Better Lagged Than Never - The Week Ahead

Ian Lyngen:

This is Macro Horizons' episode 231, Better Lagged Than Never, 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 July 17th. And on the topic of lagging, for anyone who's not yet voted in this year's institutional investor poll, great news, there's still time. Please reach out if there's anything we can do to help in the process. And as always, thank you for your support.

Each week, we offer an updated view on the US rates market and a bad joke or two, but more importantly, this 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 received the one piece of fundamental information that we expect will guide trading over the summer. Specifically, we saw the June CPI inflation figures. Headline CPI came in at 0.18% on an unrounded basis. Obviously, that rounded to 0.2, but nonetheless, the year-over-year figure slipped to 3% from 4%, making a two handle in July of very reasonable assumption. More importantly, perhaps core CPI on an unrounded basis was 0.158, suggesting it could have easily been 0.1 versus the consensus of 0.3. In fact, on a rounded basis, even the 0.2 number was sufficient to trigger a meaningful rally in Treasuries.

We'll argue that this was the pivot or the inflection point that investors were waiting for to truly start pricing the bull steepening that we anticipate will define the balance of the year. Unsurprisingly, the data was not sufficient to reduce the probability of a rate hike on July 26th. As it currently stands, odds are above 90% that the Fed will move the target range from its current level of five to five and a quarter up to five and a quarter to five and a half percent. At this point, that is very consensus and we see no reason to fade that assumption.

July's meeting doesn't have the benefit of updated SEP. However, there is still a press conference, and as a result of the combination of the June payrolls data and CPI print, we're expecting that the next 25 basis point rate hike will be characterized as dovish in nature and potentially represent achieving the terminal level for the cycle.

Returning briefly to the details of CPI, what we saw was a drop in used auto prices of 0.45% and a very significant decline in airfares down 8.1% on the month. The core services ex-shelter component was up just 0.09% versus May's level of 0.16%. When considering this as core services ex-rent and OER, the move was actually slightly negative at negative 0.004% compared to positive 0.238% in May.

The punchline here being that the super core measure of CPI is now conforming to what monetary policymakers have been attempting to achieve, and when we put this in the context of the correlation between nominal wages and the super core measure of inflation, this is certainly a success for the FOMC and, if anything, reduces the urgency to move beyond the 25 basis point rate hike that is already priced in for July.

It's also worth noting that the market is appropriately assuming that September is no longer in play, and if there is in fact another rate hike beyond July, it will come in the fourth quarter, either November or December. So as we watch the economic data unfold over the course of the summer, we expect the policy conversation to be centered on Q4.

Vail Hartman:

It was a pivotal week for the US rates market that offered confirmation in the effectiveness of the Fed's inflation fighting tools. And we saw a substantial repricing in the front end of the Treasury curve. It was just last week that two-year yields traded as high as 511 before rallying decidedly back through 475. Though, it remains effectively a done deal with respect to a 25 basis point hike on July 26th.

Ian Lyngen:

Vail, you make a great observation that what the week just passed taught us was that monetary policy still works, and it functions with a lag, which is precisely what the FOMC has been suggesting over the course of the last six months. The fact that core and headline CPI both came in lower than anticipated has refocused the market on the prospects for the July 26th rate hike to be the final of the cycle.

One thing that we did take away from the inflation data was that the rate hike will be a dovish hike, not a hawkish hike. Now the Fed continues to emphasize that they have no intention of cutting rates in 2023, and the market is content, at least for the time being, to price accordingly. What remains to be seen is how long the macro narrative will conform to the Fed's soft-landing expectations or when the labor market data will turn sufficiently to more aggressively price in the cyclical bull steepening of the yield curve.

We came into this year with a 3% 10-year yield target, and we're holding that as we anticipate the second half of the year will be defined not by the Fed's ongoing endeavor to reestablish price stability, but rather by investors' willingness to look beyond the final stages of the Fed's hawkishness and contemplate what occurs when the Fed does need to pull back from such a restrictive policy stance.

Ben Jeffery:

And as we think about what it will look like when the Fed ultimately makes that decision and when the Fed will make that decision, one of the consistent pieces of feedback we get from clients in discussing our bullish call into the end of the year is, how will rates be that much lower without the Fed actually delivering a cut?

And here it's worth discussing that given how high policy rates are now that terminal estimates have once again been nudged higher, the Fed has afforded themselves ample flexibility to bring rates lower while not necessarily bringing rates out of restrictive territory. This gets at the broader macro uncertainty of if R* is actually higher on the other side of the pandemic and the Fed certainly doesn't think so based off some of their models. And so that means even cutting 200 basis points or 250 basis points from a 550 upper bound will still leave policy in restrictive territory even if the Fed will be forced to acknowledge that super restrictive is probably no longer necessary given the trajectory of inflation. The fact that the Fed's super core measure of inflation was back to nearly flat month over month in June and what will by the end of the year presumably be a labor market picture that is not nearly as tight as it is currently.

This doesn't mean that the Fed is going to need to cut in Q1 2024, but by the time they are forced to remove some of their restriction later next year and then into 2025, it's not likely going to take the shape of 25 basis point fine-tuning cuts at subsequent meetings, rather something a bit more dramatic and that will benefit the intermediate part of the curve as a lower policy rates landscape is incorporated in fair value assumptions in later 2024 and into 2025.

Ian Lyngen:

And let's face it, the longer it takes for the Fed to cut rates, the more significant those rate cuts are going to be. The Fed has already told us that they plan to reduce policy rates by 100 basis points in 2024, and the market seems content to err on the side of assuming that there is downside, not upside risk to policy rates as the end of 2024 comes into site.

In the context of 10-year yields in particular, effective Fed Funds are currently above 5% and 10s are trading comfortably below 4%. So the notion that the funds rate should in any way, shape, or form function as a floor for nominal rates was effectively dismissed in the latter part of 2022 when we saw the early and deep inversions of funds 2s and funds 10s. Taking a step back and considering the fundamentals that will drive nominal rates lower, at its essence, it's an issue of the Fed's success.

The Fed has not only proven that they have the ability and willingness to fight inflation, but that the existing tools are also adequate to do so. And while the Fed saw an erosion of their credibility as an inflation fighter in 2022, 2023 is increasingly appearing as though it's the year where the Fed's credibility is restored and as a result, we remain biased to see lower break-even rates further out the curve. That factor alone will push nominal rates lower to say nothing, as you point out, Ben, of the fact that we are clearly on the upper end of policy rates. And once terminal is achieved, there's really only one way to go, and it's not up.

Ben Jeffery:

And early this year it was that narrative that probably accounted for January's rally as the Fed was maybe going to hike again, maybe not. The curve was going to steepen and yields were going to fall only to have that narrative turned on its head as the jobs market remained resilient, as inflation remained high, and as the Fed was clearly willing to not only hike, but also increase the dot plot first in March and then again in June.

So what's different about the current episode versus what we saw back then? I would argue it's another six months with rates and restrictive territory that's going to continue to feed through to the realized data. After all, core CPI printed at just 0.158% on a month-over-month basis, below even what was expected to be a softer print. And so now that there is evidence that higher rates are working as designed, even if it may have taken longer than the Fed would've initially hoped, that's going to translate to increased dip buying willingness from anything around 5% two-year yields or 4% 10-year yields.

Now that presumably a lot of the longs that were added during the regional banking crisis have been closed throughout the selloff back through 4% 10s, and there's more capacity for the market to add duration exposure now that there's concrete evidence in terms of the data that the economy is responding as the Fed wants and the fact that the range trade in duration that we were expecting is going to play out wrapped around 3.50 10-year yields has left the benchmark, still near the cheaper end, which is increasingly being seen as a buying opportunity.

Ian Lyngen:

And let us not forget that the rest of the world is in a tightening mode as well. We know that that's certainly the case in the UK where monetary policy officials are increasingly warning about the impact on the consumer from higher mortgage rates. Given the structure of the British housing market, mortgages in particular, consumers are much more interest rate sensitive particularly to a backup in rates than we are, for example, in the US where the largest chunk of mortgages are 30-year fixed, particularly in the wake of the low mortgage rate scene in 2020 and 2021.

And to be fair, it's not entirely clear that the US consumer is on the strongest footing, particularly when we think about non-mortgage interest paid on a year-over-year basis up over 50% to say nothing of what happens when the student loan payments come back online in September. As it currently stands, it seems increasingly uncertain that the Fed will ultimately be able to deliver on the SEP projections that they gave us in June.

Vail Hartman:

Assuming that a 25 basis point hike is delivered later this month, the dot plot still implies we would need to see another hike before year-end, though futures pricing doesn't indicate a decided conviction in this coming to fruition, what do you guys think would need to particularly be seen for market pricing to come back in line with the SEP?

Ian Lyngen:

Vail, that's a great question. I think that's one of the debates in the market at the moment. What would, in effect, need to occur for the Fed to have an even longer runway to deal with inflation? First and foremost, we would need to learn that the June CPI data was in fact a head fake, and July and August see upward pressure on consumer prices. Now, that's not our call. We think that over the course of the next couple months, we'll continue to see downward pressure on the inflation complex, but if in fact we do see that reversed and the labor market remains as resilient as it has during the first half of the year, that's a recipe for at least another 25 basis point hike in addition to July's.

I'll also note that at this point, the Fed has managed to avoid its worst-case scenario. The worst-case scenario for the Fed was we came into Q1 2023, we saw a spike in the unemployment rate, inflation ended up being sticky, and a true stagflation scenario unfolded. Fast-forward to the middle of the year, inflation appears to be moderating, jobs market remains stable, and the prospects for a soft landing look as good as they ever have.

Ben Jeffery:

And even after accounting for the fact that the market is hopeful in the soft landing or no landing narrative, the important inflection that I would argue took place at the June FOMC was that the Fed shifted from a bias where their predisposition was to continue tightening to reflecting their desire to, at a minimum, go more slowly in terms of the pace of rate hikes, if not just keep rates high and restrictive territory for an even longer period of time. We've talked before about the fact that the combination of the statement and the dot plot did a very good job at pricing out rate cuts throughout effectively the entirety of the balance of 2023. And so as long as that persists, I would say the relative incentive for the Fed to continue tightening versus communicating the message that they're willing to continue tightening probably favors the latter.     

In the first half of this year, the Fed wanted to continue tightening and it was up for the data to stop them. Now, I would say, all else equal, the Fed would like to keep rates on hold, and it's going to be up to the data to convince them to continue hiking. After all, even after we saw May's CPI data, if the Fed really wanted to be hawkish, they would've hiked in June, but instead what we saw was the pause or what's ultimately going to look like a skip as an indication of the FOMC's acknowledgement that the level of rates is going to begin having more material adverse impacts on the real economy.

Ian Lyngen:

But for the time being, it appears that turbulence is limited. Although, my seat back is in the upright position.

Vail Hartman:

My tray table is stowed.

Ben Jeffery:

And I've got my parachute on.

Ian Lyngen:

Always the optimist.

In the week ahead, we'll have no Fed-speak given the pre-meeting period of radio silence, and as a result, we are anticipating that the bulk of the price action in the Treasury market will be more consolidative than anything else. Specifically, we have now seen a reversal off several extremes that are worth noting.

First being 10-year yields, once again, reached the 4.08 to 4.09 range, but that was summarily rejected and Treasuries have since rallied. This suggests to us that the yield peaks for the cycle are in, and this double top formation is consistent with one of our core assumptions for trading Treasuries in 2023. That being that 10-year yields will hold a range of 110 to 120 basis points as is typically the case as the cycle ends, and that that range will be centered at 350, so that means buying interest north of 4% will be rewarded, and we're looking for a steady drift lower in yields from here, particularly further out the curve.

Another important rejection from a technical perspective was the market's attempt in early July to breach the negative 110.8 basis point level in the slope of the 2s/10s yield curve. We've now seen a decided re-steepening in large part because of the evolution of the fundamentals, specifically the June CPI figures. But there is also a technical aspect which argues for a period of consolidation, and in this context, that implies lower rates overall with a modest steepening bias from here.

Now, this outlook is complicated by the fact that the Fed has made it abundantly clear that even if they don't achieve that 5.75 upward bound projected by the SEP, they nonetheless have no intention of cutting rates in 2023, and it won't be until the middle of 2024, if all goes according to the Fed's plan, that a shift to less restrictive policy rates will be on offer. The SEP did indicate 100 basis points worth of rate cuts in 2024. However, the market is assuming that that's going to be weighted toward the latter half of the year.

In pondering the data in the week ahead, offerings are relatively limited with a focus on the June retail sales print. This is obviously information for the second quarter, and expectations are for a modest increase of four-tenths of a percent. Industrial production is seen up just one-tenth of a percent, and we also get an update on the housing market as well as what we'll argue is probably on par with retail sales in its relevance, i.e., jobless claims.

Jobless claims slipped lower in the week just passed, suggesting that perhaps the upward bias seen in June was the anomaly as opposed to the beginning of a more durable trend. That being said, July 20th’s release of claims will include information for non-farm payroll survey week and as a result be more instrumental as an input for payroll's forecasting models, a space to watch to be sure as is the pace of consumption revealed in retail sales. Keep in mind that retail sales is not an inflation adjusted number, and so the four-tenths of a percent needs to be put in the context of June's 0.2% inflation gain.

We'll also see the 20-year auction of $12 billion on Wednesday, followed by the 10-year tips auction at $17 billion. Given the underwriting process for 3s, 10s, and 30s, we're less concerned that the overall direction of Treasuries will be contingent on the performance of this week's auctions. Overall, we're encouraged by the recent price action and expect that it marks an important departure point for the cyclical re-steepening of the yield curve.

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. As the Fed enters the pre-meeting period of radio silence, rest assured we have not, particularly when it comes to asking for your support in this year's Institutional Investor poll. Don't worry, there's still time.

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:

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