Angsty August - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 286, Angsty August. Presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery and Vail Hartman to bring your thoughts from the trading desk for the upcoming week of August 12th. As the 2s/10s curve moves back above zero, positive has become the new negative. Sometimes it's just a world of protons, electrons, and Treasury longs.

Each week we offer an updated view on the U.S. 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 ahead, trading in the Treasury market will be defined by the July print of core CPI on Wednesday morning. The current consensus is for an increase of two-tenths of a percent on a month-over-month basis for core, as well as two-tenths of a percent month-over-month for the headline figures. This would be a pace consistent with getting the Fed back to its 2% inflation target over time, but at the same time, it wouldn't contribute to the case for a 50 basis point rate cut in September and certainly not an intermediate move. As we contemplate the other data throughout the course of the week, Tuesday's core PPI numbers could be influential in setting the market up for CPI, although recall that the month-over-month correlation between core-CPI and core-PPI is relatively low. The most important information to be derived from PPI comes in the form of the components that ultimately lead to the forecast of core-PCE.

So while the market might be back into the mode of trading more heavily toward the inflation part of the Fed's dual mandate, the reality remains that Wednesday's CPI number is the marquee release. Within the details, we'll be watching the supercore measure, which has moderated in line with what the Fed would like to see, and the pillars of core inflation remain housing costs, specifically OER and rent, both of which have begun to drift back towards the pre-pandemic norms, which is a decidedly good development for the Fed.

On Thursday, we have the Retail Sales report. We've been impressed with the ongoing pace of consumption, and as we translate this into expectations for real growth, we look to the Atlanta Fed's GDPNow tracker, which is currently running comfortably above 2%. With a backdrop of strong real economic growth in a cooling inflationary environment, we're certainly on board with the Fed cutting rates in September, although not with the type of urgency that seemed to be implied in the wake of the payrolls figures. So as we think about the major themes for 2024, we continue to like the cyclical re-steepening of the yield curve. And with 2s/10s back above zero, at least momentarily, we think that this trade still has a significant amount of room to run.

We also like selling 10-year breakevens in this environment because as it becomes more and more evident that monetary policy has been effective in re-establishing price stability, we anticipate the conversations about forward inflation expectations will shift from inflation having moved structurally higher toward the potential disinflationary risks in the event of a more durable economic downturn or outright recession. We characterize the outright yield levels at the moment as having reached a comfortable equilibrium, as the market isn't particularly stressed or strained in either direction, which will afford investors a clean set up to CPI and thereby a more intuitive response to the actual figures.

Vail Hartman:

Treasury yields have meaningfully retraced off the post-NFP lows in a move that's been reflective of a renewed sense of calm as global equities have stabilized, and the data continues to suggest the U.S. economy remains on solid footing, at least for the time being. The Fed Funds futures market has moved from the post payrolls extreme of pricing in over 60 basis points of rate cuts on September 18th to less than 45 basis points. And through another lens, the futures market has shifted from pricing in more than 135 basis points of rate reductions by year-end to now roughly 100 basis points of cuts over the balance of the year. And quickly approaching on the macro horizon, July's inflation data will play an essential role in refining the market's expectations for the size of the cycle's first rate cut next month and the pace at which the normalization process will unfold shortly thereafter.

Ian Lyngen:

So Vail, I think that that was an apt characterization of the week. I might phrase it as someone called off the recession because we came into the beginning of the week with everyone expecting that there was going to be a significant downturn in both the economic data as well as risk asset performance, and what we saw was stabilization on both fronts and a reduction in the amount of rate cuts priced into the market. We remain in the 25 basis point cut camp for September with a key caveat. We have two more inflation reports and another payrolls print from which we expect investors will refine expectations for September. Let us not forget, September is also a meeting in which the Fed will update its SEP and the beloved dot plot. So it will be an ideal moment for the Fed to provide guidance in terms of whether or not a November rate cut is actually on the table.

Now, while we do expect that the core CPI numbers in July will set the agenda for the week ahead, we're also left to contemplate Powell's appearance during the following week's Jackson Hole event. Now this has historically been a forum at which monetary policymakers choose to signal any broader shifts in either the way that they're framing their approach to monetary policy or if the event happens to correspond with an inflection or pivot point as it clearly does during this cycle. So our baseline expectations are for Powell to confirm that September will be the first rate cut while moderating expectations for both the magnitude of the cut and the frequency of the subsequent moves. So in the absence of the July payrolls number and the subsequent price action, we would have otherwise expected the market to interpret Jackson Hole from a dovish perspective. Given everything that has occurred, it will more likely than not come across as incrementally more hawkish.

Ben Jeffery:

Along with the size of the September cut and what will follow in November and/or December, also remember the core focus of this year's symposium in Wyoming is the effectiveness and transmission of monetary policy in the new economic reality that we find ourselves in following COVID. So while there's been a lot of a discussion around the potential for an emergency cut, a 50 basis point cut, a series of 50 basis point cuts in 2024, there's a case to be made that the rhetoric from Jackson Hole, both from Powell and other Fed speakers that are sure to be frequently interviewed during the event, that the focus will be less on what's going to come to pass in the next quarter or so and more on the appropriate level of rates over the longer term.

Obviously, the last cutting cycle was a bit unique given the emergency nature of it in response to the pandemic. But remember before early 2020, we did have a series of fine-tuning rate cuts that brought rates incrementally lower off last cycles peaks. And before the economy came to a screeching halt, the Fed seemed comfortable with the level of restrictiveness it was delivering. Fast-forward to today, obviously policy rates are much higher, monetary policy is much more restrictive, but it will be interesting to see on the one hand how quickly the Fed feels comfortable dialing back that level of restrictiveness, which will no doubt be a function of the incoming labor market data. And in addition to the speed of the cuts, it's also going to be very important to see if we get any more information on the finish line of cuts, and if the committee sees mildly restrictive as appropriate, as close to neutral as can reasonably be achieved as appropriate, or back to accommodative territory. All with the inherent ambiguity around where it is our star actually is.

Ian Lyngen:

We know where our star is. He's right here. Vail.

Ben Jeffery:

Never gets old.

Vail Hartman:

And transitioning to the supply front, this week we saw a sizable tale of three basis points at the 10-year refunding auction, and non-dealers took just 82.1% of the issue. And putting this in the context of recent new issue auctions specifically, this was the largest tale and the smallest non-dealer award since the November 2022 refunding auction. Now we're somewhat comfortable de-emphasizing the near-term implications of the weak takedown if only given the magnitude of the rally that we saw in the lead-up to the supply event. The auction did clear with a three-handle for the first time in a year, and at the end of the day, it appeared that investors weren't particularly excited about paying up for 10-year notes below 4%.

Ben Jeffery:

And I would agree with you, Vail, that the auction result was certainly a function of the outright level of yields and just how quickly we've seen the treasury market rally over the past week or so. But it's also worth mentioning just the outright level of volatility we've seen in Treasuries over the past several weeks and what that inherently means about how aggressive bidders were willing to come into the 10-year auction. After all, to look at Monday's price action in the two-year sector, not traditionally a part of the curve that swings around all that much, a 30 basis point intraday range will naturally leave overly aggressive levels either on the buy or the sell side a little bit more cautious just given how dramatically the market has repriced since the FOMC meeting, the payrolls report, and obviously the retracement price action we've seen this week.

Ian Lyngen:

While we're comfortable with the interpretation of cooler heads prevailing in the market as yields have moved back off of their lows, we're certainly cognizant that the core CPI numbers on Wednesday could recast the macro narrative in frankly either direction. A 0.1% or a 0.0% on the core measure could very quickly put 50 basis point rate cut expectations back on the table or even build at least a marginal case for an inter-meeting move. Again, this is not our base case scenario. The flip side being that a 0.2%, which is the consensus, would reinforce the notion that the progress being made on inflation is constructive for the treasury market, but it doesn't imply any true urgency for the Fed to deliver a supersized rate cut in September. A lower probability event would be a 0.3% or a 0.4%, which would surely rekindle the conversation about stagflation in light of the recent increase in the unemployment rate, and without question, complicate the calculus of the Fed's decision in September.

Ben Jeffery:

And this is the risk that was well discussed in the earlier part of the summer, but has clearly fallen on the back burner of investors' minds given what we've seen in terms of labor market developments. And that is that on core inflation's journey back toward 2%, the early part of that trip was always going to be the easiest, and it's the last mile of getting inflation back to target that's going to require potentially more time to be achieved. And also more importantly in evaluating the health of the economy as a whole, more demand destruction via softer wage growth, a higher unemployment rate, and a softening in consumption, which ultimately boils down to a lower growth profile.

Now, the uncertainty as it relates to the current price action and treasuries is the degree to which the Fed is going to be comfortable inflicting that demand destruction, slowing the economy, and allowing real growth to continue to grind back toward and maybe even slightly below zero. Or if the increase in the unemployment rate, the trend in jobless claims that we're seeing, and the overall level of concern on the state of the economy will prompt a quicker and more dramatic reaction in terms of lowering policy rates or potentially stopping the balance sheet run off a bit sooner than would otherwise have been expected.

Ian Lyngen:

One thing that is clear is that the Fed is attempting to thread the proverbial needle to make sure that they reduce the degree of restrictive policy that there is in place to ensure that any further deterioration in the trajectory of the real economy at least has the beneficial offset of less restriction and presumably guidance of more rate cuts to come in the future. Now, all else being equal, one would've expected that Powell's dovish tone, effectively setting up the market for a September rate cut, would've translated into a bounce in the equity market. Alas, when combined with the payrolls figures from July, what we saw was a clear downdraft in risk assets and equity valuations, which left investors with a distinct impression that the signaled 25 basis points per quarter cadence of Fed cuts will not be enough to justify the current valuations in the equity market at least.

Ben Jeffery:

And that matters for the wealth effect of course, but also for the overall state of financial conditions. And if equities remain under pressure in the coming weeks and months, even if real rates stay low and Treasuries continue to be well bid, the moves and risk assets are going to have a tightening impulse on financial conditions even without rates staying high. And so as we think about the feedback loop between the price action across financial markets and what it means for the Fed's reaction function, the greater the volatility in stocks, the more tightening that the market is doing for the Fed, and the more justification Powell will ultimately have to begin the process of bringing rates lower.

Ian Lyngen:

So to bring this full circle, at Jackson Hole, Powell will just be checking in to see what condition the conditions are in.

In the week just passed, the Treasury market started with a remarkable bid that saw 10-year yields dip as low as 3.665% in a flight to quality, which was largely a function of a significant sell-off in global equities. The trigger behind the sell-off in global equities can be attributed to the prior week's surprise move by the Bank of Japan to increase policy rates 25 basis points. This ultimately led to a sharp correction in Japanese equities as the major carry trade was unwound. Now, while there appeared to be a reasonable amount of contagion at the beginning of the week, by the end of the week, the situation had calmed down. It's notable that there were, at one point, calls for an emergency rate cut by the Fed, an outcome that we always viewed as very unlikely, especially given that Powell has laid the groundwork to start the process of normalizing rates lower next month. And the magnitude of the sell-off in U.S. equities simply didn't warrant such a dramatic response.

We also then heard from the Bank of Japan early in the week effectively calming the market by saying that the Bank of Japan is unlikely to hike in volatile market conditions. This reduced the perception that the Bank of Japan was about to enter a series of rate hikes. So it's with this backdrop that we saw the 2s/10s curve shift back into positive territory, albeit only momentarily, before we retracing somewhat. However, in light of the fact that there was very little on the economic data calendar, the supply considerations, via the $42 billion 10-year that ultimately ended up tailing, pressured the yield curve steeper. Not in a bullish fashion, but in a bearish fashion. And this follows intuitively with conversations around the return of positive term premium, even as the Fed prepares the market for a series of upcoming rate cuts.

Now, as it currently stands, the most relevant debate is not if September will mark the departure point for the Fed's rate cutting process, but rather whether the Fed will go 50 or 25. We remain in the 25 basis point rate cut camp with the caveat that between now and September 18th, investors and the Fed will have two additional CPI prints as well as another payrolls report from which to refine expectations for how much the Fed will cut. It goes without saying, if we see two soft CPI prints as well as another lackluster jobs report, the Fed could simply choose to start the normalization process with 50 basis points as opposed to our baseline assumption of 25.

In pondering the meetings during the fourth quarter, the November and December Fed decisions, we continue to operate under the assumption that if they go in September, they'll go in December. November is more of a wild card, and as with a debate between 50 or 25 basis points, will ultimately come down to the performance of the real economy, the trajectory of inflation. And as we saw early in the week just passed, the performance of risk assets as well as the flow through to overall financial conditions will remain a key backdrop in the months ahead.

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 Olympics come to a close on Sunday, the one positive result for team strategy was that none of us sustained any injuries, nor do we have to carry around those annoying medals.

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@bmocm.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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