Easy Doves It - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 266, Easy Doves It, 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 March 25th. And as the first full week of spring officially arrives, we'd truly like someone to inform the weather.

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. That being said, let's get started.

In the week just passed, the Treasury market had two major monetary policy events of note, the first being the Bank of Japan chose to increase policy rates, bringing rates out of negative territory in a shift that one could argue has been a long time coming. In addition, the Fed published the updated SEP, which included no change to the 2024 median dot, which was left at 4.6% and indicates that the Fed intends on cutting 75 basis points this year.

However, it is notable that the 2025 and 2026 dots were moved higher, as was the long run dot, albeit only by 10 basis points to 2.6%. All of this was ostensibly bond bearish, although the market certainly didn't trade it that way. Instead, the market chose to focus on the fact that the Fed didn't signal 50 basis points of rate cuts this year, and instead stuck with December's message of 75. In terms of the Bank of Japan, that was largely seen as the passage of an event risk as opposed to anything that would truly define global fixed income. It's also worth keeping in mind that, when comparing the Bank of Japan's policy rates, which are still effectively at zero, to the other major central banks, the Fed in particular, there's over a 525 basis point spread between effective policy rates. So, this puts the monetary policy decisions in Tokyo in a more accurate light in terms of their influence on overall global rates.

While there were moments of weakness in the treasury market over the last several trading sessions, the reality remains that the 4.35% support level has now held on multiple occasions, and as 10-year yields drift back below the 200-day moving average of 4.20%, we are increasingly confident that the next move will be back to fill the opening gap, which is at effectively 4.02% to 4.04%. Now, this isn't to suggest that the Treasury market is in for one-way price action. Instead, we anticipate that we'll continue to see choppy price action in the treasury market, but over the course of the next several weeks, the developing trend will favor lower yields rather than higher.

To a large extent, this was reinforced by Powell's sentiment, and as the next two FOMC meetings come into focus, we anticipate that we'll hear more official commentary regarding the tapering of QT and of course, the eventual first rate cut of the cycle. We remain in the three cut camp and expect that those cuts will be 25 basis points in size, and occur at the June, September, and December meetings this year. Now, we're certainly cognizant that the next three CPI prints, this is data representing March, April, and May, all of which the Fed will have before making its decision on the 12th of June, will be essential in determining whether the Fed cuts in June or chooses to push the departure point for the cutting cycle to the July meeting.

Vail Hartman:

There were a lot of interesting changes made to the March SEP that was defined by stronger growth and inflation expectations, a lower unemployment rate, and on the policy front, the fed funds forecasts were upped in 2025, 2026, and even over the long run. But perhaps the most immediately relevant aspect to trading in Treasuries was what didn't change, which was the committee's forecast for 75 basis points of rate cuts in 2024, a move that was particularly notable because it effectively downplayed the relevance of the early year above-trend inflation figures.

Ian Lyngen:

Precisely, Vail.

The biggest takeaway was that the Fed is unwilling to respond to the January and February core-CPI and PCE numbers. Although note, core-PCE won't be on offer until the end of the week on Good Friday, and given the market closure and the fact that the data will be published anyway, really de-emphasizes the trade-ability of February's core-PCE number. More importantly, we really have, as a market, settled into consensus expectations being a series of three 25 basis point rate cuts over the balance of the year. Now, there is obviously debate about whether or not the departure point will be June or July, but generally speaking, most investors are doubtful that the Fed will want to start cutting in September, given the proximity to the Presidential election.

Another key takeaway from the series of Fed events was the conversation around tapering QT. It was brought up at the press conference, and Powell used the language "fairly soon" in indicating the timing of an announcement related to QT tapering. Now, in light of the fact that RRP utilization is now below 450 billion, it goes without saying that the market is expecting QT tapering sometime in the second quarter. We're largely indifferent between the May or June meetings, but expect that all else being equal. It will be a May announcement, just to incrementally distance the change from the rate move.

Ben Jeffery:

And the market's response, first to the SEP and the slightly, emphasis slightly, revised language of the FOMC statement, and then to Powell's press conference, revealed very relevant information about, first, what the market was on guard for as it related to the potential for the 2024 dot to move higher, and then, more importantly, the rally in Treasuries that followed the press conference, and then extended throughout the later part of the week, was indicative of Powell's overall tone and what the Chair's messaging suggested about the potential for even more tightening to be delivered. There isn't any potential at this point of that coming to pass. So, ahead of the meeting, despite some underlying angst that may be a forecasted rate cut this year would've been removed and the potential for the Fed to surprise even more hawkishly. Instead, what we learned is that the Chair's view is that financial conditions are still tight, still slowing the economy, and two bad months of inflation data in January and February were not enough to inspire a change of plans from here. To look at labor market indicators, the outright level of yields, and the overall tone that Powell struck at the press conference, it's clear that the data is still behaving in such a way that will justify a move toward lower policy rates this year.

Timing to be determined, of course, but more broadly our takeaway was that, as soon as the data allows the Fed to cut, the Fed's bias is going to be to cut, and that means that with the event out of the way, presumably some demand was waiting on the sidelines for the new information to be revealed. We saw the Treasury market rally in the aftermath. From what was admittedly relatively attractive levels with 10-year yields back to effectively their year-to-date highs, and now with tens back to effectively the middle of the yield range that's defined the last several months of trading, the next 10 to 20 basis points is likely once again going to be a function of the incoming economic data.

Ian Lyngen:

And monetary policy changes are not limited to the US. We did see the Bank of Japan bring rates out of negative territory, but perhaps more importantly, we continue to get messaging from the ECB and the Bank of England that has focused the market more broadly on June rate cuts from not only the Fed but also the BOE and the ECB. Bailey's comments that it's not unreasonable, the amount of rate cuts that are priced into the market really reinforces expectations for 2024 to be defined by the beginning of rate cuts.

Now of course, the central banking conversations are cutting versus easing, but that's a nuance that tends to get lost on the markets. Instead, one of the primary questions that we've received from market participants recently has been based on the fact that risk assets have performed so well over the course of 2024, and to a large extent fully priced in 75 basis points worth of rate cuts, if not more. Said differently, what happens if the Fed needs to delay, or more simply put, have stock investors bought the rumor, and the summer months will be defined by selling the fact?

Ben Jeffery:

And to circle back to what you mentioned on the balance sheet, Ian, and keeping with Powell's overall dovish tone at the press conference, one of the most relevant acknowledgements he made was that liquidity is not equally distributed throughout the banking system. And that means that, as the Fed contemplates when it will be appropriate to begin slowing the pace of QT, they need to calibrate their reaction function to the lowest common denominator in terms of bank reserves.

Now, there's a meaningful amount of asymmetry as it relates to balance sheet policy in the easing direction and then in the tightening direction. Obviously, the aggressive Covid ramp up of the QE program had a material stimulative impact and was a critical driver of bringing 10-year yields to record lows. But now that we've seen the balance sheet run down for a year, more or less, the transmission mechanism of a passive balance sheet runoff and allowing treasuries to simply mature off the balance sheet has not necessarily been the wholesale tightening impulse that one would expect in a perfect mirror image of QE.

Instead, the balance sheet and the level of reserves has become far more important for the financial system and the banking sector as a whole. And so that has translated to the Fed drawing a clearer distinction between shrinking the balance sheet and what that means for banks in the overall state of monetary policy. In order to dial back some of the restriction that the Fed is delivering that will be done via the Fed funds rate and it's the level of reserves, the amount of liquidity in the RRP. And the behavior of the funding market that is clearly playing a more important role in balance sheet policy, which all else equal, suggests the relative incentive is for the Fed to err on the side of having more reserves rather than less, and a sooner tapering to QT rather than later.

Vail Hartman:

And returning to the topic of FCI, I think it was notable that Powell did not take the opportunity to push back on financial conditions at their loosest levels since summer 2022, when explicitly asked at the press conference if they were at levels consistent with reaching 2% inflation. Recall, it was just several months ago when a touchstone of the committee's hawkishness was the argument that easy FCI could make it more difficult for the committee to reach 2% inflation. And to support Powell's view that FCI is currently weighing on the economy, he pointed out two things. First, he said that significant progress was made on inflation in 2023, despite FCI sometimes being tight and sometimes looser. Second, he said that if you look at the cooling in the labor market, and specifically he pointed to job openings, the quits rate surveys, and the hiring rate, there is no shortage of signals showing that FCI is weighing on economic activity, thereby conforming with the committee's inflation objectives.

Ian Lyngen:

So, in keeping with the conversation about how the Fed has been messaging their interpretation of the progress made on the inflation front, it is notable that, while the market was looking for a recalibration following the January and February CPI numbers, the reality is that the Fed views the progress as clearly sufficient to stick to the original game plan of cutting 75 basis points this year. Now, this does trigger a new conversation and one that is consistent with worries about inflation being structurally higher as a result of the pandemic, i.e. what happens if the Fed is willing to allow inflation to run slightly hotter at this point in the cycle than the market had otherwise been expecting? This would at least incrementally delay the drift lower in breakevens that we were anticipating this year and prevent the Treasury market in outright terms from rallying as much as it could otherwise.

This isn't to say that the increase of the core-PCE estimate for 2024 up to 2.6 from 2.4 is going to put a floor in nominal tenure yields at 4%. But it does suggest that the move back to 3.75 that we're forecasting for this year will take a choppier form than was otherwise the case.

Ben Jeffery:

And to think a bit about what this conversation means over the longer term, not just the direction of rates over the next several quarters, what the move higher in the 2025-2026 and longer run dots suggests is that, if all goes according to plan, this cutting cycle need not end with rates back at the effective lower bound. And in fact, if the Fed's first step is going to be shifting policy from very, very restrictive to just restrictive, that's going to mean rates moving from 5.50 to let's say 4%, still above neutral, even in the event that R-star has shifted a bit higher on the other side of the pandemic. But assuming that the economy doesn't re-enter a Covid or global financial crisis style recession, this means that the Fed can move back to neutral somewhere in the 2.5% to 3% area as the longer run dot suggests, and then to deliver whatever form of accommodation might ultimately be required.

A move back to anywhere below 2.5% could very well be the finish line for this cycle's cutting cycle. So Ian, as you suggested this doesn't mean that 10-year yields need to go to 5%. It also probably doesn't mean that we're going to be heading quickly back to 1% or below given the sustainability of softening inflation in a jobs market that is still in relatively good shape. All of this means that for the time being, it doesn't seem as if the Fed is going to need to cut back to zero, and that probably means that Treasury yields won't be heading back to the lows we reached in 2020 anytime soon. So not outright bearish, but also probably not as bullish as would traditionally be the case.

Ian Lyngen:

And let's face it, no one wants to return to 2020, unless it's to buy equities.

In the holiday shortened week ahead, the most interesting piece of economic data comes out on Friday at 8:30 AM. This is the core-PCE number for February, and the consensus is for a three tenths of a percent increase. Now, while it is notable that the data is published on Good Friday when the market is closed, we anticipate that most market participants will at least be keeping an eye on how it comes in. That being said, it will be a difficult number to trade because, A) we already know how the Fed is responding to the February inflation profile, i.e., they still think we're going to cut 75 basis points this year, and B) Friday's market closure means that any response won't occur until Asia opens on Monday. And, at that point, there will surely be other macro influences guiding the overall level of US rates.

The week ahead also contains supply, which is skewed a day earlier, given the timing of month-end. So on Monday, we'll have $66 billion 2-years. On Tuesday we have $67 billion 5-years. And on Wednesday we have $43 billion 7-years. This front-end heavy issuance calendar should at least incrementally offset any curve steepening pressure that might've otherwise occurred as the market continues to price to the reality that we are on the cusp of a cutting cycle.

Now, as we've noted in the past, it's very important to keep in mind that, certainly from the Fed's perspective, there's a very big difference between a cutting cycle and an easing cycle. A cutting cycle that recalibrates policy rates by 75 basis points over the course of six or seven months is much different than an easing cycle in response to a negative economic outcome. The comparisons have been drawn between what we might be facing over the course of the next two or three years in terms of policy rates and what occurred during the latter part of the '90s.

Recall that in the '90s, there were a few fine-tuning rate cuts and then an extended period of relative stability for policy rates. Now, we find ourselves unwilling to fight the Fed too much on the idea that they've already told us that their expectations are by the end of 2026, that policy rates will be back down to 3.1%, which is well on the way to their longer-run estimate of neutral, which is 2.6%. Now, that being said, there is always the risk that inflation errs on the side of being stickier, and embedded in that is the conversation about whether inflation has structurally changed as a result of the pandemic, and therefore, policy rates on average will be higher over the course of the next several years. For the time being, at least monetary policy expectations are anchored to that 75 basis points worth of rate cuts this year with the only nuance being the departure point and whether we see a quarterly cadence or a more condensed series of rate cuts toward the end of the year.

We are very much of the mind that the Fed will struggle to justify starting cutting rates in September given the proximity to the Presidential election. So, that means that the first cut will either be in June or July with our current bias favoring June.

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. As the holiday shortened week ahead contains not only an early close on Thursday, but a full market closure on Friday, we'll be sending SIFMA a gift basket, or at least a card. Well, maybe just good vibes.

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.

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