Farewell, February - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 211, Farewell February, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of February 27th. It's the end of a short week at the end of a short month, and especially after February's volatility, thus far, we're grateful for that.

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 holiday shortened week just passed, the Treasury market received an update via the FOMC minutes regarding the Fed's thinking about the pace of rate hikes between here and terminal. Now, while, admittedly, the information was somewhat dated, given that the FOMC decision itself preceded the strong January payrolls report, the slightly higher than expected inflation data from January, and, of course, a rebound in services ISM and the solid retail sales print.

Nonetheless, the Fed has enough flexibility in crafting the messaging around the minutes that, if there had been an objective of signaling a more hawkish tone, then we would've expected that to have materialized. Instead, what we received was a very consistent message from monetary policy makers that, while hawkish is not as reactive to the January data as many in the market had been anticipating. This is also consistent with Powell's interview that shortly followed the strong employment data that managed to really reiterate this message of hawkish, but not reactionary. Now, recall that in January, when the market was eager to pull forward the policy pivot, that expectations were that the Fed would fall short of the then signaled terminal of 5.1%.

Not only did January's data leave the market with a decided impression that 5.1% is done, but also added another 25 basis point rate hike on top of that, leaving the market content with the interpretation that the Fed will continue to remain flexible and data dependent as we near terminal. It is relevant that from the Fed's perspective, an incremental 25 basis point hike or two is much less relevant than their ability to keep restrictive policy in place for an extended period of time, which puts us through 2023, and well into 2024.

The Fed also has a strong incentive to avoid cutting rates because, as long as they keep terminal on hold, they can continue to allow the balance sheet to run off. Now, the outright size of the balance sheet remains relevant, especially when we are pondering the performance of risk assets. Recall that the primary objective of QE was, first, to push investors out the yield curve, then to push investors out the credit curve, and ultimately to push investors out the corporate structure curve, i.e., going from bills to thirties, from thirties to credit, from credit to equity, from equity to private equity. And now, as the process is reversed, we would expect that risk assets will increasingly come under pressure as excess reserves are taken out of the system.

Now, this is also consistent with where we are in the business cycle, the reality of higher borrowing rates for businesses, as well as for consumers, and the lingering implications from the higher cost structures that have been established because of inflation during 2022. While firms were able to push through a portion of the higher input costs, they were not able to push through all of the higher costs. Instead, what we've seen is profit compression as a theme emerge from last year, and we anticipate that that will continue to define 2023. What's been notable is that, despite this dynamic, equities are not off as much as we might have otherwise expected. Instead, investors are content to assume that not only is the Powell put still relevant, but it struck a lot higher than we anticipate that it is. Sure, if the equity market sold off 30 or 40% over the course of several weeks, the Fed would do something. But, as we learned in 2022, a slow and steady grind that contributes to the dewealthing effect is welcome from a monetary policy perspective.

Ben Jeffery:

Well, in the bearishness that we've seen in the Treasury market extended this week, and the next primary uncertainty as it relates to the price action, is the degree to which any further selloff beyond 3.90 through 4% or beyond can extend. Along with this latest down trade, we've already seen a meaningful amount of dip buying interest as the macro narrative has shifted meaningfully. Remember in January, the "it trade" in Treasuries was pressing the Fed pivot and calling into question Powell's commitment to bring rates above 5%, which has now given way to a resumption of the bear flattening trend that we've seen in the curve with 2s/10s back below negative 80 basis points this week, and rates in the front end and belly of the curve the highest we've seen all year. This brings us to the coming week, where we have durable goods orders data for January, as well as a pair of ISM reports along with the ongoing incoming Fed rhetoric that will continue to drive the shape of the curve.

Ian Lyngen:

Well, it certainly was a defining week in terms of the price action itself, and it certainly is not lost on us that, at the beginning of this year when the "it trade" was bringing forward the Fed pivot, the conversation was hard landing versus soft landing. Fast-forward to today, and the conversation has shifted to soft landing versus no landing. We certainly don't think that this is warranted, given the amount of cumulative policy tightening that is already occurred, not only in the US, but also globally. There is a lag between the actions of global central banks and the impact on the real economy, and the market seems to be content to assume that that has already filtered through the system. We're a bit more skeptical on that. Nonetheless, the selloff in rates is certainly consistent with the seasonal patterns that tend to favor higher yields during the first quarter.

It's also consistent with the firmer inflation data that we've seen, because there is seasonality in that regard, as well. And one of the questions we've received several times over the course of the last week is whether or not the January data has materially changed our outlook for the year. The short answer is no. We continue to see 10-year yields ending 2023 at 3%, and, to a large extent, that's simply a Fed credibility trade. We expect that, regardless of how the inflation complex performs over the first several months of the year, that the Fed's response will be sufficiently hawkish to reestablish the price stability assumption going forward. And as a result, we anticipate that breakevens will continue to grind lower as a theme. It's important to keep in mind that historically, once the Fed reaches the end of a cycle, whether it's a hiking cycle or a tightening cycle, 10-year yields tend to hold a range of roughly 120 basis points.

The big question at this point is where's that range going to be centered? We are operating under the assumption that that range is centered at 3.5%. This gives ample room for a backup above 4%, even to 410, and to still be consistent with prior patterns. More importantly, we do not see 4.34%, i.e., last year's highs, being materially tested. Our logic here is pretty straightforward. Last year, we saw the Fed shift from what was assumed to be a 25 basis point cadence to a relatively benign terminal rate of 3% in Q1 2022, to a Fed that delivered a series of impressive 75 basis point rate hikes. And now, the conversation is about can the Fed push to 6% for the terminal rate.

All of this was accompanied by an investor base that was conspicuously absent, whether it was Japanese flows, domestic banks, or even some major central banks took 2022 off. And still, even with what we would characterize as the perfect bearish storm, 10-year yields only made it as high as 4.34. That being said, we're content with the bearishness that's being expressed in the front end of the curve. And Ben, as you highlighted, this will continue to contribute to the inversion trade, and we see a high probability path of 2s/10s inverting as far as negative 100 basis points, and the timeframe around that is most likely going to be between the March and the May FOMC meetings as investors digest what, we anticipate, will be a pretty revealing updated SEP and dot plot in March.

Ben Jeffery:

And in talking about the Fed's pursuits of lower inflation and inflation expectations, Ian, you touched on the breakevens market, and you and I are completely on the same page that, if only as a testament to Fed credibility and the ability of monetary policy to bring inflation lower, structurally and over the longer term, a steady declining trend in breakevens certainly make sense. And even after the impressive rally we've seen in breakevens over the past week or so, I would argue that 10-year breakevens that are still below 2.50 is, actually, a reflection of exactly that dynamic. Sure, maybe the lows that 10-year breakevens have probed over the last few months in the low two percents represented a bit of outsize optimism in the direction of inflation. But nonetheless, the fact that we've seen such a significant rally and still 10-year breakevens remains so far off the peaks that we saw set last year, that must be an encouraging sign for the FOMC, given the fact that the market is showing some faith that the tightening we've seen is going to have the desired effect on CPI.

There's also the additional and inflationary factor in 2023 versus 2022, which is that China is rapidly reopening. And in terms of financial markets, what we'll likely see is upward pressure on commodity prices, aka headline inflation, resulting in increased demand from China now that, effectively, all of the COVID restrictions have been lifted. And despite all of this, the fact that 10-year breakevens still remain closer to 2% than 3% is a positive testament in terms of market sentiment that consumer prices are trending in the right direction.

And moving back to the potential for a negative 100 basis points in 2s/10s. Ian, I'll pose the question to you that we got from a client this week, which is that, along with the depths of the inversion where triple digits is easily conceivable, how are we thinking about the duration of the inversion, and how long it will be before the 2s/10s curve returns to positive territory and a more traditional slope?

Ian Lyngen:

That's a great question, and one that I think is particularly relevant as we consider the Fed's signaling regarding the extended stay at terminal. We've been viewing the strong start to this year's economic data as extending the Fed's runway to reach terminal, but it also suggests that the Fed will have greater flexibility to retain terminal throughout 2023, and comfortably into 2024. That implies that we'll be in a range of negative 75 to negative a hundred basis points for longer than the forward suggests, and we could find ourselves in this stubbornly inverted range through the summer until we get further confirmation that the Fed's cumulative tightening has slowed inflation, curtailed demand, and begun to undermine the jobs market. It's important to keep in mind that, for all intents and purposes, two-year yields are nothing more than a 24-month rolling window of monetary policy expectations. So by the time we get to December of this year, the market will be looking into 2024, as well as into 2025. So, it's not unreasonable, assuming that we have the upper bound for policy rates at 5.5%, to envision two-year yields trading as low as 3.25.

That depth of inversion of funds versus two would be extreme, to be fair. However, given the outright level of policy rates by the end of this year, coupled with the fact that the Fed is already signaling rate cuts in 2024 and 2025, pushing back to a lower front end rate environment follows intuitively. It's also worth emphasizing that the Fed doesn't need to see a hard landing to cut rates. The Fed doesn't need to see the unemployment rate spike beyond the 4.6% projection that they're currently anticipating. Given how far above neutral a 5.5% terminal rate would be, there's ample room for the Fed to cut 150, 200 basis points and still, in being intellectually honest, conclude that policy remains restrictive and is consistent with continuing to reestablish the price stability assumption in the US economy.

Ben Jeffery:

And with the backdrop of that conversation, it is worth acknowledging what we learned from the FOMC minutes this week, and specifically the lack of any surprise hawkishness or undue aggressiveness in the official Fed communication as it related to the potential for an upper bound beyond 5.50. Instead, what we saw was a fairly measured tone in that, while yes, a few participants could have seen the case for a 50 basis point rate hike earlier this month, the support for the 25 bp move that ultimately transpired was unanimous. But beyond the size of the rate hike, we saw no indication that a return to half point hikes is really on the table, and that while the easing of financial conditions may ultimately necessitate the Fed to do more, we would argue that the latest market pricing and shifting to a higher terminal rate assumption reflects a degree of the market unwinding some of the easing of financial conditions that we've seen, which were also highlighted in the minutes of the December meeting.

So, in talking about the potential for the dots to move higher within the March SEP, nothing in the minutes implied that we'll see anything beyond a 5.50 upper bound. That's not to say that we may not see a couple dots move higher to reflect a 5.75 upper bound, but with even Bullard advocating for a peak rate at 5.50, at this stage, I would argue it's unlikely we get anything significantly beyond that. Now, the critique to this interpretation of the minutes is that the meeting took place before we got January's payrolls report, before we got January's CPI print, and before we got January's retail sales data.

So, even before it was released the Fed's communication was rendered stale. That's absolutely true, but nonetheless, the fact that the Fed crafted the communication after knowing all of those data points, and chose not to emphasize either the potential for a higher terminal rate or the chance of a return to 50 basis point hikes, suggests that we're still going to reach the point where the Fed's hawkishness is going to transition from actively raising rates to not cutting them, despite a market that will be eager to pull forward downward adjustments to policy rates in the later part of 2023 and into 2024.

Ian Lyngen:

There's also been increased chatter around the prospects for the Fed to increase the long run dot from 2.5%. The underlying argument there is the belief that inflation is structurally higher, and therefore R* should be higher. Certainly sympathetic to that argument, but given the Fed's need to reestablish some credibility as an inflation fighter by moving the long run dot higher, the Fed would implicitly be suggesting that inflation is structurally higher, and therefore, the market, we expect, would view that as the beginning of the conversation about shifting the 2% inflation target higher. And frankly, the Fed simply can't afford to revisit the 2% inflation target during this cycle and expect to retain any type of credibility as an inflation fighter. So, all else being equal, we'd be very surprised to see that 2.5% level increased in the March SEP and updated dot plot.

All of that being said, one thing is clear, Ben, we're seeing dots.

Ben Jeffery:

It's been that sort of week.

Ian Lyngen:

In the week ahead, the Treasury market has several key fundamental inputs to provide incremental trading data, as well as, of course, month end flows. It's notable that the start of this year saw investor surveys indicating that the market has become a lot closer to neutral, if not slightly long. And so, this implies that month end will increase in relevance insofar as the flows to match the index will be of more significance. It's also February, which contain the refunding auctions, which are larger than the reopenings, and as a result, we'll be watching the flows, and presumably buying interests, on Tuesday afternoon. Let us not forget, we also see an update of the ISM manufacturing data. That survey is expected to remain below 50 at 48.0. We've been tracking the spread between new orders and inventories, and what we see is that, for the last eight months, this has been solidly in negative territory.

When we look historically, there's no episode during which this has been so negative for such a long duration, and we haven't been entering a recession. Now, we are in a unique moment for manufacturing, to be sure. Supply chain issues are certainly changing the way in which purchasing managers consider and evaluate the outright level of inventories. Nonetheless, this is a troubling trend that we expect will, eventually, result in lower production and could leave the manufacturing labor force a bit more vulnerable. On Friday, we also see the ISM services print for February. Consensus there is for a 54.4 level. That is well off the December drop, but consistent with the rebound that we saw in January, which has triggered some of the negative sentiment in the Treasury market. We continue to anticipate that there will remain a bearish undertone in Treasuries, albeit not one that will last indefinitely throughout 2023.

Rather, we'd characterize the beginning of the year as the peak bearishness. It's consistent with the seasonals, it's consistent with the soft landing versus no landing debate, but ultimately, at the end of the day, we continue to anticipate that the Fed will be successful in containing realized inflation, and, therefore, contributing to downward pressure on forward inflation expectations and undermine the labor market to the extent that nominal wages continue to moderate. And as we know, the correlation is high between nominal wages and services inflation ex-shelter, which is a point that policy makers have emphasized recently. Investors will also be monitoring incoming commentary from monetary policy makers for any insight as to whether or not the FOMC minutes were an accurate reflection of the prevailing sentiment on the committee. All else being equal, we think the short answer there is yes. Slow and steady hawkishness with the willingness to respond to the data will remain the mantra for the foreseeable future.

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 as the first Friday of March approaches without a payrolls report, we are reminded that NFP is released on the fourth Friday following the week containing the 12th of a given month. BLS Wonk Trivia for 200, please Alex.

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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