Dot Plot Twist - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 241. Dot Plot Twist, 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 September 25th. And as the market continues to digest the Fed's updated dot plot and the optimism implied by the projections, we're reminded that, in the long run, it's Powell's Fed.

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 past the biggest influence on the macro landscape came in the form of the FOMC's rate decision. The Fed chose not to hike rates. However, the increase in the 2024 dot, which showed that the Fed only plans to cut rates by 50 basis points next year was the biggest driver for US rates. We repriced bearishly following the Fed with Treasury yields in most sectors making new cycle highs. In contemplating how far 10-year yields can back up from here, we are reluctant to fight the move simply because there's a lack of meaningful economic data between now and the October 6th release of the September nonfarm payrolls change.

Moreover, the Fed is holding fast to their year-end target for Fed funds, which suggests another quarter point hike at either the November or the December meeting. To be fair, part of the Fed's incentive to keep another rate hike in play is to avoid the market more aggressively pricing in rate cuts in 2024.

So while we're certainly sympathetic to the market's unwillingness to fade the Fed at the moment, at the end of the day, keeping another quarter point on the table for the foreseeable future could ultimately end up being the fed's MO for the next two or three quarters.

It's with that backdrop that we've been impressed with the ability of the yield curve to re-steepen. 2s/10s in particular has steepened out as chatter picked up about term premium, the need for greater inflation compensation to move further out the curve, and of course, the potential for larger auction sizes going forward remain topical.

Beyond the monetary policy updates from the Fed, we also heard from the Bank of England, which held rates steady as well as the Swiss National Bank, which opted not to add a quarter point to their policy rate. Norway and Sweden both hiked a quarter point in line with expectations, all of which brings us back to one of our core assumptions for the next stage in the cycle.

Specifically, even if the US economy ends up being on strong enough footing to withstand an extended stay in restrictive territory, we struggle to imagine that every major economy around the world will do so. And given the nature of Treasuries as the flight to quality instrument in fixed income, as the broader global economy slows, we anticipate that 10 and 30 year Treasuries will disproportionately benefit versus other fixed income instruments.

In pondering the impetus for flight to quality, the performance of US equities is very much top of mind. It follows intuitively that stocks did not like a hawkish Fed, nor the backup in rates that we subsequently saw. We'll be closely watching the feedback loop between higher nominal yields and equity performance as a potential influence on overall financial conditions and one that could dissuade the Fed from ultimately delivering the fourth quarter rate hike.

Vail Hartman:

The developments of the September FOMC meeting largely reinforced the committee's commitment to an extended stay in restrictive territory. Specifically, the upward revision to the 2024 dot was in focus. Recall we only needed to see two dots move up to 4.875 to bring the median to that level. And further, four dots below 5.125 needed to move up to at least that level to bring the median to there. The latter scenario is what ended up playing out, and that means that only one dot made the difference between a 75 point spread and a 50 basis point spread between the '23 and '24 dots.

Ian Lyngen:

And to a large extent, the market was looking for a 75 basis point spread, which was a narrowing from the 100 basis point spread that we saw in the June SEP. The fact that the Fed is now telling us that they only intend to cut 50 basis points in 2024 speaks not to the ultimate endpoint for the normalization process when it occurs, but the departure point for that process.

The market is now content with the expectation that the Fed will at least attempt to avoid cutting rates until the fourth quarter of 2024. At that point, the operating assumption, at least implied by the SEP, is that the Fed will cut by 25 basis points at the November 2024 and December 2024 meetings.

Now looking at what's priced in the futures market, investors are clearly skeptical that the Fed will be able to maintain terminal for that long. But nonetheless, the post Fed price action has been decidedly bearish. Not only did the Fed reinforce the higher-for-longer narrative, but we then had Thursday mornings unexpected drop in initial jobless claims, which reinforce the assumption that the US remains on strong enough footing to withstand an extended period in restrictive territory.

Ben Jeffery:

And the consistent theme of the conversations we had with clients both immediately following the Fed, but also during the sell-off that followed on Thursday, was the sustainability of front-end yields and to some extent the belly as well, at these new cycle high levels. The combination of the dot plot and Powell's press conference was fairly successful at continuing the process of pushing rate cuts out of market pricing. And that in turn got two-year yields to nearly 520.

To do a very simple fair value analysis on twos using policy rate assumptions over the next 24 months, even if the Fed hikes in November or December, one must assume that a lot goes right in terms of the real economy's performance between now and 2025 that will allow the Fed to keep rates in restrictive territory for a very long time. And while yes, that could happen, our underlying skepticism is rooted in the fact that the economy is not designed to withstand real borrowing costs this high.

And aside from initial jobless claims, which you touched on, Ian, we've already started to see enough evidence that the trajectory of the labor market is turning, that it seems unlikely a materially higher unemployment rate is going to be able to be avoided over the next two years. So if we're currently priced to perfection in terms of a soft or no landing, that creates a value proposition for the two and five year sector, and also a steeper yield curve as well, even if one takes into consideration higher term premium arguments, given that that is probably more consequential for the 10 and 30 year sectors than the front end.

Ian Lyngen:

And in fact, the curve steepening trade has performed reasonably well recently, at least. In part because of the term premium argument, as well as the fact that auction sizes have increased and might increase further. Let us not forget the beginning of 2024 will see the Treasury department's buyback programs begin, which are designed to enhance liquidity at least for on-the-run securities and will be accompanied by elevated coupon auction sizes.

The question quickly becomes whether or not that has been adequately reflected in current pricing or if there's another steepening impulse on the horizon as a result of the supply and demand dynamics.

Vail Hartman:

The coming weeks' front-end supply series comes amid a second tier slate of economic data, which should provide a relatively clean read on sentiment in the front end as yields continue to surge into uncharted territory this cycle. The fact that 12 FOMC members still see another hike before year-end, with seven favoring the current terminal rate, certainly complicates the outlook for monetary policy as well as the fact that economic data has continued to send mixed signals on the outlook.

Ian Lyngen:

And the Fed wasn't the only central bank in focus. We also saw the Bank of England decide not to hike rates as well as the Swiss National Bank choose to pause. But during the same overnight session, both Norway and Sweden increased policy rates by a quarter point, serving as a reminder of the fact that the rest of the world continues to push toward tighter monetary policy, even if Powell and company have taken a meeting off.

Ben Jeffery:

And within the Bank of England's announcement, there was a dynamic that's worth mentioning that's reminiscent of a theme that's becoming increasingly important at the Fed. Yes, the Monetary Policy Council left rates unchanged, but the increase in the pace of QT from 80 billion pounds to a hundred billion pounds over the coming year, including active guilt sales off their balance sheet, serves as a reminder of one of the more important shifts in Fed communication that we've seen over the past few months.

Namely that Powell and others have explicitly said that the Fed's balance sheet can continue to run down even after rate cuts are being delivered. And after terminal is more definitively at hand, really what this means is that the FOMC is going to have greater flexibility in delivering those initial, what will likely be framed as fine-tuning rate cuts, given the fact that they'll still be able to point to the balance sheet that's going to continue to run down as a tool to continue to fight inflation, even if rates will not be quite as deep into restrictive territory as they once were.

Now, does this mean the Treasury department would ever consider actively selling Treasuries? That seems unlikely, given the distortions that it would cause in the market, but we've had several conversations around the idea that maybe the Fed could increase the pace of QT as a way to reaffirm hawkish commitment without needing to hike more. It's probably too soon for that to be anybody's base case, but once rates stop rising and inflation will still be above 2%, an increased focus on the restrictive impulse of a shrinking balance sheet is going to be an important monetary policy theme in 2024, both for the Fed, but other central banks as well.

Ian Lyngen:

And when we think about the composition of SOMA, we run into a maturity problem, something that, Ben, you might have familiarity with. The reality is that we don't have enough coupons rolling off every month to meet the 60 billion runoff that the Fed is already targeting. So instead, any increase in QT would be accompanied by larger bill sales, arguably contributing to some of the distortion risks that the Fed typically worries about when putting securities back into the market.

Ben Jeffery:

And it was a week undoubtedly dominated by monetary policy and an extension of the selloff in Treasuries. But this all took place with the backdrop of another important macro development. And that is the price action we've seen in the energy market, specifically crude oil that is quickly closing back in on a hundred dollars a barrel, as supply constraints from producers are pushing up oil prices with all that means for on the one hand, headline inflation, but also consumer confidence and behavior, given the fact that higher necessity costs, whether at the pump or at home will have negative implications for consumption, and ultimately the overall state of growth in the final quarter of 2023, even before accounting for the potential downside from the United Auto Workers strike or what may come of a potential government shutdown.

Ian Lyngen:

And on the topic of economic growth, a question that we've received quite often is whether or not we see a lower or higher probability of a recession over the course of the next 12 months. All else being equal, the amount of tightening that has gone through the US economy implies that there will be greater strain on consumption and hiring in the year ahead. While Powell and the FOMC might be messaging to the market that a soft landing is possible, at the end of the day, when we look at the outright level of real yields as well as 30-year fixed borrowing costs for mortgages, it's difficult to envision that over the next 12 months we don't see far more material strains in the real economy. For the time being, however, the Goldilocks scenario seems to be the operating narrative and the Fed's rhetoric has only served to reinforce that.

Ben Jeffery:

On the topic of fairytales, Goldilocks, Little Red Riding Hood, Hansel and Gretel, Snow White, Cinderella, Game of Thrones, those all end well, right?

Vail Hartman:

Everything's better with a dragon.

Ian Lyngen:

Or a rate hike.

In the week ahead, the Treasury market will have a variety of inputs with which to contend, not least of which being the final auctions of September and the third quarter. On Tuesday, the Treasury will offer $48 bn 2-years, followed by $49 bn 5-years on Wednesday, and capped by $37 bn 7s on Thursday.

The data calendar includes the Conference Board's Consumer Confidence figures, as well as New Home Sales and Case-Schiller. We also have the PCE numbers for August with the consensus looking for a core PCE month over month gain of two tenths of a percent.

It's with this backdrop that the market will continue to digest the Fed's updated projections. Most notable of which on the economic side, we maintain is the fact that the Fed believes the unemployment rate will end 2023 at 3.8%. For context, the August employment report showed the unemployment rate at 3.8%.

So implicitly the Fed is signaling that as the cumulative impact of prior rate hikes flow through to the real economy, they're not anticipating that that will hit the labor market any more materially than it already has. Perhaps part of what the Fed is assuming has to do with the labor force participation, but nonetheless, it's challenging to envision that the unemployment rate is precisely where it is today come the end of the year.

The market will also be watching for any indication of a government shutdown. The deadline for the budget is the 30th of September, which means in the absence of a compromise, come October 1st, the federal government would be in a shutdown mode. There have been 14 shutdowns since 1981, ranging in duration from a single day to 35 days in the 2018-2019 episode. Of the last 10 government shutdowns, the average has been 8.7 days with a median of three days.

The impact of a government shutdown, particularly if it is a short one, is unclear and probably largely a non-event for US rates. Perhaps there's an argument about flagging confidence in Congress and their ability to push through any further initiatives, but unless the government shutdown extends for several weeks, then it won't really impact the inflow of economic information.

In the event that they shut down lasts the entire month of October, however, the Fed will lack any meaningful economic data from which to base its decision on rates come the 1st of November. So it's with this backdrop that there is some relevance to whether or not the federal government is shut down or a compromise is ultimately achieved. Given the history of this Congress, combined with the willingness of lawmakers generally to shut down the government, we'd frankly be surprised if there wasn't at least a temporary shutdown in the offing.

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 with auto workers, Hollywood writers, and B-list actors all on strike, we're looking forward to overpaying for used Teslas sold to us by David Hasselhoff without a single scripted word.

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:

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.