Cooling, Not Cold - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 234, Cooling Not Cold, 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 August 7th. In the wake of the July jobs data, we cannot help but ponder what happens if NFP falls in the forest and the refunding isn't around to hear it.

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. That being said, let's get started.

In the week just passed, the Treasury market sold off and it sold off rather dramatically. 10-year yields broke above that 4.09 support level that we've been tracking. While they failed to reach the 433.5 cycle low, there was still a decidedly bearish tone that emerged. There were several factors that drove the price action, most notably, and what we will attribute the bulk of the move to was a higher than expected increase in the 10-year auction size evidence to via the refunding, as well as confirmation from the Treasury Department that there are larger coupon auction sizes yet to be seen at the November refunding, if not again in February.

Now part of this was driven by the Treasury department's need to increase coupon auction sizes to fund their buyback program, which will be $30 billion a quarter. The Treasury department did give us some interesting context for the composition of the program. There will be a total of nine buckets, seven in nominal coupons and two in TIPS. Presumably, each bucket with a maximum of 4 billion in purchases will see programs once a quarter. The Treasury department did leave open the option to do more than once a quarter, depending on participation, of course. It's also notable that the week just passed did reveal that there are tighter credit standards as evidenced by the Feds’ senior loan officer survey for the second quarter. The majority, albeit a slight majority of respondents saw tighter lending conditions on the part of small and medium-size lenders. This is relevant in the context of the Fed's guidance that the dislocations created by the regional banking crisis have yet to be fully realized in the US economy.

If and when there is further evidence, we would expect that that would offset any of the selling pressure that we might see later this summer. That being said, July's payrolls report came in below expectations, albeit just slightly. Headline payroll gains were 187,000 versus the consensus for 200,000. In addition, we saw the net two-month revisions down 49,000, so that leaves the June figure revised at 185,000 versus the initial print of 209k. Overall, we are interpreting this as confirmation that monetary policy still works, and perhaps more importantly, that the assumed lag of two to three quarters remains relevant.

This implies that the cumulative rate hikes have yet to fully work their way through the system, and that should leave one biased for disappointing payrolls growth in the second half of the year. Now this also begs the question, whether that disappointment will be sufficient to get the Fed to rethink the timing of rate cuts, or if as I think most people are expecting, it will simply conform to the weakness that the Fed has already told investors we should anticipate as monetary policy makers do whatever it takes to reestablish price stability. Further within the details of the payrolls report, we did see that average hours worked slipped to 34.3 from 34.4. This is consistent with an inflection in the direction of the labor market. As the slowing outright number of job gains reveals, there has been a decided shift in the overall trajectory of the employment landscape.

Vail Hartman:

This week we saw a remarkable underperformance of the long end of the curve as tens reached above 4.20 after breaking the double top formation we'd been watching at 4.09, and now the conversation has quickly become whether or not we'll see a breach of the cycle yield high mark of 4.34. There was also an impressive breakout in 30-year yields that reached above 4.30 and too have come back within close proximity of the cycle yield highs.

Ian Lyngen:

To be fair, there was a lot of new information that hit the market in the week just passed, including but not limited to the refunding announcement, which outlined increases in coupon auction sizes perhaps a bit more and earlier than some in the market had anticipated, as well as offered a roadmap for future increases in coupon auction sizes, which triggered an eagerness on the part of market participants to price in a concession for the upcoming auctions themselves. This was coupled with a downgrade by Fitch, which we'll argue is probably less impactful than the stronger than expected wage data contained in the payrolls report, although headline payrolls, particularly when combined with revisions did disappoint on an absolute basis, leading us to conclude that the labor market is cooling but not yet cold.

Ben Jeffery:

The payrolls report really had something for everyone. Yes, at 187,000 jobs added, a below consensus gain in terms of NFP, but close enough to the 200,000 consensus that really the bigger takeaway was the unexpected decline in the unemployment rate to 3.5 from 3.6, and the fact that the wage data, as you touched on Ian, came in above expectations with average hourly earnings up four-tenths of a percent versus three-tenths anticipated, which left the year-over-year rate of AHE unchanged at 4.4%. On the whole, what the jobs data exemplifies is that the rate of hiring has now slowed to its lowest level since December 2020 after accounting for the revisions to June's data down to 185,000 and July's print at 187.

Yes, there is building evidence that the lagged impact of monetary policy is showing up in the labor market data. However, the departure point was so strong, and the tightening cycle was so fast that the damage done has not reached a degree that warrants any major rethink from the Fed's perspective. Another rate hike at some point this year is still very much in play, even if that doesn't come until November. But more importantly, there is no urgency to cut rates until at least early 2024 if not beyond.

Ian Lyngen:

Frankly, I think that the way that the data is playing out at this stage suggests that the most reasonable timing for the first cut of the cycle should be the second half of 2024. Now, the Fed has signaled as much, although as the market is certainly cognizant of, this is all very data-dependent at this point. The data is cooling, but it certainly hasn't fallen off of a proverbial cliff. As we've cited in the past, both a hard landing and a soft landing look the same in the beginning, and this is precisely what we're seeing at the moment. We're seeing jobs growth and inflation via the June series start to cool, and that's also in keeping with the traditional assumption of how long it takes monetary policy to hit the real economy i.e. six to nine months after we moved into restrictive territory, we finally start to see the real data conforming with the Fed's objectives. Now the question quickly becomes, did the Fed overshoot the tightening campaign? Well, we probably won't know that until the beginning of 2024.

Ben Jeffery:

Before we got the job report along with some of the price action that you touched on, Vail, one of the most prominent themes that was in focus over this past week was the discussion around term premium that was kicked off by the larger than expected refunding announcement and the reminder from the Treasury Department that deficits are large and are going to continue growing and that's going to necessitate more borrowing and larger auction sizes going forward. The question of term premium that's justified in the longer end of the curve is partially related to the soft landing narrative, and a real growth environment that continues to hold up remarkably well along with the fact that inflation is now back in the US economy all the while Treasury issuance is on the rise.

It was really the debate around the amount of term premium in the longer end of the curve that translated through to the bear steepening we got ahead of NFP that pushed 5s/30s back into positive territory and 2s/10s decidedly off the depths of inversion we reached last week, which was somewhat unique given that this cycle thus far hasn't seen a lot of bear steepening. Sure we've seen bearishness and bullishness, but usually selloffs have been accompanied by a flatter curve while rallies have been steepeners. It did represent an interesting, if not necessarily durable shift in the market's reaction function after we got Wednesday's new information.

Ian Lyngen:

I'd further make the point that the week's incremental steepening, as you point out Ben, the bear steepening is rare enough and comparatively small enough to point to it simply as what supply is worth from a broader market perspective. Yes, supply and the reintroduction of some positive term premium matters, but it won't be sufficient to recast the overall level of rates. That means that as we go forward, the steepening that we have seen achieved will be somewhat all else being equal, durable and imply a floor and perhaps more importantly, a solid departure point for the cyclical bull steepening that we expect will eventually emerge, and that frankly, the market has been preparing for throughout the bulk of 2023.

Ben Jeffery:

After we saw 10-year yields back to that 4.20 level, there's also a positional and behavioral component of the price action to acknowledge as well. The selloff that we've experienced over the past month or so has occurred with the backdrop of a market that generally speaking still has a long bias in duration, and that means the pain trade is still to move toward higher yields. The fact that there was a reluctance or simply lack of capacity to buy into the selloff that we've seen probably means that some positional closeouts contributed to the magnitude of the selloff that brought us back to nearly the cycle high yield marks in the long end of the curve. However, now we have another softer than expected jobs print building evidence that the Fed's hiking campaign is working, all coming at a time when yields are almost back to the cheapest they've been in over a decade.

And so, the combination of a cleaner positional backdrop, the outright level of yields, the timing of next week's Treasury auctions and the proximity to CPI all support the idea that for those who have been sidelined for the better part of the last several months, this latest move in Treasuries is coming at a time where it's becoming increasingly compelling to buy the dip for fear of missing out on what is still broadly expected to be a later part of this year that's going to show more economic damage, greater disinflation, and generally lower Treasury yields.

Ian Lyngen:

I think that's very consistent with where we are in the cycle. We have started to see convincing evidence that things are turning on the labor front. In practical terms, when we've looked not only at the underperformance of headline payrolls, but also the hours worked, which is a classic indicator of a turning cycle, most signs confirm the observation that the balance of this year will be characterized by a grind lower in yields as opposed to any significant breakout higher. Now, it's also worth noting that within the refunding report, the Treasury Department acknowledged the fact that they're going to need to increase auction sizes further in part to fund the $30-billion a quarter buyback program, which will actually be net neutral for the budget and net neutral for the amount of Treasuries outstanding even if the auction sizes will be incrementally larger.

Now, while that might at least incrementally support the argument for more term premium further out the curve, the reality is that the week ahead represents an important that missed test for buyers of Treasuries at these levels. We expect, as you point out, Ben, that the combination of existing demand for nominal Treasuries and the proximity to the CPI data will result in a tone change from bearish to bullish as the summer doldrums come into focus.

Ben Jeffery:

Looking beyond CPI in the bond auction on Thursday, the macro calendar thins out very quickly until we reach August 24th, which is when the Jackson Hole Symposium kicks off, and we'll hear from Chair Powell at a time yet to be confirmed as he delivers his annual late summer monetary policy update. Over the next several weeks, in what will probably be trading conditions best characterized as the doldrums, the seasonal tendency for rates to move lower in the back half of August is another trend to keep in mind, especially given where the market has left the departure point with yields back at the highs in nominal space, but also real rates either at or beyond previous cycle highs. In the long end, we saw 30-year real rates over this past week reach their highest level since 2011, and for those that see value in an inflation-protected return of nearly 2% over the course of the next 30 years, there will certainly be debates being had on if this is a great buying opportunity.

Ian Lyngen:

Frankly, Ben, that resonates. It is a unique moment for the amount of Treasury supply versus the evolving macro narrative, and buying the dip is going to look increasingly attractive as the second part of the summer unfolds. While our bond bullishness isn't based solely on the seasonality in the Treasury market, it is worth noting that, as you point out, Ben, we're entering a historically constructive time for duration and the attractiveness of 10 year yields of above 4% will surely resonate with a variety of buyers in both the primary and secondary markets for US rates.

Vail Hartman:

This week I'll highlight that we heard one of the more dovish members on the committee in Chicago Fed, President Goolsbee, who is unable to rule out a September hike given all the data will receive in the coming weeks, and he also gave us some interesting context heading into July CPI update in his belief that we don't yet have to see much progress on services inflation. Instead, core goods and housing inflation are the two key components that we should be watching over the next three to six months, if the Fed is going to be successful in bringing down inflation.

Ian Lyngen:

While that certainly does resonate, I will note however that core services ex-shelter in terms of the CPI supercore series has been trending lower and consistent with the Fed's objectives. If the Fed is now attempting to refocus the market on what had been some of the key drivers of core inflation, I think that is very telling that the market will more likely trade off of the classic measure of core inflation as opposed to the supercore that the Fed had been attempting to emphasize.

Ben Jeffery:

Ah, super core.

Ian Lyngen:

Could be super bad.

Vail Hartman:

I need to call my super.

Ben Jeffery:

His name is Clark Kent.

Ian Lyngen:

In the week ahead, the Treasury market has plenty of fundamental inputs, as well as supply with which to contend the recent selloff and modest balance in the way of non-farm payrolls has set the market up for an important litmus test for buying interest with a slightly larger than anticipated $38 billion 10-year auction on Wednesday. This comes after the $42 billion three-year supply on Tuesday and ahead of long bonds on Thursday, which come in at $23 billion. Overall, our expectations are for the auction process to go orderly. Even if a greater concession is needed versus the 1:00 PM when issue rate, the reality is that we'd come out of the auction process biased for lower yields as the supply is absorbed. Let us not forget, Thursday also offers what we'll argue is probably the most important fundamental input in the form of July's CPI data. Expectations are for a two tenths of a percent increase in headline CPI, as well as a two tenths of a percent increase in core CPI.

Within the details of core CPI, we'll be watching the recent trend toward a lower pace of gains in the supercore i.e. core services ex-shelter. Given the unexpectedly strong average hourly earnings print and the correlation between the supercore measure of inflation and nominal wages, the persistence of the trend lower will be worth watching. We'll also get greater context for some of the Fed's key concerns in the form of the trajectory of owner's equivalent rent and the housing sector more broadly in the CPI series. Used auto prices are expected to continue to drag on core inflation, which leaves us biased for a low 0.2% on a month-over-month basis. As we move further into the cycle and there's greater evidence that monetary policy is finally having an impact on the real data, we anticipate that policymakers will attempt to recraft the narrative away from the realized inflation data and instead focus on inflation expectations.

It's with this backdrop that we'll be watching Friday's release of the University of Michigan survey data, in particular the 5 to 10-year inflation expectations sub-component. This has remained stubbornly high. As households face elevated gasoline prices during driving season, it will be notable to see the degree to which current energy costs are factoring into consumers' expectations for inflation in the medium-term. The Fed has emphasized this survey on a number of occasions in the past, and we expect that they'll continue to emphasize the survey-based measures of inflation over the market-based measures of inflation expectations, primarily because this cycle in particular has been much more about household's, perceptions of the real economy than investors' perceptions of the trajectory of inflation, and frankly, the Fed's credibility and ability to reestablish price stability, going forward. Said differently, 2022 was the year in which the Fed saw its credibility as an inflation fighter undermined, and 2023 and increasingly 2024 will be the period in which the Fed does everything necessary to regain that lost credibility.

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. With the combination of CPI and the refunding auctions on the immediate horizon, our thoughts quickly turned to the prospects and necessity for the US to continue inflating its way out of debt. There is a reason TIPS are such a small share of Federal borrowing.

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