ben Jeffery:

Well, the market has returned from summer in an unquestionably bullish fashion, with 10-year yield staging an over 20 basis point decline heading into the jobs numbers, as investors eagerly awaited clarity on what went on in terms of hiring during August and what that means for the magnitude of the Fed's first cut coming up in just under two weeks. For better or for worse, a softer headline hiring figure accompanied by two-month net revisions lower by 86,000 jobs was offset to a degree by a participation rate that remained unchanged and an unemployment rate that declined as expected, all with the backdrop of an upside surprise in wage growth. So not exactly a definitive answer one way or another as it relates to 25 or 50 basis points in September. And for that, we're probably going to have to wait for the passage of time and of course next week's inflation data.

Ian Lyngen:

I think that you're right, Ben. I think it all comes down to the core-CPI print on Wednesday. Expectations are for a two tenths of a percent gain in the month of August, and of course following that event, the market will be watching the press for any indication of the Fed's bias toward 25 or 50 basis points. In our endeavors to be intellectually honest, we think that the Fed, if afforded the opportunity to only cut 25 basis points, would be happy to take it. The concern from the perspective of monetary policy makers would be how investors might interpret 50. It goes without saying that a 50 basis point departure point would lead the market to price in 50 basis points for November and December as well, almost regardless of what the SEP and the dot plot suggest for the end of 2024. There's also the question of the pace of rate cuts going forward.

That information will be gleaned from the spread between the 2024 and the 2025 dots. All else being equal, we're assuming that 100 basis points next year is going to be the minimum that the Fed delivers in terms of rate cuts, although it's more likely than not going to be the level that they're comfortable signaling. All of this suggests that the market is overpricing what the Fed is going to signal in terms of dovishness, although not necessarily ultimately deliver. Admittedly, that's a bit of nuance, but at the end of the day, it implies even if the dot plot shows fewer rate cuts than the market is pricing in, that doesn't mean that Fed funds are going to conform to the dot plot.

Ben Jeffery:

And in our conversations with clients this week, there's been two competing narratives around what the Fed should do as it relates to both the size of September's cut and the forward guidance delivered at the press conference and the dot plot. On the one hand, we now have sufficient evidence, given this week's JOLTS numbers and the NFP figures themselves along with what we heard from Powell at Jackson Hole, that the softening in the labor market has reached a point when any further deterioration would not be acceptable, given that real policy rates are the tightest they've been this cycle. As inflation has continued to come down, what's the benefit of just a 25 basis point cut? If the Fed is in fact worried that they are too restrictive, wouldn't it be better to start the normalization campaign with 50 basis points and demonstrate a commitment to limit any further damage in terms of the employment landscape, given the fact that there's already 35 basis points of a cut priced in September? And so an extra 15 BPs at any given Fed meeting is not really going to do much in terms of an economic outcome.

The flip side of that argument, related to what you touched on, Ian, is that given how far the dovish pricing has extended, the outright level of rates in the very front end of the curve and rate cut pricing, but also the level of 10-year yields and what that means for actual economic activity, by not going 50 basis points, does the Fed risk delivering a tightening impulse at a moment when they're endeavoring to pursue the exact opposite? A market priced for 100 basis points, give or take, of easing this year, and the Fed unwilling at this point to conform with that pricing runs the risk of a policy error response, where the market is attempting to press Powell to cut by more, but the Fed is unwilling to respond just yet. That holds tightening financial conditions implications in nominal rates, real rates, and probably further weakness in risk assets.

Ian Lyngen:

And I think it's that risk asset component that would potentially be the most influential for monetary policy makers. In the event that the Fed chooses to do 25 and the equity market reacts poorly, i.e., selling off 5%, 10%, 15%, that will then start the Fed conversation about more dramatic rate cuts either in November, December, or 2025. Let us not forget that we also have the end of QT and the presumed upcoming announcement. Now, it's unclear whether the Fed chooses to announce that in September or November, but assuming that the program is done by the end of 2024 to avoid any issues with the year-end turn, we expect that the end of QT will be an olive branch to the doves, if nothing else.

Ben Jeffery:

And of course with this backdrop, we also reached a milestone in the Treasury market this week where we saw 2s/10s return to positive territory on a sustainable basis for the first time this cycle. Yes, there was that momentary or transitory flash steepening of the curve we got during the large rally that started August, but the fact that coming into September the price action has been slower and more orderly in nature, as we've seen rates move lower and the curves steepen out, that implies a greater degree of staying power to this latest steepening episode, as end-of-cycle dynamics in terms of the shape of the curve become a bit more apparent. 5s/30s back to effectively the steeps, 2s/10s back into positive territory, two-year yields at the lows as the Fed's first cut approaches, all resonate with what investors were anticipating would play out this year, even if obviously that has taken a bit longer than anticipated.

Ian Lyngen:

It was also interesting that perhaps for the first time in a very long time, the beige book contributed to the market's price action and perception of where the real economy is at the moment. Specifically during the inter-meeting period, nine of the 12 districts reported flat or slightly lower economic growth. This is the first time in the cycle where we have started to see more significant concerns from the beige book, and on the margin at least, that's a check in the column for a 50 basis point departure to the normalization cycle. Again, CPI has yet to cast its vote, so we'll remain on the fence between 25 and 50, at least for the moment.

Ben Jeffery:

And even if the beige book, the jobs data, presumably this week's CPI report are all going according to "the plan," that doesn't provide a clear answer to one of this cycle's biggest uncertainties, which remains whether or not the Fed will be able to pull off a soft landing and avoid a more material increase in the unemployment rate and a sharper deceleration in real growth as the economy continues to respond to the tightest monetary policy conditions we've seen in quite some time. So while anecdotes from the beige book show signs of flashing yellow, if not necessarily red yet, and a softer headline hiring number was offset to a degree by wage growth that remains nothing if not solid, the risk is that beyond simply the fourth quarter of 2024, we're going to be heading into 2025, quickly coming to the realization that even if initially it looked a lot like a soft landing, what ultimately is playing out is something a bit more troubling for the real economy.

And given that the lagged impact of Fed action works in both the tightening and easing direction, that will almost by definition mean that at that point it's already too late. Probably a bit too soon to have a high conviction opinion on what that means for the shape of the curve and the level of rates at the end of 2025, for example. But nonetheless, we suspect that's the macro narrative that's going to become increasingly relevant as we look forward into next year.

Ian Lyngen:

In addition, and it almost goes without saying, any Fed rate cuts between now and the end of 2024 really won't have an impact on the real economy until we're well into the second half of 2025. So to a large extent and consistent with the notion that the Fed might soon appear to be behind the curve, the market certainly is cognizant of the fact that the next couple months are without question the make or break period for the soft landing narrative.

Ben Jeffery:

And of course, even though last year saw a lot of questions about overseas investors willingness to own treasuries, what we've learned this year is that US rates remain the global benchmark. And so that means it's not just a prospect for a US soft landing that is going to determine the direction of treasuries and the shape of the curve, but it's also what we're seeing from the BOE, the ECB, and then on the flip side, from the BOJ, that all plays into the trajectory of the global economy. And given that on an outright basis the level of yields in the US still remain attractive by any longer term historical measure, that means that in addition to watching the domestic data and how the economy starts to cool into 2025, it's also going to be crucial to be cognizant of what's going on in Europe and Japan and what that means for those buyer bases of treasuries' willingness to chase the rally.

Ian Lyngen:

So what you're saying is that the chase is on.

Ben Jeffery:

And we might have just found the title for the 2025 outlook.

Ian Lyngen:

The rest will write itself.

In the week ahead, the Fed will be in its period of radio silence ahead of the September 18th FOMC meeting, and as a result, the interpretation of Wednesday's core-CPI numbers will be assisted by any messaging that the Fed chooses to use the press to communicate to the market. Now, there certainly is nothing that requires Powell to offer further guidance to the market simply because CPI falls in this particular window. That being said, this will be the first rate cut of the cycle. The Fed has done a very good job of telegraphing the timing while being vague about the magnitude of the move. So in the event that the Fed does choose to provide more concrete guidance, the press communication channel seems to be the path of least resistance. The treasury market will also be tasked with taking down $58 billion three-years on Tuesday, followed by $39 billion 10-years on Wednesday, and capped with $22 billion long bonds on Thursday.

Supply considerations as a theme have been a background factor and not truly driven the outright level of rates recently. Now, that's owing to a large extent to the fact that global policy rates have shifted from a period of being on hold, awaiting rate cuts, to most central banks now cutting or expected to cut, with the notable exception of the Bank of Japan. With our curve steepening bias in place, we'll be looking at the details within the core-CPI figures to see how owner's equivalent rent and rent has performed, whether we see a continued moderation in the key measures of housing inflation, or if there's a rebound, which would bring into question whether or not the Fed has in fact finally reestablished price stability in the US economy. PPI follows CPI on Thursday, and the release of producer prices will be helpful in refining expectations for core-PCE, although we don't expect it to be the tradable event that it was last month.

All of this occurs with the backdrop of a market that's settling into a new trading range, where lower yields and dip buying interest has become the norm, not the exception. And as policy rate normalization quickly approaches on the macro horizon, so does yield curve normalization back more sustainably in positive territory. We'll be closely watching any material changes in the volatility and the direction of risk assets, with a nod to the fact that a spike in uncertainty and volatility could easily start to tighten financial conditions. And if the move proves to be significant enough, it could further add to the case for a 50 basis point rate cut as opposed to a more pedestrian 25 basis point start to the cycle.

We have 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 market awaits official guidance via the press channel of Fed communication, it strikes us as nothing more than the Reporter Full Employment Act. 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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