Deflate and Recalibrate - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 235, Deflate and Recalibrate, 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 14th. And as Barbie takes the box office by storm, we cannot stop hearing, "Hey, isn't that Ken from the movie?" in our heads. 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, financial markets had a lot of new information to digest. First and arguably the most important was that core CPI printed for the month of July at just 0.16% on an unrounded basis. This is comparable to what we saw in June, which was 0.158% on an unrounded basis. So the conclusion by most market participants is that core inflation is finally starting to reflect the cumulative tightening that the Fed has executed over the course of the last 18 months. Even headline printed at two tenths of a percent, which was in line with expectations and the year-over-year figure came in at 3.2% versus 3% in June. That was slightly below the 3.3% consensus, but overall, the data is conforming with broad expectations for this to be the summer of disinflation.

Within the details of the release, we saw that shelter costs were up four tenths of a percent in the month of July. This is the second time that they printed there, i.e. June was the same pace. OER ticked a bit higher to five tenths from four tenths, but nonetheless is back to, or close to the pre-pandemic norms. Apparel was flat used, auto prices dropped 1.3%. We're expecting used car prices to drop further in August, which will contribute to the forecast for August's core-CPI number to also be 0.2%.

Further within the details, airfares dropped more than 8% and as a result of all the crosscurrents within the CPI series, what we saw was that Core-CPI services ex-shelter came in at 0.2% from 0.1%. Ideally we would've had another downtick or more contained inflationary pressures on that super core measure from a monetary policy perspective, but trending at 0.2% or 0.1% is a much better place for monetary policymakers to be than the 0.3%/0.4% levels that we saw earlier this year. The aggregate takeaway from the inflation data is that the Fed will have no urgency to hike rates in September. So if nothing else, September will be a skipped or paused meeting. We still maintain that the Fed has already reached terminal and any conversations around the idea of pricing in another rate hike between now and the end of the year will be more a function of monetary policymakers seeking to avoid the market pricing in an aggressive rate cutting campaign as opposed to any true need to add another quarter point.

The Fed's most reasonable expression of hawkishness at this stage, particularly in light of the June and July CPI data, will be to extend the period during which they retain terminal. We are on board with the idea that the Fed won't need to cut until the second half of next year. If for no other reason, then while inflation has begun to moderate, what we haven't seen is a wholesale shift in the direction of the employment market. So slower inflation in a tighter policy environment that doesn't translate through to a spike in the unemployment rate is a no-landing narrative. We don't expect that this will last indefinitely, however, for the time being, the Goldilock scenario is at least ostensibly here to stay.

Vail Hartman:

It was always going to be a week that was defined by the inflation data and the consensus CPI report we received for the month of July was in keeping with the summer of disinflation narrative and we've now received two NFP and two CPI reports that have supported the peak rates narrative. And even though we still have another CPI and NFP report ahead of the September 20th meeting, the odds that the FOMC has already delivered the final hike of the cycle are far more likely than not at this stage.

Ian Lyngen:

I'm in complete agreement, Vail. I think that we have already achieved terminal and now the conversation among monetary policymakers will quickly shift to how long will they need to keep terminal in place before starting the process of normalizing rates. At the last FOMC meeting, Powell was specifically asked the question about allowing the balance sheet to run off in the background and what are the implications for monetary policy going forward. And he said that he's content to cut rates while the balance sheet is still unwinding, which bodes well for the market's expectations that rate cuts will start in the second half of next year and be accompanied by an ongoing runoff of the Fed's balance sheet.

In the very near term, the market traded CPI on the initial impulse, pretty much in line with expectations I'll be the first to note that on an unrounded basis that 0.16% month-over-month for core was low enough that I would've expected a more significant and durable repricing. The fact that rates simply consolidated in and around the prevailing range speaks to a very important undercurrent as the market considers the balance of 2023. Specifically moderating inflation in an environment where the labor market remains resilient is almost by definition a Goldilocks outcome for the real economy.

Powell and members of the FOMC are undoubtedly happy with the results and therefore a leg lower in nominal treasury rates will need to be triggered by some deterioration on the labor front. While yes, we did see an increase in initial jobless claims and the two most recent non-farm payroll prints have shown moderation in the monthly jobs gains, the reality is the unemployment rate is still at 3.5%, which makes it very difficult for investors to interpret the prevailing landscape as anything other than a no landing scenario, at least for now. Recall that when economic momentum shifts, it tends to shift dramatically and the recalibrations, both in terms of the economic data as well as market prices, tend to occur in a very condensed timeframe

Ben Jeffery:

And more broadly now with two CPI reports that have shown monetary policy still does in fact work and is coming through in the form of disinflation, especially on the core side. The narrative in the market has evolved beyond the uncertainty of whether the Fed was willing and probably more importantly, able to control inflation to now timing that inflection that you talked about, Ian. Yes, we have evidence that monetary policy is working on the inflation side and I'll argue on the labor market front as well with some of those more modest job gains we've seen over the past few months, but nonetheless, the departure point from which the economy is incorporating the realities of tighter financial conditions means that there's still a lot of capacity for especially the labor market to withstand higher rates. And while that doesn't mean the Fed needs to continue hiking, it does suggest a longer runway for the soft landing or no landing idea to persist up until the point that it becomes undeniable that the labor market is turning, the unemployment rate is moving higher, and a "true recession" becomes a far more likely outcome.

Now, as for what this means for the shape of the curve, I would say given that positioning is far more balanced and the post CPI price response speaks to what's probably a market closer to equilibrium, that's going to mean that flattening interest that got 2s/10s back down below negative a hundred basis points for the second time this cycle, is going to begin flipping in favor of steepening interests. So will we get negative a hundred basis points in 2s/10s again, it's possible, but I don't think we'll be there for long.

Ian Lyngen:

That certainly resonates when we make the rounds and speak to clients. One of the things that we have heard quite often is that there is a sense that the no landing scenario has increased in probability, but confidence remains that monetary policy still works, and it ultimately comes down to a question of timing. Let's assume that monetary policy functions with a three-quarter lag. That means that the bulk of the rate hikes that occurred in the second half of last year have yet to truly translate through to the real economy or become evident in the economic data. So that implies that there's downside risk for the next six or eight months, and perhaps more importantly, as the market is so eager to decide recession, no recession, hard landing, soft landing, that in the background there are forces functioning that will ultimately catch up with the real economy regardless of how market participants feel about it in late August.

Vail Hartman:

On Monday, we heard from Fed Governor Bowman who said that she expects additional increases will likely be needed to lower inflation to the 2% target. And that was before we had July CPI data in hand. What do you guys think the new information means for those on the Committee who had already been calling for more hikes before we had the data in hand?

Ian Lyngen:

I think that one of the key takeaways from the recent Fed commentary is that while there has been some success in containing realized inflationary pressures, the Fed is very concerned that forward inflation expectations remain elevated, which would in and of themselves, be justification for another rate hike even if we get an August CPI print comparable to what we've now seen in June and July. All of that being said, I think at essence what is going on is the Fed wants to keep the degree of flexibility that they've convinced the market to price in between now and the end of this year, making sure that there's at least the presumption that every meeting is live.

The reason that they want to achieve this is to avoid the market pulling forward rate cuts, because if the Fed came out and said, "We are done, we're not hiking again during this cycle", the market would very quickly start the debate about how soon they're going to need to cut. So by keeping another rate hike on the table at one of the next three meetings, the Fed is efficiently accomplishing the job of avoiding the market pricing in rate cuts.

Ben Jeffery:

I completely agree, Ian, and I would also add that the latest data and Governor Bowman's comments really serves to reinforce the inflection point that we reached at the June meeting, which when the Fed opted to take their first meeting off in terms of rate hikes, the messaging changed from a predisposition to hike unless the data warranted a pause, to a predisposition to stay on hold unless the data justifies another hike. And so, Ian, as you put it, by keeping meetings live in terms of the probability of a rate hike, the Fed has been successful in making the question not one of hold or cut, but rather one of hold or hike. And that in turn has been very effective at keeping real yields high and what that ultimately means for the economic impact of higher borrowing costs.

Ian Lyngen:

In the process of deconstructing the post-CPI price action, we'd be remiss not to at least give a nod to the fact that it was the refunding auction week. We saw a solid reception to threes and tens and thirties are as thirties do. But the reality is there has been a transition in the conversation around whether or not the market should be pricing in greater term premium. This was triggered in part by the larger than expected 10 year auction size as well as the TBAC charge. The notion being that given the fact that we are so deeply in negative term premium territory, that the increase in issuance combined with the uncertainty regarding the outlook for inflation and therefore monetary policy rates, implies that we need to get back to zero or at least be less deeply in negative territory.

While we are certainly sympathetic to that argument conceptually, getting back to zero seems unlikely given all of the unknowns over the course of the next 12 to 18 months. Nonetheless, the conversations around term premium will prevent 10-year yields from declining as much as they might have otherwise during the final weeks of August. Recall that late August has historically been a seasonally strong period for duration with 10 and 30 year yields having a strong bias to decline between effectively now and the 1st of September.

Ben Jeffery:

And in thinking about the seasonal bullishness that we tend to see into the unofficial beginning of fall, I'll also highlight the two sides of that term premium debate that have been discussed over the last week or so as we've watched rates move higher following the refunding announcement. The first is that unlike the better part of the last several decades, there's now clearly concrete evidence that inflation can in fact return to the US economy, and that means that on a longer term structural basis, there needs to be some premium accounted for given the fact that before the pandemic, the unifying theme in the inflation discussion was the inability of the Fed to get core consumer prices high enough to be in line with the 2% inflation target.

So now that we have inflationary evidence, maybe rates do in fact need to be higher. However, and you touched on this, Ian, unlike a more traditional asset and despite the recent downgrade by Fitch, Treasuries are still the benchmark safe haven, they're still denominated in dollars, and the dollar is still the world's reserve currency. And so that means from an insurance perspective, there's always going to be more demand for Treasuries than should be the case, simply as a hedge against the admittedly ambiguous, something going wrong. And given the global macro backdrop, there's no shortage of opportunities for things to go wrong, and I would say it's precisely that dynamic that brought in enough demand to pull 10-year yields back below 4% over this past week.

Ian Lyngen:

And on the topic of something going wrong, it is summer travel season.

Vail Hartman:

Wait, I'm supposed to be getting on a plane soon.

Ian Lyngen:

Well, you're supposed to be going to the airport soon.

In the week ahead, the Treasury market will continue recalibrating to the realities that inflation has moderated at least over the course of June and July, and expectations are for that process to continue in August. Now, we do have Wednesday's FOMC meeting minutes, which will give some context for the Fed's decision to move 25 basis points and the degree to which committee members are open to a pause in September. Now, while the information in the minutes predates the July CPI release, there still should nonetheless be reasonable context for policymakers thinking on the probability of another rate hike by year-end.

Perhaps the most important piece of new economic information comes in the form of the July retail sales print. Tuesday's release of retail sales is expected to show a three tenths of a percent increase. Now, in the context of a two tenths of a percent increase in headline CPI, this represents, at least from the back of the envelope's perspective, a net add for GDP estimates for the third quarter. It's worth highlighting that Q3 real GDP estimates remain solid and any economic slowdown or potential recession risk has been pushed forward into 2024. This is consistent with the soft / no landing narrative, and when we take a step back and put it into the context of how long it takes economic data which tends to be backward looking, to catch up with the realities on the ground, we remain cautious that the Fed will make it through this process without doing at least some degree of excess damage to the real economy.

In part, this is a function of some of the significant dislocations that we saw in the regional banking sector during the first quarter. We have seen through the Fed's senior loan officer survey that the majority of respondent see credit conditions as tighter, which implies that in addition to higher real rates of borrowing, access to credit will become an issue for many businesses. When pondering the implications from restricted access to capital for small and medium-sized businesses, this becomes the most direct impact of tighter financial conditions on the labor market. Recall that the bulk of jobs added over the course of the last 18 months have come from small and medium-sized businesses. So if there is a shift in the trajectory of hiring, which in practical terms would probably manifest as a reversal of the labor hoarding that apparently continues to persist, then we would anticipate that that would actually mark a broader shift in the labor market and worry about a snowball effect that would eventually bring the unemployment rate higher.

Nothing that we've seen in the top tier data would suggest that that shift is imminent. For the time being, the market is content to move forward under the assumption that the US economy is on strong enough footing to sustain sustainably higher policy rates for an extended period of time. And frankly, there is nothing in the latter part of August that is likely to dissuade investors of that notion. That fact alone won't offset our bond bullishness, after all, the seasonal influence in the latter part of August has a tendency to be outsized and biased toward lower rates in tens and thirties.

We've reached the point of 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 as the final weeks of summer arrive and holiday logistics overshadow inflationary angst, we take solace in the sage words of advice from management, "Out of office is really just a state of mind." See you on Monday.

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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