Delay of Steepening - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 223, Delay of Steepening. Presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey and Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of May 22nd. With the June FOMC meeting quickly approaching the debate has shifted to whether Powell will pause the pause or let it play. Remember VCRs?

Vail:

What's a VCR?

Ian Lyngen:

Think streaming shows only without the content or the streaming.

Vail:

Oh, like our podcast.

Ian Lyngen:

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's weaker than expected headline retail sales, but within the details of the release, we saw an upside surprise in the control group. So, this implies that the consumption aspect of second quarter's real GDP has started on comparatively strong footing. We also had a mix of data with Empire manufacturing disappointing while the Philly Fed Index improved more than anticipated, albeit still in negative territory. The housing data was mixed and the two auctions, the 15 billion 20 year on Wednesday, and the 15 billion 10 year tips on Thursday, were both well received.

The bigger theme however, was increased confidence in two key areas. The first being that the fed's macro prudential tools are sufficient to limit any further contagion from the regional banking crisis. And, the second is that there's sufficient progress in the process of Congress coming to an agreement on the debt ceiling. Now, it's still too soon to have complete confidence in Congress's ability to deliver a deal sometime during the next two weeks, but the reality is that the headline suggests that progress toward a framework has been achieved and by the end of next week, a bill will be brought to the house and presumably if passed, quickly voted on by the Senate.

The most tangible price action that resulted from these events has been a bear steepening in the treasury market. Two year yields backing up sharply as the prospects for a June rate hike are once again on the table. We're viewing the weakness in the front end of the curve as a buying opportunity if two year yields sustainably trade above 4.25. That being said, the comparatively light data calendar, at least in terms of major releases in the week ahead, suggests that it's a bit too soon to fade the current bearish momentum in US rates, at least at the moment.

Of course, eventually we're anticipating that a meaningful amount of dip buying interest will occur, thereby limiting the extent to which yields can back up from here. Peak inflation is in. Peak 10 year yields are in. Peak two year yields are in, and the depths of the 2s/10s inversion have been established for this cycle. That doesn't imply, however, that we can't see the current bear steepening extend a bit further before there is a meaningful inflection that brings us back to the anchors of 4% 2-year yields, 3.50% 10-year yields, and an inverted 2s/10s curve of negative 50.

Vail:

The defining theme of the price action in US rates over the last week has been of bear flattening nature. Hawkish comments from the FOMC committee helped push two year yields back above 4.25, and tens above 3.60.

Ian Lyngen:

Vail, that's a great observation, and when we think about the price action that played out over the course of the last week, I think it's important to put it in the context of the evolution, not only of monetary policy expectations, but also the apparent moment of calm as it relates to the regional banking turmoil. The fact that the contagion appears to be limited cleared the way for the curve to begin to bear flatten. However, underlying all this price action was incremental progress toward a debt ceiling deal of some type.

The market has been preoccupied with the notion that the US Treasury could default in the beginning of June, but the reality is that since the early 1960s, the debt ceiling has either been suspended or increased 78 times, begging the question that not withstanding the apparent dysfunction of the current Congress, what makes this time different?

Ben Jeffrey:

And, that's certainly among the complaints we've heard offered over this past week, given that bills maturing in early June continue to trade at a sharp discount to surrounding maturities and the amount of time that's been spent answering the question, "No, we know it's very, very unlikely, but what if there's a delayed payment?" And, what's emerged is something of a bifurcated outcome as it relates to the debt ceiling and that big what if question?

We have those heavily affected bills that are maturing in the second week of June, but everything after June 15th, which is going to be when the Treasury Department receives quarterly corporate taxes, is trading at much more traditional valuations given the collective expectation that if the Treasury Department can make it to June 15th without defaulting, then there is a much, much longer runway that they'll be able to operate on before risking another delayed payment, at least into early July. And, there have been some out there that suggest maybe even reaching August would be achievable depending of course on how those tax receipts look.

Speaker 4:

And, let us not forget that there's been a lot of emphasis put on longer term deal from Congress and the administration, but a classic kick the can into the fall should certainly be on the radar as a potential outcome if for no other reason than Ben, as you point out, it does afford a little bit more runway for the process of negotiation to continue to play out.

Ben Jeffrey:

But, in terms of the broader market impact and something that we've discussed as this process has played out, it was encouraging if only as an indication of the reaction function that the increased prospects for a deal as soon as next week has been viewed bearishly by the long end of the curve. Vail, you touched on that 360 level in 10-year yields. We've traded a touch above that in the 10 year sector and also risk assets have put in a solid performance this week as some hope of a deal getting done in Washington is most apparent in terms of the risk on price response.

After all, it's a bit counterintuitive that less of a chance of a near term default is actually bearish for treasuries. However, treasuries are not a traditional asset class and that means that the flight to quality benefit they enjoy, leads to a little bit of an upside down reaction function versus what would "normally be the case."

Ian Lyngen:

And, we can also see that as it plays out in terms of near term monetary policy expectations. While it's very difficult to envision a path to a rate cut resulting from the Treasury Department missing a bill payment, it would be much more reasonable to assume that the Fed would be reluctant to deliver another quarter point hike in June if in fact we don't have a deal at that point. So, as optimism continues to build that there will be a deal, it's not surprising to see the odds of a 25 basis point rate hike in June increase. Were roughly at 60/40 in favor of a pause, but for all intents and purposes, that's 50/50.

Ben Jeffrey:

And before Powell’s comments on Friday, it was Dallas Fed President Logan, who is a voter and offered her opinion that based on everything she's seen thus far, she would not advocate pausing yet. Now, she's been one of the more hawkish members of the FOMC, so not particularly surprising to hear her offer that opinion given the strength of the wage gains we saw in April's payrolls report and also core inflation that remains far above the 2% inflation target.

But, from the more centrist members of the FOMC, Bostick, Jefferson, and Williams, who is admittedly a bit more dovish, what we've heard is a greater emphasis on the lagged impact of monetary policy and the fact that rates are very high and they favor data dependence, yes, but also a bit more patience in evaluating how the data comes in ahead of the June meeting. After all, we do have another NFP report and another CPI print to contend with, before the Fed actually needs to decide on whether or not another 25 basis point hike is appropriate.

Vail:

So, do you think the Fed is currently signaling that they're going to hike?

Ian Lyngen:

I think that what the Fed is attempting to do at this moment is to instill a degree of symmetry around terminal. Now, as a market, we're very quick to assume that once the Fed pauses that the next move is going to be a rate cut. It's just a question of timing that rate cut. What the Fed is attempting to do is suggest that if the committee does choose not to move in June, it could at some point restart the hiking campaign.

Now, we think it's a low probability that they pause and then restart. The bar would be very high to restarting, but for that reason, the threshold for hiking in June is lower than it might otherwise have been. The logic there being if the market affords the Fed the opportunity to deliver another 25 basis point rate hike, there's a more likely than not chance that they will take it.

Ben Jeffrey:

And Ian, I think you put that well, that the Fed wants to introduce some symmetry around terminal. And, that's especially true given the fact that there's still 50 some odd basis points of rate cuts priced into the second half of this year starting as soon as July. So, in terms of the Fed's game plan for attempting to try and talk the market out from such a quick reversal of hiking to cutting, the fact that some of the more hawkish committee members are saying rates still need to go higher is surely in an attempt to guide the market closer to some version of what the Fed is actually intending to do, which we're of the opinion is keeping rates higher for longer even if that doesn't necessarily require a higher terminal rate.

Vail:

On Thursday, Jefferson said, "We have not yet made sufficient progress in bringing down inflation." What do you guys make of his comments?

Ian Lyngen:

I think that what Jefferson is saying is that when we look at the overall trajectory of inflation, particularly the core services ex-shelter component, that while some progress has been made, we haven't returned to the pre-pandemic norm, which was plus 0.1% on a month-over-month basis. While I'm certainly sympathetic to the notion that the Fed is trying to avoid a burnsesque scenario in which the Fed quickly pulls back from being restrictive in response to a slight moderation of realized inflation, the reality is that simply keeping policy rates this high for an extended period of time is actively restricting the real economy and thereby curtailing the inflationary pressures that the Fed has been so worried about.

One caveat that I would add is we continue as a market and monetary policy makers as well to focus on the realized data. Inflation expectations just spiked as evidenced by the University of Michigan survey with the five to 10 year number at 3.2%. That is tied with 2011, as the highest since 2008. As a result, the Fed is surely concerned about embedded inflation expectations on the household level, becoming the norm.

Ben Jeffrey:

And, it's worth caveating those longer term inflation expectations within the UMich survey, given that they're always subject to heavy revisions and also compositionally, the distribution of the responses were a little bit skewed.

Speaker 4:

Just like our podcast? Subject to revision and skewed.

Ben Jeffrey:

But nonetheless, the progress made in containing realized inflation has been encouraging over the past month, but inflation expectations have remained comparatively sticky either via the survey-based measures or even the bounce we've seen in 10-year breakevens.

And Ian, as you touched on this, means that it's premature to declare victory on inflation. So yes, the Fed wants to be cognizant of the damage it's doing to the real economy, but they're also surely cognizant of the risk of pulling in about face too soon.

Vail:

And, along with the Fed speak, we saw two strong stop throughs at this week's 20 year auction and 10-year tips auction. And, that means we've now seen four of the five auctions since the May FOMC meeting stop through, which is consistent with the idea that we're going to see stronger debt buying interest in US treasuries as the peak rates narrative prevails.

Ian Lyngen:

And, it does follow intuitively that even if the Fed has another quarter point hike in it, the reality is that we are at the end of the tightening cycle. Inflation and inflation expectations will begin to moderate over the course of the year, that should compress breakevens and the amount of inflation compensation that investors require to go further out the curve.

And, ultimately, that is part of the story that has led the curve to move flatter over the course of the last week. Now, eventually we do see a bull re-steepening emerging as the primary theme for 2023, but as evidenced by the price action itself, it is still too soon for that big thematic macro trade to take hold.

Ben Jeffrey:

And, that's a function of the fact that for better or worse, it's going to take time for the realized data to show the more significant implications of what higher rates are doing to the real economy. Obviously, March and April showed the impact in the banking sector specifically, but there's more to the economy than simply the regional banking sector, and that means that as summer gets underway, it's going to be the labor market, the housing market, and the inflation complex that are almost certainly going to start to demonstrate the influence of higher rates.

After all, it was in March of last year that the Fed still had rates on hold at zero and was actively buying bonds. So, it's been a very fast and very aggressive tightening cycle.

Vail:

And, building off the theme of the lagged impact of higher borrowing costs on demand, on Thursday Jefferson said a year is not a long enough period to see the effects on demand from higher policy rates.

Speaker 4:

I don't know about you guys, but I think it's pretty cool that he's already on the $2 bill.

Ben Jeffrey:

That's just good luck.

Ian Lyngen:

In the week ahead, while our focus might be Friday's recommended early close and a long weekend with Memorial Day on May 29th, the reality is that there'll be some pretty meaningful inputs for the US rates market. On the supply side, we get 42 billion, two-years on Tuesday, followed by the 43 billion, five year auction on Wednesday, and then capped with the 35 billion, seven year auction on Thursday. There's a variety of Fed speak early in the week, and then on Wednesday afternoon, we will see the FOMC meeting minutes from the May meeting. The information contained in the minutes will be useful only in so far as they give the market more guidance as to whether 5.25 is the upper bound of terminal, or there's a potential for another rate hike in June. Needless to say, the conversation around a pause will define price action in the yield curve if nothing else.

From a fundamental perspective, we also see April's personal income and spending data released on Friday, which is expected to show modest increases. Core PCE will also be part of the release, although ultimately we think that CPI and the core services ex-shelter component has provided enough evidence of sticky inflation for the market and the Fed for the time being. Our view remains that the bearish price action is a buying opportunity and eventually 10 year yields will drift back towards 350 and two year yields re-anchor at 4%.

Now, a lot of the intra-week price action is going to come down to incremental progress on a debt ceiling deal. As it currently stands, expectations are for the house to bring a bill to the floor sometime in the week ahead and the Senate then, if the house passes it very quickly, turn it around giving Biden the opportunity to sign it before the US risks a default scenario. As a result, the US rates market is going to be vulnerable to any headlines suggesting that progress has either stalled or is on track to come to fruition before the beginning of June. Now, needless to say, it is an open question whether or not in the absence of a debt deal the Treasury Department would miss a payment before June 15th.

All of that being said, the sentiment related to a debt deal at the moment is positive, and there's a large enough window that we don't expect that this will be retraded until we're past the FOMC minutes release on Wednesday afternoon.

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, as the G7 meeting comes to a close, we cannot help but marvel at the simple brilliance of the naming convention. Perhaps we should rebrand the podcast as Group of Three or Three Gs.

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, 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 6:

The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries. For full legal disclosure, visit BMOCM.com/MacroHorizons/legal.