Dotting the 'I's and Eyeing the Dots - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 240, Dotting the I's and Eyeing the Dots, 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 18th. Along with the crucial macro takeaways from the data revealed over the past week, let us not forget the new iPhone 15, the next iteration of Apple's handheld supercomputers with an emphasis on improved camera quality, precisely what is needed for a team with faces made for podcasts.

Each week we offer an updated view on the US rates market and a bad joke or two, but more importantly, this 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, there were a lot of notable events that occurred in the US rates market that have helped define the forward trajectory of US yields. Now, the most relevant was of course the core CPI print that came in effectively as expected, but rounded a bit higher than consensus to 0.3% on a month over month basis for August.

Now, the expectations in the market were for a high 0.2, and that's precisely what we saw. Translating that through to price action wasn't as immediately obvious as one might have otherwise expected. Said differently, Treasuries rallied in the wake of a slightly higher than expected core inflation print. Now that suggests that if nothing else, investors are looking at the outright level of yields in this current environment and finding them attractive on a number of different levels. Now, that doesn't mean that we are poised for a significant rally that brings 10 year yields back to 3.50 on the immediate horizon. However, it does imply that the extent to which yields can sustainably back up from current levels is going to be limited. Now, our logic here is relatively straightforward. We don't need to see a massive recession to cap the backup of 10 year yields. In fact, all we need to see is a continuation of the soft landing narrative in which we have inflation coming back in line with pre-pandemic norms. This will translate into downward pressure on breakevens.

The one complicating factor in the current environment is the fact that energy prices remain elevated, and while core inflation doesn't directly reflect energy prices, the reality is that forward inflation expectations, particularly on the household level, often do. And as a result, there's a reasonable correlation with breakevens, particularly shorter dated breakevens and headline energy costs. As a result, we expect that while ultimately breakevens will be biased to drift lower over the course of the rest of 2023 and into 2024, we could be entering a period of sticky breakevens even as core inflation moderates further. Let us not forget that we also saw a higher than expected retail sales print as well as an upside surprise on PPI.

Given that those two releases came in the wake of CPI, they were never going to be as impactful on the outright level of rates per se. However, the fact that we haven't seen further moderation in consumption is yet another positive touchstone for those in the soft landing camp. Keep in mind that this data was for the month of August and we're just now entering a period where the personal savings rate printed at just 3.5% for last month and student loan payments are once again a thing with which consumers will need to contend and ultimately we expect provide a meaningful headwind for consumption as back to school translates into the holidays and the new year.

Vail Hartman:

Despite all of the crucial economic data on offer this week, 10 year yields are still near 430 with two year yields anchored at roughly 5%. CPI and retail sales held the most potential to influence the monetary policy outlook. And despite core CPI surprising on the upside with super core also spiking and retail sales coming in largely better than expected, the market still remains skeptical that another hike will be delivered in 2023.

Ian Lyngen:

And that's a fair point, Vail. I think to a large extent we have as a market written off the potential for a September rate hike and frankly we did that several weeks ago. What will be more interesting is to see how the Fed chooses to update their projections for both GDP as well as inflation. And let us not forget the beloved dot plot, we are anticipating that the 2023 dot will not be changed, but 2024 we'll see a upward revision which will reduce the amount of rate cuts implied from 100 basis points to 75 basis points, which frankly is not that far off from how the market is viewing the evolution of the economic data at the moment and the balance of the risks between now and the middle of 2024. What has occurred is what we'll argue is probably the best case scenario for monetary policymakers.

We've seen inflation slowly start to moderate demonstrating that the Fed still has the tools to impact realized inflation. And while the unemployment rate is now four tenths of a percent off the cycle lows, it hasn't spiked in a way that would deter the Fed from remaining hawkish and if not delivering another quarter point by the end of the year, at least avoiding rate cuts before the second half of 2024. Now, as one thinks about the coming quarters, one needs to be cognizant of the fact that we're just now beginning to see the impact of the cumulative rate hikes that have already been pushed through the system, and therefore we would anticipate that at some point investors will shift away from being comfortable dismissing any weaker data to using it as a touchstone for buying duration as opposed to simply dismissing it as the natural result of tighter monetary policy.

Ben Jeffery:

And to go a little bit further within the details of what we saw in the CPI report, on an unrounded basis core climbed 0.278% month on month. And while yes, the official consensus was for a two tenths of a percent gain, we'll argue that the market was really prepared for something between 0.2 and 0.3. Looking at the distribution of official forecasts, it was a very close call whether the median was going to be 0.2 or 0.3. So the fact that what was ultimately delivered was more or less in line with expectations triggered that very telling market reaction and the knee-jerk sell off of course, but then rates managed to grind lower throughout the rest of the day.

And Ian, in line with something you mentioned, I would also credit the price action with this idea that while sure it was a slight upside surprise on a monthly basis, the year over year rate of core CPI is now back to its lowest level since September, 2021. And from a bit of a broader perspective, this is keeping with the idea that monetary policy is working, things are beginning to slow, they're just not slowing quite as quickly as was initially expected coming into this year. Looking at the payrolls report a few weeks ago, that same dynamic is also evident. On a three month moving average basis, headline payrolls gains are their lowest since the pandemic. And Ian, you mentioned it, the unemployment rate is now four tenths of a percent off the cycle low and to a level that runs the risk of a more material inflection.

Also within the details of the inflation data, OER continues to decelerate and erode as the pillar of strength we've seen in terms of core consumer price gains and the performance of used auto prices are also contributing to the sense that maybe the concern around resurgent inflation sometime in Q4 was a bit overdone. And firstly, what it means for the Fed is that soft landing hopes remain firmly intact. And then as it pertains to the market, instead of the surge steeper in the curve that many were expecting, what we've settled into is a range as investors continue to contemplate just how much longer things can hold up okay, before a more material inflection in the labor market ultimately materializes.

Ian Lyngen:

I do think it is notable how inverted the curve remains. This year's big macro trade was widely anticipated to be the steepening of the yield curve and the fact that 2s/10s have remained stubbornly inverted, I think is very telling as to the uncertainty facing the macro outlook at the moment. Now we continue to see the path of least resistance being slow and steady progress toward un-inversion in 2s/10s by the end of next year. But timing of that trade is particularly difficult given the macro headwinds. All else be an equal, one would assume as soon as the Fed makes it clear that they've reached terminal, whether that's already occurred or it's on the November 1st meeting, that event would function as the natural inflection for people to get more excited about the front end of the curve, which would lead to a typical bull steeping.

Our concern, however, is given that the Fed has a strong incentive to remain higher for longer, that investors will be less willing to aggressively price in rate cuts in the latter part of 2024. And instead, any weak economic data, particularly from overseas economies, will trigger a flight to quality that benefits 10s and 30s. While 2s remain relatively anchored to monetary policy expectations, and if one doesn't expect the Fed to respond to a slowdown in Europe, which one shouldn't, then that will prevent the curve from un-inverting. So we're certainly at a challenging moment for the curve call if nothing else.

Ben Jeffery:

And along with the labor market and inflation and especially topical ahead of next week's Fed meeting, there's also the idea that we haven't really yet seen the implications from tighter lending standards and more stringent access to credit show up in terms of both consumer behavior but also corporate behavior as well. And this goes beyond simply the regional banking crisis, but instead is a result by design of higher rates. Specifically this week we got the New York Fed survey of consumer expectations, and while we often talk about the inflation expectations component of that survey, which was effectively unchanged versus last month, another metric that caught our attention was that the combination of those seeing somewhat or much harder access to credit climb to almost 60% of those asked. That's the highest this metric has ever been on this survey, which goes back to 2013, and especially as student loan payments restart, we see credit card delinquencies start to climb, and in turn revenues in corporations begin to moderate.

This all means that both households and companies are going to have an increased need for credit at the precise moment when it's becoming harder to access. The banking system has obviously been in focus for this reason. And additionally this week we got some questions around what potentially more stringent capital requirements might mean for not only lending, but also banks’ ability to interact in the Treasury market. The initial implication is less capacity from dealers to warehouse inventory and what that ultimately means for the ability to market-make. But as we get ready for the Treasury Department's buyback program to be implemented in 2024, the regulatory side of the market is clearly something that's going to remain relevant over the longer-term.

Ian Lyngen:

Another interesting development that we've seen over the course of the last several weeks is an increase in the importance of incremental flows as the market reaches something of an equilibrium in terms of policy expectations. Now, we did get an as expected rate hike from the ECB, although it had a somewhat dovish tone, and as we contemplate what will come out of the Fed, expectations are for at the most another quarter point between now and the end of the year. While there were some rumblings that the Bank of Japan might move out of negative territory for policy rates, the reality is that 2023 is nowhere near as exciting from the monetary policy front as was 2022.

And that's put the market in something of a holding pattern. As we await clarity from monetary policymakers, And in such an environment, it's not surprising to see that incremental flows, whether it was the rate lock hedging that we saw on the corporate side at the beginning of September, or simply big positions being established or unwound end up being more influential for the outright level of yields in an environment where frankly, conviction is relatively light compared to where one might have otherwise anticipated it should be given the evolution of the global economy at the moment, certainly from the data side.

Ben Jeffery:

And it wasn't just domestic data this week that contributed to the trading paradigm. We got stronger industrial production and retail sales figures out of China, and also via the Japanese Ministry of Finance whose weekly bond buying data showed in the week ending September 8th, so last week, that Japanese investors purchased an impressive $25 billion in overseas notes and bonds. And remember, that series is defined as long-term securities, so that means the purchases were executed in something other than simply the bill market. In dollar adjusted terms, that $25 billion figure matches the largest weekly inflow that we've seen this year, but that was during an auction settlement week and before that one needs to look back to the pandemic and before that back to 2016 to see Japanese purchases of foreign bonds at the level that we've seen recently.

A bit counterintuitive to be sure given that JGB yields have continued to climb and the yen has continued to weaken, but particularly from such bearish extremes, the fact that we saw the MoF data show Japanese investors starting to get interested in Treasuries at these levels is telling as it relates to the forward trajectory of demand from here. To bring it back to the domestic issues at hand in the labor market, it's also important to mention that the United Auto Workers have decided to go on strike, and that means that nearly 13,000 employees for car manufacturers in the Midwest will be striking for the foreseeable future.

Now, there's more immediate implications on Q3 GDP as it relates to diminished auto output, but also more broadly, the situation exemplifies that workers continue to have a meaningful amount of negotiating power versus corporations, and that's going to mean that wage gains and ultimately inflation are going to remain stubborn. Now, does this justify another hike from the FOMC this year? Not necessarily, but it absolutely feeds into the idea that Powell is going to keep policy restrictive for even longer in an effort to bring labor demand and supply back closer to some version of equilibrium.

Ian Lyngen:

While one can debate the quality of products coming out of Detroit, there's no question that the Motor City has complicated Powell's job if nothing else. Vail, you're from Michigan. What do you think?

Vail Hartman:

Well, I've never been one for bowling, certainly not familiar with strikes.

Ian Lyngen:

I get it.

In the week ahead, the most relevant macro event is of course Wednesday's FOMC rate decision. We are expecting no change in the policy rate. This is very consensus at this point and has been well telegraphed by a variety of monetary policymakers. Therefore, it won't be a surprise. That being said, within the details of the statement, we could find some forward guidance as to the Fed's thinking about a November or a December rate hike. All else being equal, we think that the Fed has a very high incentive to retain as much flexibility as it can over the coming quarters. So in practical terms, this translates immediately through to the dot plot. We see no change in the 2023 dot, which suggests that we will have another quarter point by the end of the year bringing the terminal rate to 5.75. Moreover, we anticipate an increase in the 2024 dot, which would bring the amount of Fed cuts anticipated in 2024 down from 100 basis points as signaled in June SEP to just 75.

And as we think about how that actually plays out of the course the next year, it's simply means that rate cuts are going to start later than they might have otherwise. It doesn't imply that we're going to have fewer cuts overall, but at the end of the day, what we've seen is a US economy that is performing well enough to justify holding terminal for longer. And recall that one of the key takeaways from Jackson Hole was that the Fed is not actively nor will they actively consider revising the 2% inflation target. And one of the things that clearly suggests is that even if we're in what is ostensibly a no landing scenario, the Fed will continue to remain restrictive long enough to get the unemployment rate well off the cycle lows, and to get realized inflation back to the Fed's 2% target. Said differently, we don't think the Fed is actually in the position to accept a soft landing or no landing, and they need to engage in an amount of excess demand destruction to ensure that price stability is restored.

Also within the updated SEP, it'll be notable to see how the Fed chooses to handle the GDP estimates. All else being equal, we'd expect them to be revised a bit higher. Core inflation estimates unchanged, if not nudged a bit higher. And overall, the most tradable event resulting from Wednesday's monetary policy meeting will be the dot plot. So keep in mind the spread between the 2023 and the 2024 dot and ultimately a hawkish pause is what will be on offer. Let us not forget, the week ahead also includes the $13 bn 20-year auction on Tuesday, as well as the $15 billion TIPS reopening on Thursday. Aside from that, the economic data is relatively limited. Although given the relevance of the employment landscape, Wednesday's weekly jobless claims figures will either reinforce or challenge the notion that the US jobs market remains resilient and will continue to be a pillar of support and allow the Fed to retain terminal for an extended period of time. At the end of the day, it does all come down to jobs.

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 all the chatter about Motor City, Detroit steel and strikes, we're just now catching up to speed that it's not really about bowling, although the parallels between the negotiations and a split certainly have not been wasted on us.

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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