CPI, or CP-Why? - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 273: CPI or CP-Why? Presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring our thoughts from the trading desk for the upcoming week of May 13th. And for those of us who suffer from a modest to moderate fear of all things 13, Monday the 13th has always been far more ominous. Just a thought.

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 refunding came and the refunding went. Now that isn't necessarily to downplay the relevance of the results, but rather the price action that preceded the auctions was sufficient enough to provide a convincing change in the tone of the Treasury market.

We're now viewing 4.735% as the upper bound of 10-year yields that we expect to hold for the foreseeable future. Now, whether the foreseeable future ends up spanning all of 2024 and effectively the balance of this cycle remains to be seen. We're very cognizant that retesting the upper bound of the 10-year yield range is to a large extent, going to be a function of the realized inflation data as well as the ongoing rumblings about growing deficit spending at this point in the business cycle.

One key takeaway from the post-Fed price action has been that the monetary policy story is to a large extent, going to play out in the front end of the curve. We now know that the Treasury is readying to conduct its buybacks, $10 billion a month to provide some liquidity combined with the slightly higher than expected tapering of the Fed's QT program takes a lot of the upward pressure out of yields in the longer end of the curve.

Now, this isn't to say that there's not a path by which we could retest 4.75% or even 5%, but the likelihood of sustainably trading above 5% for an extended period of time has been decreased dramatically by the Treasury Department's signaling that coupon auction sizes won't increase again this year and that the Fed has taken rate hikes off the table. So as we think about the most reasonable expression of hawkishness from the Fed at this point, it continues to come in the form of delaying rate cuts even further.

Now, as we consider whether or not the Fed will ultimately be able to cut rates in 2024, it does come down to the economic data. But the Fed has also opened the possibility that even if inflation hasn't conformed to target, a spike in the unemployment rate would be a sufficient trigger to start the process of lowering policy rates. Now, it's interesting because in the event of an unemployment rate, say north of 5%, the Fed could make a very credible argument that that should lead to downward pressure on wages and therefore eventually flow through to the realized inflation data.

So responding to a spike in the unemployment rate wouldn't necessarily be abandoning the dual mandate, but rather taking the evolution of the jobs market and extrapolating that to the future path of realized inflation. Now, as it currently stands, there's nothing in the economic data that would suggest that the Fed will currently need to go that route, although we will make the observation that at both of the last two Fed meetings, Powell has deliberately emphasized the employment component of the dual mandate.

Vail Hartman:

It's been a fascinating period in the market and attention is once again focused on the incoming inflation data. While this week also contains comments from Powell who speaks with the ECB's Knot, the reality is that inflation will set the agenda.

Ian Lyngen:

That's very well said Vail. The reality is that at this stage in the cycle, the only missing piece for the Fed is some confirmation that inflation has begun to moderate back in line with the Fed's objectives. Now, recall that at the Fed's most recent meeting, Powell offered two potential paths toward cutting rates. The first one, which is the most obvious, is that inflation finally starts to moderate.

The second, which I'll note was a bit more interesting, although we all on some level assumed this to be true, but to hear Powell articulate that a sharp spike in the unemployment rate could also be a path forward to cutting rates, serve to re-emphasize the dual mandates at the Fed. Now, obviously over the course of the next several months, as the employment data continues to evolve and we see the overall trajectory of the real economy, it will be notable to see the way in which the Fed adjusts its policy messaging, if not the actual policy rate.

Ben Jeffery:

And the Fed's path was arguably macro topic number one coming into 2024. We're almost halfway through the year, and in some ways, timing Powell's first cut has remained investors’ preoccupation. Over the course of the last four months, however, there's been meaningful changes in sentiment as it relates not only to the economy but the Fed and also of course, the level of yields and the shape of the curve.

Coming into this year, the bond market's behavior was very similar to what we saw in 2023 with a buyer base in Treasuries eager to press end of cycle trades, whether that be simply outright long biases or steepening the curve only to have the realities of the data show a job market, that as you touched on Ian, was still in a very good place and an inflation backdrop that while yes, had made progress back toward 2% over the prior six or eight months, began to stall out at a level that was simply not consistent with the Fed's 2% objective.

Leading up into the Fed meeting in payrolls a few weeks ago, that left the market in a decidedly hawkish stance after stretching too dovishly to start the year. And it was the Fed meeting that served as something of a catalyst and a reminder that the Fed's hawkish reaction function is still more or less the same as it has been since the fourth quarter last year, where hawkishness is being expressed not via some likelihood of a rate hike, but rather simply delaying cuts further and further.

And so we've mentioned the first chapter of 2024 where the market got a bit too dovish, the second chapter of 2024 where the market was presumably a bit too hawkish, and now from a departure point of rates that are still high in any historical context, begs the question of how the data will evolve from here and whether there's any evolution that could put a hike back on the table or if the next move from the Fed is definitively a cut. Not to mention the fact that other major central banks around the world seem to be intent on cutting.

Ian Lyngen:

And to a large extent, this really comes down to a Fed credibility issue. The Fed has told us consistently that delaying rate cuts will be the response to sticky inflation. Now, while we're comfortable with the notion that rate hikes won't be on the table, there's nothing to suggest that the Fed by definition needs to start cutting rates in 2024.

Frankly, the Fed doesn't know when they're going to begin cutting rates, and so the market is simply attempting to take as many cues as we can from monetary policy makers in terms of what it will take to reintroduce rate cuts back into the broader narrative. Now, the credibility aspect of this comes in the form of if we see an event that forces the Fed's hand to cut rates, even if price stability hasn't been reestablished.

Now obviously that's going to be a steepener, but it would be a steepener that was accompanied by wider breakevens, if not higher nominal rates further out the curve. And one could argue that that's probably the worst case scenario for the Fed. Although this far into the cycle, any rumblings of stagflation would be far less concerning than if they had occurred in the beginning of 2023, which frankly appeared to be a risk at the moment.

Returning to this notion of Fed credibility, as long as the market is ultimately convinced that the Fed will do everything that's required to ease inflation, there's very little case to be made for a sustainable bear steepener. Sure, we can get episodes of bear steepening as supply works its way through the system, but to sustainably bring the 2s/10s spread back above zero, we would need to see the Fed in action i.e., beginning the process of normalizing rates lower.

If inflation doesn't eventually conform to the Fed's target, one could be excused for questioning the prudence of the Fed's 2% inflation target. Now to be clear, we think the Fed is going to continue to hold the 2% inflation target, and even if there is some belief on the committee that inflation has shifted structurally higher, at least for a temporary period, in order to regain and reestablish credibility, the Fed would need to err on the side of overstaying its welcome at terminal, thereby increasing the probability of a more significant economic downturn.

For the moment, the market is comfortable with the assumption that it's the strength in the economy that has afforded the Fed more flexibility in fighting inflation. But the flip side of the same argument is that as the realized data continues to demonstrate strength, that actually increases the probability that the Fed is forced to overdo it and therefore recession odds are slowly increasing in the background.

Ben Jeffery:

And there's another reality of higher interest rates that's worth mentioning as it relates to the recession question and the risk the Fed overdoes it and drives a more significant downturn in the labor market than would otherwise maybe be necessary.

And that reality is that higher inflation and higher interest rates are most burdensome for the subset of consumers who are the least well-equipped to deal with the higher costs associated with simply higher costs, but also interest payments on mortgages, auto loans, student loans, credit card debt, and household interest payments that remain very elevated and erode discretionary purchasing power are already becoming an issue for lower income households even before there's been any material weakening in the jobs market.

The flip side of this is that as corporate profits benefit from higher inflation and in turn, equities and risk assets broadly continue to perform well, not to mention the potential benefit from interest earned on savings, that's much higher than it's been at any point over the past decade. And it's the individuals who have excess savings, who have excess discretionary spending power, and who have exposure to financial assets who are most insulated from the restrictive influence of higher policy rates.

Especially during an election year, and regardless of what one believes about the role that political pressure plays in the Fed's decision making, having lower wage and lower skilled employees bear the brunt of the Fed remaining stubbornly on hold for an extended period of time is not exactly the outcome that Powell would ideally like to deliver. Said differently, a demand-driven recession among lower income quartile households, even as higher income households still remain relatively in good shape.

Ian Lyngen:

And it's interesting to put this in the context of demographics. The pandemic led to a lot of accelerated decisions on the household level. We saw people who were always intending to leave densely populated urban centers bringing forward those timelines. We saw people who were on the cusp of retirement deciding to lean into the golden years as it were. And when we look at the drop in the labor force participation rate of the 55 and older cohort, we can see how truly striking this shift has become.

Essentially, everyone in that group that left during the pandemic has stayed out of the labor force. Now, this becomes relevant when we think about the amount of asset appreciation that has occurred during this period. To your point, Ben, there are people who are holding assets there in retirement. These assets continue to improve in value, thereby driving up the wealth effect and leaving those who have recently joined the ranks of the retired in a much more confident position to continue increasing spending or at least not start decreasing it, which is more typical in one's consumption life cycle.

Ben Jeffery:

And the flip side of this coin is what we've seen in terms of immigration patterns in the US and what the potential inflow of workers, presumably of the lower wage and lower skilled variety into the labor force means about the sustainable longer-term rate of payrolls growth. Obviously, more people entering the workforce increases the denominator of the labor force participation rate.

And in terms of what it means for interpreting headline payrolls gains, obviously that's going to be a boost to the outright number of jobs added during any given month. But more broadly, it creates an additional nuance and interpreting the type of jobs that are added to the economy and the consumption and ultimately inflationary potential of those jobs with what that means for the broader arc of inflation's journey back toward 2% or not.

Ian Lyngen:

Ben, like they say, every journey begins with a single CPI.

In the week ahead, not only do we start with Monday the 13th, which is ominous enough in and of itself, but we have an array of data that is sure to set the tone for trading in the US rates market for at least the next several weeks. Now, the obvious highlight comes in the form of Wednesday's release of CPI. Expectations are for core-CPI to print at three tenths of a percent on a month-over-month basis.

This is April's data, so it will be the first look that we have at the second quarter. Recall that the BLS employment report showed a lower than expected 0.2% monthly gain for nominal wages, average hourly earnings as defined. The high correlation between wages and the super core measure of CPI has left the market anticipating and as expected, if not erring on the side of slightly softer core-CPI number.

It's difficult to overstate the relevance of the April core-PCI print. The logic here is fairly straightforward. We have seen realized inflation during the first quarter of this year help perform expectations and provide a material challenge to the Fed's narrative that progress had been made on the inflation front. Now, of course, Powell has acknowledged that this progress has stalled, although we'll characterize that as simply marking to market monetary policy guidance with the realities of the data.

The stickiness of inflation in the first quarter has also materially undermined the Fed's March SEP at which the dot plot revealed 75 basis points worth of rate cuts was the Fed's operating assumption for 2024. Now, clearly that's no longer on the table, and the debate has quickly shifted to 50 versus 25 basis points worth of rate cuts this year. Putting that in the context of Wednesday's CPI update, if CPI prints at 0.4% or higher, it will be very difficult for the Fed to justify signaling 50 basis points worth of rate cuts when they update the dot plot on June 12th.

It's with this backdrop that we expect Wednesday's CPI print will define the direction of trading in the US rates market. Now, in light of the fact that the Fed has recently confirmed that its reaction function to sticky data will be delayed rate cuts, we anticipate that stronger than expected inflation data will translate through to weakness in the two-year sector and further invert the yield curve.

We also hear from Mester, Jefferson, and Powell ahead of the data and get PPI, and let us not forget the April Retail Sales figures. The pace of consumption during the first quarter definitively undershot the market's expectations, although it was still solid from a broader perspective. Nonetheless, as anecdotes about households continuing to struggle with the impact of higher costs and higher inflation on their monthly budgets, it follows intuitively that investors will be on edge for any evidence of a pullback in spending as the second quarter's data begins to unfold.

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 looking beyond the near-term data, we're wary of a slide into early summer trading conditions as investors await the FOMC decision on June 12th, or as we call it, 13th eve. 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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