Doubting the Dots - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 278, Doubting 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 June 17th. And as Fed Day fades, investors have gone from forecasting the dots to fretting over the dots, then interpreting the dots, and the current stage of doubting the dots. All that's left now is fading the dots, a distant cousin of fighting the Fed.

Each week we offer an updated view on the U.S. 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 had a wide variety of macro influences to dictate the price action. The biggest event from the perspective of the economic data was May's CPI release. Core CPI came in at just 0.163% on an unrounded basis that compared to the consensus of 0.3%, it follows intuitively that the Treasury market rallied as a result. Looking further into the details of the release, we see that core-CPI services ex-shelter in the month of May was effectively 0.0%. That compares to an increase of half a percent in April. When we put this in the context of the correlation with nominal wage gains, it was a decidedly good print for the Fed. It certainly offered monetary policymakers some solace that Q1's flashes of reflation were the anomaly, and the broader trend in the second quarter is resuming what we saw during the second half of 2023.

Now, the market was quick to interpret this as evidence that the Fed was likely to keep 50 basis points worth of rate cuts signaled within the SEP's dot plot. Wednesday afternoon, however, revealed that the opposite was true. In fact, the Fed signaled only 25 basis points worth of rate cuts in 2024. However, they added an additional rate cut to 2025, which confirms the market's assumption that once the Fed begins cutting rates, they will do so at a cadence of 25 basis points a quarter until returning to neutral wherever the Fed might decide that is. What was more interesting within the dot plot was that it was only two dots that made the difference between 50 basis points and 25 basis points.

And when we consider that between now and the September 18th FOMC meeting, the Fed will have three additional CPI prints by which to be convinced on the inflation front, we are very much of the mind that there's still a reasonably high probability that we get a September rate cut followed by a comparable move in December, and that would be consistent with 25 basis points per quarter. It would also align well with the quarterly updates of the SEP and the dot lot. In terms of price action, it was remarkable to see that even despite the 25 basis point rate cuts in 2024 signaling, the Treasury market retained the vast majority of its bid. Ten-year yields dropped below 4.25% and held there throughout most of the session. Our thinking is that to a large extent, this was a function of the fact that CPI came on Wednesday morning after the Fed's forecasters had already submitted their projections and the dots for the dot plot.

Now we know that the Fed has the option of revising those dots in the event of a major data release. However, it's unclear that that option is often utilized. In fact, during the press conference, Powell was asked specifically about whether or not the May CPI numbers were incorporated into the dot plot. His response was, "When there's an important data print during the meeting, first day or second day, what we do is make sure that people remember that they have the ability to update. We tell them how to do it. And some people do, some people don't. Most people don't." It's that context that reinforces our notion that the market was correct to dismiss the 2024 dot as being somewhat stale. After all, as Powell said, most people don't.

Vail Hartman:

The median 2024 fed funds projection in the June SEP implied 25 basis points of rate cuts by year-end. But there are a couple of reasons why we're hesitant to take the Fed's median forecast at face value, and why the September meeting can still be viewed as a reasonable departure point for rate cuts. Of the 19 forecasts for the 2024 fed funds rate in the SEP, four policymakers estimated no cuts this year, seven predicted one cut, and eight members predicted two cuts in 2024. So using this outlay of projections, the mode outcome was two cuts this year, even while the median was one cut. Additionally, only two dots made the difference between the median implying one 25 basis point rate cut this year and 50 basis points of cuts. Taken together there remains a reasonable path to a commencement of quarterly cuts at the September 18th FOMC meeting.

Ian Lyngen:

And there are a few clear reasons that we're comfortable doubting the dot plot at this moment. First, it was the timing of May's CPI release as well as Powell's comments regarding the process of updating the SEP in the wake of a top-tier data print such as the core inflation numbers. Specifically, he said, "There's an option of updating the dot plot, but most people don't." In addition, the second reason that we're comfortable doubting the dot plot at the moment is that as you point out Vail, it would only take two dots to change the September SEP back to 50 basis points worth of cuts. Third is that the details within the core-CPI numbers showed that core services ex-shelter, i.e., the supercore was at 0.0 in May. That's after printing up half a percent in April. Fourth, there's still three additional CPI prints between now and September 18th when the Fed meets to decide what they're going to do on rates, and will also offer another updated SEP at that point.

Fifth, there's evidence of slower spending and stress for consumers across the market. We have seen that in retail sales, we have seen that in personal spending. And as consumers continue to grapple with elevated prices, it follows intuitively that tradeoffs will be made in consumption patterns. Sixth, the G7 now has two central banks, the ECB and the Bank of Canada that are actively lowering rates. And a third, the Bank of England, which is expected to do so later this summer. And as we know, such divergences in monetary policy tend not to persist for very long, and we expect that by the end of the summer, the Fed will have plenty of evidence compelling them to cut rates by a quarter point and start the quarterly cadence of 25 basis point reductions that will likely last through 2025 barring a more significant economic downturn or other dire consequences from the Fed's lengthy stay at terminal.

Ben Jeffery:

And those six reasons are absolutely applicable to the June dot plot and this specific instance of the Fed's attempt to forecast the forward path of policy rates. I'll throw in a seventh higher-level reason to be a little bit skeptical of what we saw within the summary of economic projections. And that is quite simply, the dot plot has done a pretty abysmal job of forecasting what actually comes to pass in terms of policy rates. Being rates forecasters, there's a glass houses criticism to be levied here, but nonetheless, to look back at prior dot plots and compare those and what the Fed was thinking at any given time to what actually came to pass… remember back to the inflation being transitory episode. There's plenty of reasons to doubt that the Fed's median forecast and certainly each individual FOMC members are absolutely watertight. And if we've learned anything through both the pandemic economy and post-pandemic economy, the reality of the performance of the data can change very quickly.

And some of the nuances you mentioned Ian around the state of spending, we got the highest initial jobless claims print since August 2023, core-CPI now at its lowest level year-over-year since 2021. All of these factors reinforce the argument that monetary policy is in fact restrictive and adds backing to the idea that the labor market is not going to be able to stay this strong forever, ultimately inspiring the Fed to cut. And with each subsequent inflation read that we get, that shows an extension of the journey back toward 2%, that's just one more reason, while the Fed doesn't need to inflict quite as much damage on the labor market as would otherwise be expected, and given the lagging nature of the employment data, the Fed is going to become increasingly concerned about overstaying their welcome at terminal. And even if that is framed as just a fine-tuning 25 basis point cut in September followed by another in December, this along with the behavior of central banks globally, is going to leave a much stronger dip buying bias in treasuries over the medium and longer term.

Ian Lyngen:

So to your seventh reason to doubt the dots, I'll add an eighth. And the eighth is not all the dots are weighted equally on the committee. So as we know, the SEP doesn't reveal whose dot is being represented at any given level. However, it's safe to assume that of those 8 dots looking for 50 basis points worth of rate cuts this year, included would be Powell, Williams, and some of the other core decision-makers on the board. So just to close the circle on the conversation about the dots, we were not surprised to see the market retain the bulk of its pre-FOMC rally even though the dots hinted at 25 versus 50.

Ben Jeffery:

And there's another aspect of the price action to discuss this past week. In terms of what we saw or rather didn't really see all that much in the reaction of the shape of the curve. Had we been sitting here last week or a few weeks ago and known that we were going to get a soft CPI print, sure hawkish dots, but generally a measured FOMC, soft PPI read, and high jobless claims print, we all probably would've thought that the curve would've been more than just a few basis points steeper. And even as the market has put in an impressive outright bullish performance over the course of past week, generally speaking, curves like 2s/10s, 5s/30s are still very well contained within the trading range that's defined the better part of the last few months.

There's a couple nuances that help explain this dynamic, one of which is more positionally motivated and the other is more on the macro side of things. First and perhaps most simply is that even after the volatility experienced over the course of 2024, one of the favored trades among the clients we speak to is the bull steepening of the yield curve that is obviously historically associated with the outset of a cutting cycle. So a crowded positional backdrop in terms of steepeners is naturally going to limit the extent to which we ultimately can see the curve steepen, not to mention the fact that the negative carry associated with holding a steepener means that sideways isn't good enough to justify holding a steepener position. All points to the pain trade still being toward a flatter curve.

And the fact that profit-taking is going to come into naturally limit any material steepening episodes helps explain why the curve has not been able to steepen more in response to data that should be a steepener. There's also another argument to make that resonates with what we heard from the FOMC this past week, and that for the time being the Fed is comfortable delaying cuts. And even if we ultimately do get two cuts this year as opposed to what the dot plot was suggest, there's no great urgency on the Fed's part to bring rates back down to 3%.

So as we think about this idea of less cuts now translating to more cuts later or a Fed that's stubbornly on hold even as the economy begins to roll over, what this runs the risk of is investors reaching further out the curve into the five and ten-year sector to lock in what are still historically high yields for a longer period of time rather than run the reinvestment risk associated of just being long the front end of the curve. And so stronger demand for the long end, I would argue the 10-year auction was a good example of that, has capped the extent of the steepening that we otherwise would have expected to see in response to what we learned this week in terms of the data.

Ian Lyngen:

And Ben, to your point, since you're indirectly saying that the path to the exit is paved with positive carry, at the end of the day, there will be an inflection point where the market capitulates into the bull steepener. We anticipate that will either occur immediately ahead of the first rate cut or upon realization of the first rate cut and Powell's messaging associated with it. So does that mean September or December? It goes without saying at this point that it's data-dependent. And we do expect that there's a reasonably high probability that the combination of the next three CPI prints as well as what we'll learn about the state of the labor market will give the Fed more than sufficient cover to cut a quarter point in September.

Vail Hartman:

And transitioning to the supply front, this week we saw an unusually strong reception to the 10-year supply, despite the event risk that was posed by the next day's CPI figures in the FOMC meeting. On Tuesday, the 10-year auction stopped through by an impressive 1.9 basis points with a decidedly above-average non-dealer bidding allocation. For context, this was the largest stop-through at a 10-year reopening in over seven years, and this was the highest non-dealer award at a reopening auction since October 2021. This was also the first stop-through at a ten-year reopening since January 2023 and the second over the last twenty 10-year reopenings.

Looking at what drove the strong non-dealer bid, we see that the 74.6% allocation to indirect bidders was the highest on record at a reopening auction, and the highest since February 2023 when inclusive of new issues. Given the strong correlation between indirect bidding and overseas allocations at Treasury auctions, we'll be curious to see if the investor class data released on June 25th shows an influx of demand from a buyer base that has largely remained on the sidelines throughout the cycle.

Ian Lyngen:

Those are interesting statistics when put in the context of Japan's MOF data showing that Japanese investors during the first week of June sold the most in overseas notes and bonds since February 2021. So there are clearly a number of cross-currents at play from a flow perspective that suggests that over the course of the summer months, while there typically tends to be a seasonal bias towards lower rates, it promises to be, if nothing else, a choppy episode for U.S. rates.

Ben Jeffery:

Lot of wood to chop.

Ian Lyngen:

Well, tis the season.

In the week ahead the trading week will be split in half by Wednesday's market holiday. Nonetheless, we do on Tuesday have Retail Sales for the month of May. Recall that April saw weakness from the consumer, and that's an issue that is going to remain very topical as the Fed continues to keep terminal in place as it awaits further confirmation on the inflation front. This implies that while there has already been some softening of the real economy, the Fed is content with the degree that we've already seen and is comfortable in the event that there's more downside risk.

Now, the market, on the other hand, has been eager to get in front of that move, which to a large extent is what's driven the bid for duration. Curve shape remains relevant, as does the fact that we have yet to see the cyclical re-steepening of the yield curve really take hold. Now all else being equal, we would expect that given the Fed's signaling about a pending rate cut this year, that the 2s/10s curve would have moved back into positive territory, at least made some progress out of the negative 40 to negative 50 basis point range. That being said, such a move has failed to occur thus far, and we think to some extent that's a function of the fact that the two-year sector remains so well anchored to near-term monetary policy expectations while yields further out the curve remain a function of the global growth and inflation outlook. Not simply tied to what monetary policymakers will be doing domestically, but also as a nod to the fact that there is a growing divergence between Fed policy and the policy of other major central banks.

Recall that the Bank of Canada and the ECB have both moved into rate-cutting mode, and the Bank of England is expected to make the same shift sometime over the summer. As it contributes to our outlook for duration, we think that the global rate environment and this divergence in monetary policy will ultimately cap the degree to which long-term yields are able to back up and further support the inversion of the yield curve. Now, ultimately, we do expect that the yield curve will move back into positive territory. However, given the back and forth between the market and the Fed regarding the timing of the first rate cut, we suspect that this will continue to be delayed and that investors will ultimately need to see the first rate cut before we actually have the cyclical re-steepening of the yield curve take place.

Now, as the market continues to digest what we've heard from the Fed, the week ahead does contain a variety of Fed speakers, voters, and non-voters that will be making the rounds early during the week. Now, we expect that this will be an opportunity for monetary policymakers to offer some further clarity on what the potential triggers will be for the first rate cut and perhaps even afford investor's greater understanding in terms of how much the May CPI data was actually incorporated into the dot plot, or if it should still be considered new information in the wake of the Fed. Our interpretation remains that it is new information and not fully incorporated in the Fed's projections. And to reinforce this interpretation, we point to Powell's tone at the press conference and his attempts to downplay the relevance of the dot plot, which wasn't the first, nor will it be the last time that the chair advocates discounting the dots.

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 Wednesday's market holiday splitting the week in half, we are content to view it as two two-day weeks, either one of which is begging to be turned into a five-day weekend. The truest sign that summer trading conditions have arrived.

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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