Anxious in Autumn - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 244, Anxious in Autumn, 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 16th. Mid-October is upon us, and as Fall begins to fall, we're left to ponder the perennial question, why was there no pumpkin spice in everyone's favorite iconic British nineties pop band?

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, there were three major developments in the global financial markets that defined the direction of US rates. First was the war in the Middle East. Second was the dovish tone shift on the part of monetary policymakers in the US. And third is what we'll characterize as a bit of supply indigestion in the US Treasury market. Heightened geopolitical uncertainty has intuitively led to a flight to quality bid in the Treasury market that brought rates nearly 35 basis points off of last week's peak. In addition, and perhaps more importantly from a sustainability of the move perspective, was the fact that the Fed is now characterizing the recent backup in rates as tightening financial conditions, effectively for the Fed. So if the market is doing the Fed's heavy lifting, that intuitively leads to a lower probability that the Fed will need to hike again this year.

While the Fed's most recent projections showed a 5.75 upper bound for policy rates at the end of this year, the reality is that the last quarter point is going to be considered much less relevant from the Fed's perspective than maintaining terminal for an extended period of time. We're continuing to function under the assumption that the Fed is able to make it into the fourth quarter of 2024 without needing to cut rates. Now while the market isn't too far off, the investors are still seeing cuts sooner and deeper than the Fed has signaled. We anticipate that one of the defining characteristics of the next stage of the rate cycle will be a Fed that proves to be more stubborn at terminal than the market is currently expecting. So in translating that through to potential price action, that means that the cyclical re-steepening of the yield curve led by a bid in the two-year sector will be delayed.

We're viewing the recent bull flattening bid in Treasuries that was largely driven by the flight to quality as a preview of what to expect during the fourth quarter. Two year yields are anchored to effectively 5%, give or take 10 basis points, and therefore the curve has simply become a directional trade. Any rally will result in a more inverted curve, whereas any selloff will be a curve steepener. Of course, this will all eventually change once it becomes evident that either the economy has slowed too much or the Fed deems the progress made on inflation sufficient to begin the process of normalizing rates lower. Now, it's important to keep in mind that rate cuts from terminal at 5.50 or 5.75 have decidedly different implications than rate cuts when monetary policy is at neutral. Said differently, the Fed has already told us that they're going to take rates from very restrictive to restrictive but lower over the course of the next year.

If history is any guide, once it becomes obvious that the first rate cut is coming, the market will price in a series of rate cuts over the following several quarters, which will trigger that bid for the two-year sector and ultimately the macro trade that most investors have been waiting for, i.e., the cyclical bull steepening of the curve. But for the time being, the resilience of the economic data combined with the Fed's resolve have pushed out the potential for a recession and therefore limited the potential for any policy response.

Vail Hartman:

It was a week that saw some pretty remarkable swings in the trading direction in Treasuries as the price action was a function of mounting geopolitical uncertainty, a dovish tone shift from the Fed, a firm look at realized inflation in September, all while the bond market was tasked with absorbing new 3-, 10-, and 30-year supply.

Ian Lyngen:

Vail, you make a great point. It was an extremely volatile week, both in terms of price action in the US rates market, but also in terms of the evolution of the macro outlook. We came into the week with a very significant bid in Treasuries, given what occurred over the weekend in Israel, but that was also accompanied by what I will say was a unexpected tone shift on the part of monetary policymakers at the beginning of the week. We heard specifically from Jefferson and Logan on Monday on the fact that the Fed is now viewing the recent backup in rates as the equivalent of a rate hike, give or take, which intuitively took a November rate hike off the table.

When we look at it in terms of market pricing, the Fed's comments dropped the probability of a November rate hike to roughly 10%, and even the firm CPI data on Thursday only saw that probability get up to roughly 12%. What has occurred is expectations for a November hike have been rolled forward to December, but still, the probability of a December move is just at 25%. Now to be fair, the December 13th meeting will come after the Fed has two additional CPI reports to better gauge the trajectory of realized inflation during the fourth quarter.

Ben Jeffery:

And it's also worth discussing in addition to outright yield terms, what the latest developments in the Middle East have done for the shape of the curve and what that implies about investors' assumptions around the Fed's reaction function to the potential for a more widespread conflict in the region. Specifically the fact that the rally in Treasuries has generally been flattening in nature with, of course, the caveat of some distortions around supply, speaks to the idea that the Fed has successfully communicated the idea that now that rates are in restrictive territory and the balance sheet is continuing to run down, the mission among monetary policymakers is to continue to push out rate cuts further into 2024, if not beyond. And that means in the front end, the two-year sector for example, we've seen a period of relative stability even as the long end of the curve was the primary beneficiary of the impressive flight to quality we saw that pulled 10 and 30 year yields well off the peaks we achieved in the wake of the stronger Payrolls report.

And this is indicative of the shift we've seen in the reaction function in the shape of the curve from bull steepening to bull flattening and bear flattening to bear steepening in so far as the one, two and maybe even three year sector are increasingly well anchored and, we would argue, priced to a soft landing outcome even as the flight to quality, growth and inflation assumptions are becoming far more impactful for the long end of the curve with the term premium discussion that we've had several times already. Meaning that we're definitively in the mode of the curve steepening or flattening being a function of outright duration’s performance rather than the implications for the Fed and what that means for the shorter dated part of the curve.

Ian Lyngen:

And the week just passed also saw some pretty unimpressive results for the auctions. And that brings up a question that we have heard several times from clients over the course of the week, and that is who's going to be the buyer of the ever increasing Treasury issuance profile? When we think about the account bases that have historically participated in the auction process, the big overseas players of China and Japan remain relevant but are unlikely to drive the next leg of funding for the US government. For that, we suspect that the Treasury Department will need to look within the US' borders and specifically to domestic investment funds and a little bit on the retail side. Domestic investment funds have remained a significant player in underwriting the auctions, and in part we'll argue that this is the reason that there's been such an emphasis on the return of term premium.

Using the ACM model, what we see is that term premium in the 10 year sector is back into positive territory for the first time since June of 2001. Recall that in the second quarter of 2001, term premium ranged between zero and positive 35 basis points. In the most recent runup in term premium, that level reached 33 basis points and closed out the week at seven basis points. We'll note here that the luxury of pricing in positive term premium came at a moment in time where the safe haven value of US Treasuries was being underestimated, obviously until the developments in the Middle East and the subsequent rally in Treasuries. So it's with this backdrop that we'll be closely monitoring the performance of upcoming auctions for any indication of angst or concern on the part of the marginal buyers.

Ben Jeffery:

And talking about flight to quality in the move in Treasuries specifically, it's also worth having the discussion around what hasn't really played out in terms of energy prices and what would traditionally be a response of a rally in crude as a reaction to the potential for wider supply disruptions in the Middle East and what that might mean for the potential for higher energy costs specifically obviously, but higher input costs, higher prices at the pump and what that might ultimately suggest for the consumer. Instead, what's played out is some swings in oil, but still in outright level terms, WTI is well off the levels that we reached just a couple of weeks ago as demand concerns have been cited in keeping prices a bit more subdued than one would have otherwise assumed would've been the case, given what's taken place in Israel over the past week.

Additionally, circling back to the conversation on what it all means for the Fed, a few weeks ago when oil looked like it was quickly approaching a hundred dollars a barrel once again, unlike early in the cycle when monetary policy was accommodative and the Fed wanted to get rates into restrictive territory as quickly as possible, now, given the fact that policy rates are already so high and especially real yields are effectively at their peaks, that means that the Fed must draw the distinction between headline and core consumer prices, simply given the fact that monetary policy isn't going to be what offsets the influence of higher oil prices. Now, clearly it's too soon to have any high conviction opinion on how the situation overseas will ultimately play out, but looking at the response in the energy market, will be an important place to watch, given what it means for the overall global economy, the state of the consumer and inflation expectations.

Ian Lyngen:

And it's difficult to have a conversation about commodity prices without at least acknowledging what's going on in the Chinese economy. In the week just past, we saw a CPI print at 0.0 as well as conversations about the potential for the Chinese government to establish a stabilization fund to start buying equities. Overall, the Chinese recovery has underperformed expectations and to some extent that is presumably at least part of the reason that energy hasn't responded more dramatically to the developments in the Middle East. The question quickly becomes whether or not there's potential downside risk in the event of a relatively quick resolution to the conflict in Israel.

Vail Hartman:

In transitioning to the topic of Fedspeak, we came into the week wary of the potential for a dovish tone shift from policymakers after, in the prior week, San Francisco Fed President Daly acknowledged the potential the Fed may have to do less as rates surge higher into uncharted territory this cycle. And that's precisely what played out, and I'll highlight that Fed Governor Waller said the real side of the economy seems to be doing well. The nominal side is going the direction we want. So we're in a position where we can kind of watch and see what happens on rates. What do you guys make about the extent to which this dovish tone shift will offset the tightening of financial conditions?

Ian Lyngen:

Vail, that's a great question and one that we've received several times. Essentially, if the Fed is saying that the 92 basis point backup in rates that we have seen that brought 10-year yields to 4.88 was in effect tightening for the Fed, if a dovish tone shift combined with heightened geopolitical tensions leads to a rally in Treasuries that bring 10-year yields back to 4.25, let's call it, does that then mean that the Fed will have to hike in December just to make sure that financial conditions remain tight?

Well, certainly if the economic data dictates, one would be remiss to fully dismiss the potential for a December rate hike. However, the one caveat that I'll add is it comes down to the performance of risk assets. If we have a rally in 10 year Treasuries that bring the benchmark rates to 4.25, and that's because of an external trigger, whether it's on the geopolitical front or on the economic data front, that is accompanied by a selloff in equities, that will, in and of itself, tighten financial conditions and keep the Fed at bay in December. So it ultimately comes down to the impact of rising rates, a less hawkish Fed, the performance of risk assets, and the ever-increasing uncertainties resulting from the war in the Middle East.

Vail Hartman:

Well, if anything, it's clear that uncertainty is running high.

Ben Jeffery:

One thing is for certain, pumpkin spice is back.

Ian Lyngen:

Wait. They're getting the band back together?

In the week ahead, the Treasury market will continue to digest the firmer headline CPI numbers and the core CPI print at 0.3, which was consensus, although there were some in the market expecting a lower 0.2 or even 0.1. The fact that inflation continues to run above where we saw it during the pandemic speaks to the risks that the Fed faces over the course of the coming quarters.

In the event that inflation doesn't moderate but growth begins to slow, monetary policymakers could be faced with a very undesirable scenario, i.e., true stagflation, even after the Fed has managed to hike rates as far as it has. With this in mind, investors will be closely watching incoming Fedspeak for any confirmation of the tone shift to a decided wait and see stance. While the CPI numbers and the strong Payrolls report would have, all else being equal, argued for a rate hike in November, the Fed has made it very clear that we've reached the point in the cycle in which it will err on the side of caution as the market continues to watch for any signs that the cumulative rate hikes that have occurred both in the US as well as overseas are starting to weigh more materially on the real economy.

For the time being, the real economy appears to be on strong enough footing to withstand tighter monetary policy. But as we've seen historically, when sentiment around that assumption shifts, it tends to shift very quickly and the subsequent market repricing can be rather dramatic. Within the details of the upcoming week's data offerings, we'll be watching the September retail sales print. Expectations are for a 0.2% increase in headline sales, and with that number, it's important to keep in mind that those are in current not constant prices, i.e., not inflation adjusted. So a rudimentary comparison between headline CPI at 0.3 and retail sales at 0.2 suggests that real consumption might've actually been skewed negative in September.

It's also important that the Redbook data shows that there's been a rotation in the year-over-year change in consumption away from higher end stores and in favor of discount stores. Now, this is a very typical end of the cycle dynamic when higher prices are leading consumers away from luxury items and toward the essentials. While it's still a bit early in the cycle to anticipate a sharp downturn in consumption, especially as long as the unemployment rate is at 3.8%, this particular type of rotation, when combined with the fact that the savings rate is well below where it was prior to the pandemic, suggests that consumers are at least starting to show some early signs of stress as we head into the holiday spending season.

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 a world with so much uncertainty and angst, we hope that the consistency of our questionable humor serves as a comfort, or at least as less of a discomfort on a relative basis. Relative value, basis, Treasury trading. Get it?

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:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.