Approaching Handle Change - The Week Ahead

Ian Lyngen:

This is Macro Horizon's episode 243, Approaching Handle Change, 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 10th. And in addition to the long weekend, sorry equities, there's a lot to be thankful for in October. Topping the list this year is Crocktober Fest; comfortable, fashionable and machine washable, not to be confused with the American alligator.

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 sharply. This started with the fact that the federal government managed to not shut down, which led to a bit of a bearish tone in the market to start the week. Now, ultimately, 10-year yields managed to back up as far as 4.88% before stabilizing around 4.80%. Now, given the severity of the backup in the move, the fact that it has been accompanied with the reintroduction of positive term premium into the 10-year sector, we actually expect that there is another leg yet to be realized in the selloff. So in this context, we're targeting a range between 5.0% and 5.10% for 10-year yields to top out in this current move. Now, the fact that non-farm payrolls, which printed much higher than expected, failed to trigger a move to 5%, isn't particularly daunting, especially when we put this in the context of the fact that next week has a couple major events that we expect will ultimately resolve bearishly.

The first and perhaps most obvious is the 10-year auction of $35 billion on Wednesday. A supply concession of some magnitude for the takedown could very easily put five handle 10s on the table. In addition, we have the September CPI release. Expectations are for a three-tenths of a percent headline print as well as a core figure. Now, even if there is a slight downside surprise on the inflation front, as long as the print isn't negative, then we wouldn't expect the November rate hike to come off the table. If we have a negative inflation print, then it becomes less obvious whether or not the Fed is in a position to hike in November. All else being equal, the strong September showing on the jobs front gives the Fed the increased amount of flexibility that they need to deliver the year's final quarter point hike.

While the government did avoid shutting down on the 1st of October, the stop gap bill put in place only extends to the 17th of November. So this means the Fed will have plenty of economic data between now and the 1st of November to make a rate hike or pause decision. But assuming that the government shuts down in mid-November, it becomes a lot more difficult to anticipate a December hike. So at its essence, either the Fed hikes in November or risks not being able to hike until January at the earliest. Within all of this, we'll highlight that the two-year sector remains remarkably well anchored around 5%. Obviously, non-farm payrolls led to selling pressure in the front of the curve as the market contemplated a November 1st hike. Another defining characteristic of the week just past was the re-steepening of the yield curve. At one point, 2s/10s got just beyond negative 25 basis points to print at -24.5. Now we are on board with re-steepening the curve back into positive territory.

All else being equal, we would've assumed that it would've occurred in a bullish fashion, but even a bear steepening can push us back into positive territory. The move between zero and +100 in 2s/10s, however, we expect will need to be triggered by a rethink of the Fed and a transition to a classic late cycle bull steepening that's led by the two-year sector as the market prices and rate cut sooner than the Fed has been signaling. Now that's not our call for the very near term, but ultimately, to get to a positive slope in 2s/10s of a hundred basis points, we would need to see the Fed jump into action and normalize rates lower.

Vail Hartman:

With September's NFP data in hand and the largest monthly gain in headline payroll since January marginally improving the odds of a hike in November, but not quite to a degree that would allow the Fed to deliver a hike, the onus will now be put on this Thursday’s CPI data to justify and move in November.

Ian Lyngen:

Well, Vail, when you said wake me up when September ends, I'm not sure this is exactly what you had in mind for the first week of October, but it was a very dramatic move in the Treasury market. We got 10-year yields as high as 4.88% and counting, and that was even before we saw the stronger-than-expected payrolls report. In addition to the jobs number, one of the biggest surprises of the week was the fact that the federal government managed to cobble together a deal and not shut down. We came into the week expecting that would not be the case. We anticipated a shutdown of some type, but what ultimately transpired was a stopgap deal that keeps the government open until November 17th.

The House then subsequently removed McCarthy and that for all intents and purposes, all but guarantees a shutdown on the 17th of November. The question then becomes how long of a shutdown and are there any monetary policy implications? Our takeaway is that if the Fed intends to deliver a quarter point rate hike by the end of the year, the best opportunity for that will be at the November meeting. So while the market is currently pricing only a one in three probability that the Fed hikes, we expect that as the event nears, those odds will increase.

Ben Jeffery:

And part of that has to do with what we saw in September's jobs data. Obviously the headline payrolls gain was very impressive. Jobs up over 330,000 versus the expectation for a 170,000 gain, and that was accompanied as well by strong upward revisions of nearly 120,000 over the past two months. This came despite the fact that we saw some underlying softness in the alternative job measures we were tracking this week leading up to the payrolls report. And the fact of the matter is the employment market certainly remains strong enough to withstand another tightening move.

Now, it wasn't a universally strong jobs report. The unemployment rate remained unchanged at 3.8% versus expectations for a decline to 3.7% and still four-tenths of a percent off this cycle's low. And we also saw wage growth come in softer than expected with average hourly earnings up just two tenths of a percent month over month, and that brought the yearly pace of wage gains to its lowest level since June 2021. So nothing that indicates the committee won't be able to deliver another hike this year, but jobs in and of themselves also don't ensure that we'll be getting a higher terminal rate. For that, we'll need to see September's inflation data and the additional updates on consumer prices that are going to be revealed over the balance of the fourth quarter.

Ian Lyngen:

It's also worth highlighting that the 92-basis-point backup in nominal 10-year yields that has occurred since the middle of July has, in effect, been a tightening by the market for the Fed on the margin that might limit urgency on the part of monetary policymakers to deliver that final quarter point of the year. But Ben, as you point out, as long as CPI continues a pace and doesn't slip into negative territory, then the Fed will have all the fundamental backing needed to follow through on the projections that they laid out in the September SEP.

The credibility of the SEP has been circumspect at best. Nonetheless, the signaling on the part of monetary policymakers that a quarter point was in fact still on the table for the end of the year, implies that an actual hike would be a credibility enhancing event.

Vail Hartman:

And returning to your point, Ian, about the implications of the market-induced tightening of financial conditions, it was San Francisco Fed President, Daly who is not a voter this year, who said that the recent surge in Treasury yields is equivalent to a 25-basis-point rate hike. And so the need for additional policy tightening from here is diminished. With the heavy slate of Fed speak scheduled in the week ahead, we'll be curious to see if there's been a notable tone shift in light of the recent rebasing in yields.

Ian Lyngen:

Well, one point was made very clear by Daly, and that is she'll be non-voting for a pause in November.

Ben Jeffery:

And more broadly, really what Daly and probably others on the committee are monitoring is the feedback loop between higher rates and pretty much everything else. We've seen 30 year mortgage rates reach 7.5%, 10-year real yields are closing in on 2.50%, and all of this thus far has come with a still relatively resilient consumer, corporations that have not yet been required to shed workforces, and risk assets, whether it's equities, high yield, or investment grade credit, that have all held in relatively well. However, as 10-year yield surged past 4.75% and now might be closing in on a five handle, one of the universal questions that we've been fielding is how long can this last before something really breaks? And is there the risk of a credit event that appears in response to rates that are now back to levels we haven't seen in well over 15 years?

Ian Lyngen:

It's also notable that the backup in rates has come this late in the cycle. That's somewhat surprising from our perspective. Conventional wisdom holds that 10 year yield should be roughly equivalent to GDP and inflation. And given that GDP while holding steady isn't on the uptick at the moment, and CPI continues to drift lower, the logic behind pushing 10-year yields materially above 5% is difficult to embrace. The one caveat is that term premium is very topical at the moment, and for the first time since 2021 is in positive territory, that's a development and a dynamic that the market will be focused on, particularly ahead of next week's reopening auctions where we see $35 billion 10-years and $20 billion 30-years. All of this implies that a greater auction concession will further re-steepen the yield curve.

2s/10s got as close to flat as negative 25 basis points, and frankly, as with the bulk of this sell selloff, we are reluctant to stand in the way of the move until there's more convincing evidence of stabilization. One of our big macro trades for 2023 was the re-steepening of the yield curve, and while we had assumed that it would have a more bull steepening character, the fact that it has occurred in a bear steepening fashion speaks to the fact that once the economic data finally turns and the forward path of policy rates is skewed lower, that the re-steepening could ultimately be even more dramatic than what we have seen over the course of the last few months.

Ben Jeffery:

And it's timing that transition that's going to be one of the market's most difficult tasks over the coming quarters. We've entered a paradigm where the predisposition has been to sell duration, both as a function of soft landing optimism, but also larger supply and what that means for term premium. Meanwhile, it's been very notable what hasn't happened in the front end of the curve, namely that two-year yields remain well-anchored, still above 5%, but nowhere near keeping pace with the scale of the selloff we've seen further out. That suggests that while yes, we might get another hike in November or December, at this point, investors are unwilling to pass up the opportunity presented by two-year yields meaningfully north of 5.10%.

So for the time being in terms of evaluating a dip-buying bias, it seems most prudent to exercise that strategy in the front end of the curve because as we frequently discussed, when something goes wrong and when something breaks, it's going to be the two-year sector that is the main beneficiary of that as the market calls into question, the Fed's willingness to maintain terminal in an environment when soft landing optimism has given way to something far more pessimistic.

Ian Lyngen:

And with 10 year yields nearing 5%, the reverberations throughout broader financial markets will be closely followed by investors. After all, the pace and magnitude of the backup in rates certainly warrants caution if nothing else when thinking about valuations in the equity market, in real estate, in commercial real estate, in a variety of different asset classes. The question then quickly becomes, as you point out, Ben, if things get bad enough, will the Fed pivot? The short answer is yes, but the market doesn't know how bad, bad enough really is. Said differently, there is a Powell put, we just don't know where it’s struck. Our take is that the Fed will be willing to absorb more economic downside than the market is currently anticipating and, therefore, the front end of the curve will struggle against a stubbornly-hawkish Fed, even as we eventually see signs that the situation is deteriorating.

Ben Jeffery:

And there's a market function dynamic to this argument that's worth considering as well in the fact that part of the Fed's unofficial mandate is to keep financial markets and obviously the financial system more broadly functioning well. We saw it in March with the swift rollout of the Bank Term Funding Program, and we've also seen it in times of market stress before that. Remember the repo volatility of 2019 and the Fed's reserve management purchases in the bill market. And while the nature of the selloff thus far in the long end of the curve has not been disorderly enough to really trigger any concerns about official intervention, AKA it's been a relatively well-behaved selloff, there have certainly been some investors who have begged the question of what it would take in terms of a real breakdown in market function to elicit an official response.

We're not there yet, and we're probably not even close to there yet, but particularly as dysfunction in Washington comes back into focus and the November refunding process quickly approaches, just how well-behaved long-end yields remain will be something to monitor as we get further through the fourth quarter.

Ian Lyngen:

So on the topic of well-behaved, Vail, what's on tap for the long weekend?

Vail Hartman:

Oh, you know the usual, just reading through some Fed transcripts.

Ian Lyngen:

Is that a new restaurant?

In the holiday-shortened week ahead, the Treasury market has one key fundamental input in the form of the September CPI release. The official consensus expectation is for a three-tenths of a percent headline print and a comparable three-tenths of a percent move in the core inflation series. Now, there's a lot of variability that goes into core, particularly during September, so all else being equal, we'd probably bias that a bit lower. That being said, it's unlikely that anything comes out of the CPI release that materially undermines the prospects for the Fed to move on the 1st of November. On the inflation front, we'll also get the first look at October's University of Michigan survey of inflation expectations in the 5-10 year range. Our underlying concern in that regard is given the high correlation between household's inflation expectations and realized prices at the pump, an upside surprise shouldn't be taken off the table.

Let us not forget, it's also reopening week. We have $46 bn 3-years on Tuesday, followed by $35 billion 10s on Wednesday, and capped with $20 billion 30-years on Thursday. The combination of supply, term premium, and just the outright backup of rates has left the market very focused on the question, who is going to step up and buy these bonds. The week ahead, if nothing else, we'll provide some context for that. In this context, the recent cheapening of the market has presumably brought outright yield levels to a point that at least certain pockets of the market will find attractive.

The question quickly becomes whether or not there's a greater concession from current levels that will be required for the underwriting process, or if the auctions tail. Tailed auctions with 10-year yields, this close to 5% would be troubling for the market to be sure, unless the tail is relatively small and the market finds a bid after the fact. Wednesday afternoon also sees the release of the FOMC minutes from the most recent meeting. We know that the Fed paused in September and the minutes will be useful only in so far as they offer any context on the Feds thinking about the response function of policymakers to a government shutdown, and of course, how they're framing the current trajectory of employment as well as consumer inflation.

Ultimately, we expect that the biggest issue in the week ahead will come down to how other asset classes are able to withstand higher nominal and higher real yields, and if there is a more significant correction ahead for equity prices, as the market becomes more comfortable with 10 year Treasury yields nearly a hundred basis points higher than they were in the middle of the summer. 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 for anyone planning a trip to Paris soon, may we suggest picking up a copy of a Hitchhiker's Guide to Entomology. 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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