Falling Back - The Week Ahead

Ian Lyngen:

This is Macro Horizons, Episode 248, Falling Back, 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 November 13th. And as daylight savings time ends for the year, we're left to settle into surplus darkness time. Thanks, Earth's rotational axis. We'll be thinking of you until the December solstice. Our forecast for this year is cold.

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, there were a few notable inputs to help guide direction in the US rates market. However, overall, the price action itself was the story. We did have Monday's release of the Senior Loan Officer Survey, which disappointed for those in the market looking for evidence that the regional banking crisis has led to tighter financial conditions. What we saw was that overall, the majority of respondents, which in this case included 59 large and medium-sized banks, saw that credit conditions were basically unchanged versus the prior quarter.

Now, all else being equal, we would have anticipated some evidence of tighter credit conditions. So the fact that the survey didn't reveal that should have been an incrementally bond bearish development. However, 10-year yields nonetheless managed to make their way back below 4.5% by midweek. The 10-year refunding auction of $40 billion did tail, but it was a modest tail of 0.8 tenths of a percent, and it came at the low yield marks of the day.

Incoming Fedspeak did precisely what the market was anticipating, which was to reinforce this notion that while the Fed might have reached terminal in July, it's going to stay here for much longer than it has in prior cycles, and therefore the aggressive rate cuts that the Fed funds futures market is pricing in for the first half of next year could ultimately prove a fade.

Now, it's notable that this is also consistent with the deeper inversion that we've seen in the 2s/10s curve, as well as the stabilizing bid that we've seen further out the curve. Term premium also remains topical, and after the New York Fed's ACM model showed term premium peaking above 47 basis points on the 20th of October, this measure has since seen term premium drift back to roughly 12 basis points, bringing into question whether or not term premium will remain positive for the foreseeable future or if we're poised to a revisit back into negative territory.

The other data point of some relevance was the initial jobless claims print. We did see claims at 217,000 which was the number from the prior week, although the prior week's read was revised higher to 220,000. Overall, however, the labor market still appears to be on comparatively strong footing even if there is some evidence that the cumulative rate hikes are finally having a toll on the realized economic data.

Recall that while the Fed does have a dual mandate of inflation and employment, inflation has definitively trumped during this cycle, given the fact that we had decades-high prints on the CPI front. In keeping with the notion that the price action itself has become the story, we're left to ponder whether or not the rate hike that was foregone because the 10-year yield increased 100 basis points from this summer's level, is poised to return given the 50 basis point rally in 10s that has occurred since the Treasury Department released their financing estimates and followed up with less dramatic increases to the auction sizes via the refunding announcement.

All else being equal, the apparent lack of progress on a budget deal increases the probability of a government shutdown on November 17th. And that would put the Fed in a difficult situation, where they would be effectively flying blind in terms of incoming economic data, therefore, pushing forward any potential rate hike if there is another in the cycle. Again, not our base case scenario, but if the Fed were to be compelled to hike again, the most likely point at this stage is going to be the late January meeting.

Vail Hartman:

This week's Senior Loan Officer Survey and the 10-year refunding auction didn't end up being the market events one might have anticipated, with the survey showing credit standards largely unchanged, and the softer takedown at the 10-year auction was unable to deter the bid for duration as 10s dip back below 4.50%.

The 30-year refunding auction drew a greater deal of attention, however, and it was the 5.1 basis point tail that accelerated a downtrade that brought 30-year yields more than 20 basis points lower on the day, an event that was certainly troubling from the Treasury Department's perspective, as it continues to contemplate how it's going to fund the deficit. It's notable that we've only seen two larger tails since the beginning of 2010 with the November, 2021 auction tailing by 5.2 basis points and the August, 2011 auction by 10.3 basis points.

Ian Lyngen:

One of the more surprising aspects of the week was the emphasis on the energy sector. Now to be fair, Front Month WTI crude oil contracts did dip below $75 a barrel at one point, and that corresponded with a strong rally in Treasuries that brought 10-year yield back below that 4.50% level.

Now, given how notoriously volatile the energy sector can be, we're somewhat hesitant about assuming that any such bond bullish price action will be sustainable if it's based solely on moves in oil. The reality is that both monetary policy makers and investors are treating geopolitical concerns at the moment as inflationary, i.e., anything that disrupts supply or delivery of energy is being viewed as potentially increasing the amount of time it will take inflation to come back in line with the Fed's objectives.

Now that being said, there hasn't been any grand progress on the geopolitical front that would suggest that a downward trajectory in oil will continue. Instead, lower prices appear to be driven by a dimmer global economic outlook. That's also consistent with how the Treasury market is pricing. The move was a combination of lower breakevens and lower real rates that got 10-year yields back below 4.50%.

Now when we think about the balance of the year, it's important to keep in mind that at present, there seems to be little to no progress being made to keep the federal government open after November 17th, which will create a disruption in the data flow and decrease the likelihood that the Fed executes another rate hike in December. Although frankly, all the messaging from monetary policymakers thus far has been far more consistent with the Fed being at terminal as opposed to readying the market for another hike. Recall that it hasn't been since the July meeting that the Fed has hiked.

Ben Jeffery:

And Ian, the fact that you touch on the move was driven by a downshift in growth expectations, AKA a move lower in real rates, also highlights one of the important inflections that's taken place over the last several weeks and a critically important reversal from the trend that began at the August refunding announcement and ultimately brought 10-year yields above 5%. And that is what had been surging term premium in the long end of the curve, predominantly as a function of supply worries from the Treasury Department, but also soft landing hopes and optimism that the Fed will be able to bring inflation lower without delivering excess demand destruction.

We've seen that narrative unwind to an extent, in part due to geopolitical developments and the implied insurance quality that Treasuries hold. And given the persistent risk of a wider spread conflict in the Middle East, clearly global investors are still willing to buy Treasuries. And also, the information we learned last week and have discussed, in the fact that smaller than expected supply increases represented an acknowledgement from the Treasury Department of the influence that higher issuance is going to have in the long end of the curve, combined with a jobs report that served as a testament to the effectiveness of tighter policy in bringing the labor market back closer to some version of equilibrium.

So all of these factors, geopolitics, Treasury supply, and evidence of a softening if still strong labor market has in turn rationalized real rate levels, but also the overall term premium structure of the curve, which versus just a couple weeks ago when the only direction term premium seemed to be headed was up. Now we've seen that dynamic rationalize, at least a bit.

Ian Lyngen:

And that really does set us up for an interesting next several weeks. Obviously, there's still an open debate about whether or not we're faced with a no landing, soft landing, or a hard landing scenario. We maintain that with the unemployment rate more than three tenths of a percent off the cycle low, in fact, it's up half a percent, and the yet-to-be fully realized impact of the cumulative rate hikes that have already been executed, there's more downside than upside in the near term.

That being said, it's important to put this into a global context as well. As we look overseas, we see dimming outlooks both in Europe, the UK, and as we saw with the negative CPI prints out of China, China is now back in a deflationary mode. All of which suggests that perhaps 10-year yields have finally peaked slightly above 5% and the Fed has now settled into terminal with Effective Fed Funds at 5.33%.

Vail Hartman:

We came into this week especially attentive to policymakers' thoughts about the recent shifts in financial conditions and what a nearly 50 basis point rally in 10-year yields and a strong rebound in equity prices could mean for the monetary policy outlook. And on Tuesday, we heard from Dallas Fed President Logan, who said that the FOMC is going to need to see tight financial conditions in order to bring inflation at 2% in a timely and sustainable way, and that this is going to need to be an area to watch as we get closer to the December meeting.

Ian Lyngen:

And Vail, I think that's precisely one of the biggest worries in the market at this point. Specifically, the Fed acknowledged that the 100 basis points selloff in Treasuries was worth at least one if not two rate hikes. So what does it mean that we've now seen a 50 basis point rally? Does that mean that another quarter point hike should be on the table for December? If the government shuts down and we don't have the economic data to justify it, will the FOMC be content to make that decision based solely on price action? That seems unlikely, and if anything, we would assume that the combination of a government shutdown and a rally in the Treasury market would increase the odds of a late January hike as opposed to locking in the probability for something later this year.

Ben Jeffery:

And there's a case to be made that that reaction function, AKA, the Fed communicating taking the next meeting off, but being willing to hike at the subsequent meeting, is precisely how the FOMC wants investors to respond to their incoming communication, an emphasis on data dependence and the more likely outcome at the near-term next meetings being a hike rather than a cut.

By being able to roll that pricing forward, the Fed is hoping to prevent the dynamic that you sort of touched on, Ian, which is the market rallying too much and undoing the tightening impulse the selloff had delivered. So once next week's inflation data is in hand and once we have November's information as well, maybe the Fed ultimately doesn't need to hike in December. But presumably, they'll be very explicit in their messaging that they could hike in January, then maybe they could hike in March again. What remains critical is that inflation doesn't start to re-accelerate and the increase in the unemployment rate doesn't continue to move sharply higher. And Powell can still say, we might hike. Maybe next meeting, maybe the meeting after that, maybe the meeting after that, until core inflation is much closer to 2%.

Ian Lyngen:

One thing the monetary policy makers aren't discussing, certainly not in any public form, is the possibility that they'll have to cut earlier than anticipated next year. The market is more than willing to price in rate cuts during the first half of the year, whereas the signaling for monetary policymakers has been that rate cuts, if they occur at all, won't happen until late into 2024.

While it's still a ways out, it'll be very interesting to see how the Fed chooses to update the SEP. Assuming that they're done hiking rates, we will see a downtick in the end of the year 2023 forecast for effective fed funds, but there's a reasonable possibility that the Fed signals, whether it comes to fruition or not remains to be seen, but that they signal their intention to keep rates at terminal throughout all of 2024. I think that that would have clear implications for the shape of the yield curve as well as for the outright level of yields in the two and three-year sector.

At the same time, it would probably ultimately be bond bullish for 10s and 30s and push the yield curve even deeper into inverted territory. That being said, eventually there will be an inflection. The economic data will either get bad enough or the Fed will want to get in front of any further excess demand destruction, and we will see the traditional bull steepener reemerge. To be fair, we thought that there was a good probability that that occurred in 2023, but alas, we have rolled those expectations forward to the middle part of 2024 when we have enough evidence that the Fed has been A) successful in their campaign to reestablish price stability and also, and perhaps more importantly, B) that the damage being done to the real economy has exceeded the Fed's and investors' threshold for acceptability.

Ben Jeffery:

And to zoom the conversation out a bit, a fairly consistent theme we're starting to hear in client conversations is the divergence between bond market and monetary policy pricing across markets, notably Canada, Europe, the UK, and the uncertainty around which central bank will ultimately be forced to deliver a rate cut first.

Now, we've talked before about the differing sets of risk and interest rate sensitivity across different countries, given varying borrowing practices, mortgage structures, and other factors. But looking at the spread between cut pricing between the US and Canada or the US and Europe, the clear expectation is that other central banks, not the Fed, will ultimately need to undo some restrictive policy action sooner than the FOMC.

The question, of course, is when will that take place and by how much? But given the fact that Germany's already in a technical recession, the economic data in Canada has already started to soften more quickly than what we're seeing in the US. Looking at the discrepancy in terms of economic performance and valuations in the market across different geographies has become increasingly relevant now that it appears terminal is at hand, not just in the US but also for other major central banks around the world.

Ian Lyngen:

You're right, Ben. No matter where you are, monetary policy is terminal.

Vail Hartman:

Well, that's dark.

Ben Jeffery:

Vail, did you forget to set the clock back?

Ian Lyngen:

In the week ahead, the Treasury market has marquee data in the form of the October CPI print. Expectations are for the headline number to come in up just one tenth of a percent on a monthly basis. But more importantly, core CPI during the month of October is seen increasing at three tenths of a percent on a monthly basis. In fact, the early chatter suggests that it could be a high 0.3, which would imply a potential for a 0.4%. In the event of a 0.4 on the core measure, we'd expect that any resulting bond bearishness would be expressed primarily in the 2-year sector.

Logic here is relatively straightforward. It would simply push out the market's pricing of any potential rate cuts. And perhaps on the margin, it might increase the odds of a December or January rate increase. At the end of the day, we maintain that the Fed has achieved terminal, and 5.33% will prove the upper bound for the effective fed funds rate during this cycle.

In keeping with that, we also think that 10-year yields have finally peaked for the cycle, reaching slightly above 5%, which means the challenge now becomes one of timing, not only how long the current period of consolidation in 10s and 30s can persist, but if we do see another inversion push, how far can 2s/10s press before there's more pushback?

Now, our baseline assumption is that over the course of the next several months, the 2s/10s curve will settle into a range of -11 to -60 basis points, and the most productive trading will be within that range. So look to fade in a steepener that appears to be getting us back into positive territory. And conversely, once we get below -50 or -55, we expect that there will be a stabilizing, steepening bias that emerges.

What the bigger inflection on the horizon will ultimately be, however, is that of the more typical bull re-steepening that occurs when it becomes not only clear that the Fed has moved beyond hiking rates and settled in at terminal, but also that the first rate cuts of the cycle are in fact nearing. While the Fed has signaled that they intend to cut 50 basis points in 2024, we've yet to see the December updated SEP.

But regardless, the market is pricing in a far more significant series of rate reductions. And ultimately, once rate cuts commence, the market will err on the side of assuming that they are more dramatic and ultimately deeper than monetary policymakers would like to see. Keep in mind that at 5.33%, effective fed funds are well into restrictive territory, and even 50 or 100 basis points of rate cuts in 2024 would still leave policy restrictive, especially in the context of the balance sheet that continues to unwind.

Note that when Powell was specifically asked about the Fed's willingness to allow the balance sheet to continue to run off in the background, even if the committee chooses to cut rates, he made it very clear that the Fed was content with such a scenario, especially if they are fine-tuning rate cuts or said differently, as long as monetary policy is restrictive, i.e, above 2.50% by the Fed's estimates, or 3% by many in the market's assumption, then while allowing the balance sheet to shrink while Fed funds are edged slightly lower, is internally and intellectually consistent. Whether the market chooses to interpret it that way or not is an entirely different discussion.

The week ahead also includes retail sales for the month of October, where expectations are for a slight downtick. As back-to-school transitions to the holiday shopping season, all eyes will be on the pace of consumption, especially given the fact that the unemployment rate is half a percent off the cycle lows and the implications for consumer confidence, and subsequently retail spending patterns, will be of paramount importance as the market gets a sense of how growth in the fourth quarter is developing.

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 please note, SIFMA, in its infinite wisdom, has once again disappointed on the holiday front and there will be no market closure or early close for Veterans Day. No matter how many times we refresh SIFMA's website, the answer is still, "None." It's kind of like waiting for that bank error in your favor.

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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