Finding Normal - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 291, Finding Normal, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of September 16th. And as Powell prepares for the beginning in policy normalization, we're left with a lingering concern that what passes for normal in central banking circles isn't as universal as one might hope. Remember when the vice chair was also a folk singer? Time, no changes. Rates, yes changes.

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, the Treasury market got the final data input of relevance ahead of the FOMC decision. Specifically, the August core-CPI numbers came in slightly above expectations. The monthly change was 0.3% and on an unrounded basis that was 0.281%. So arguably a solid to low 0.3%, but nonetheless, it was enough to take a 50 basis point rate cut off the table for all intents and purposes. We also saw a solid take down to the 10-year auction, which was an important bellwether given that the event came in the wake of the Harris versus Trump presidential debate. The pundits concluded that Harris took the day, as it were, and that offered solace for Treasury market participants, at least in so far that a Trump 2.0 won't risk reflation and another focus on increasing tariffs.

The treasury market performed well. 10-year yields, drifted as low as 3.60%, which is an impressive move all things considered. And a lot of this price action was retained even despite the higher-than-expected core-CPI figures. This suggests that there will continue to be an underlying bid for Treasuries, and one that we expect will limit the extent to which 10-year yields can back up. Now, this doesn't mean that we won't see 3.80% or 3.90% again, however, we do think that any attempt to push 10-year yields materially above 4% will be short-lived. In fact, all else being equal, we would expect that the next several months will be defined by a trading range in 10-year yields of effectively 3.50% to 4%.

Now, this trading range won't persist indefinitely, but as the market's focus shifts towards the front end of the curve, and pricing in whatever rate cutting cadence is revealed at the FOMC meeting, we anticipate that the most dramatic price action in the treasury market will be a function of the shape of the curve as opposed to any choppiness in 10- and 30-year yields.

It is also notable that the ECB lowered rates by another 25 basis points, serving as reminder that with the exception of the Bank of Japan, all the major central banks are now in rate cutting mode, which is a significant shift from where we started the beginning of the year and certainly where we were in the middle of 2023. As the process of bringing policy rates lower becomes the new norm, we'll be watching the price action in the breakeven space for any evidence that pockets of sticky inflation and a Fed that's removing restriction could translate into upward pressure on breakevens.

Ultimately, however, we remain sellers of breakevens and anticipate that over the course of the next several quarters, 10-year breakevens will convincingly break below 200 basis points and return to the pre-pandemic range of 175 to 195. To a large extent, this is a function of the market's increased confidence in the effectiveness of monetary policy combined with an acknowledgement that the lagged impact of prior rate hikes will still continue to put downward pressure on realized inflation over the next couple quarters.

Ben Jeffery:

This week in the Treasury market was always going to be a function of two things. First was treasury supply with the reopening series of tens and thirties, along with the three-year auction on Tuesday that stopped solidly through pre-auction levels as an indication of still robust demand for the front end, even at these yield levels. Secondly and more importantly was August CPI data that came in above expectations that 0.3% month over month on the core measure, 0.281% in unrounded terms, above the two-tenths consensus and even further above what we'll argue was an expectation for somewhere between 0.15% and 0.2%, which has now left investors' expectations for next week's FOMC meeting firmly favoring a quarter point rate cut to begin this cycle's normalization campaign.

Ian Lyngen:

If nothing else to take away from the last several weeks, both in terms of the economic data as well as the commentary from Fed officials, is that the FOMC is not really sure how much they're going to cut between now and the end of the year. Monetary policy is data dependent and it will depend on what happens to the employment market. That being said, the market can take solace in the fact that there will be at least one rate cut in September and that's 25 basis points. Whether the Fed follows through with cuts at every meeting, as is currently priced in, will most likely be a function of the evolution of the real economy as opposed to any concerted effort on the part of monetary policymakers to provide predictability outside of keeping rate cuts at each meeting, if nothing else.

We could easily envision a scenario in which the Fed cuts by 25 basis points on September 18th, announces the end of QT at the November meeting, and then reduces policy rates by another 25 basis points in December, at which time the Fed would have greater clarity on the performance of the real economy as well as the opportunity to signal the cadence of rate cuts next year via the beloved dot plot.

Ben Jeffery:

And on Wednesday, the updated SEP is going to be especially relevant for exactly that reason. Most immediately will be what the committee sees in terms of a median expectation for the amount of easing that will be delivered over the balance of this year. But then exactly to your point, Ian, the next most important theme for the market will quickly become how Powell is envisioning rate cuts next year. Is the blueprint going to be similar to 2019 where we got three 25 basis point fine-tuning rate cuts before the pandemic quickly made that a moot point, or will the game plan for normalization feature a longer and more drawn out rate cut path back to neutral?

Or maybe not, maybe slightly above, where the Fed sees R-star as a way to assess how the easing that's been delivered is impacting the economy? Obviously, as we learned at Jackson Hole and have continued to see as the data has played out, this is all predicated on a labor market that finds its footing from current levels, a banking system that stays well-behaved and risk assets that don't necessarily need to grind higher every day, but nor can they risk a more material disorderly correction.

Ian Lyngen:

And it's that potential for a correction in risk assets that remains so relevant as we think about the balance of September and into Q4. Assuming that the Fed commences a rate-cutting campaign that will eventually get us back to whatever version of neutral the Fed ultimately achieves, then that should support or at least limit any significant sell-off in the equity market. After all, a less restrictive Fed is supportive for equity valuations. The flip side from the Fed's perspective is that to some extent the persistent gains in equities combined with the solid performance of the housing market and home price appreciation have contributed to the wealth effect and thereby added to the upward pressure on inflation. So in the absence of a spike in the unemployment rate that hits consumption or a pullback in valuations more broadly that curtail spending for the upper two quartiles, for example, then the Fed might find itself in the uncomfortable position of seeing more upside surprises on core-CPI than downside ones.

Ben Jeffery:

And it's not just stock prices that lower rates are going to be relevant for, and especially given what we saw in terms of Shelter's contribution to the upside surprise we got in terms of August's core CPI numbers. Continued moves toward lower rates, regardless of if the Fed is actively cutting by more or not, is going to have a stimulative or at least less restrictive influence on the housing market with what that means for home prices, obviously OER's contribution to core CPI and the general trend of disinflation that has brought us to this point. This was always going to be the hard part of the easing campaign and that the Fed wants to relax their restrictiveness enough to prevent a surge higher in the unemployment rate and a massive increase in joblessness that triggers a more traditional recession but not allow rates to fall so low.

And by rates I mean not just fed funds, but market rates in the longer end of the curve, given what that means for corporate borrowing and for household borrowing, that we start to see a renewed pickup in demand. Not just for housing, but also simply on the consumption side, as cheaper access to credit drives greater activity on the household level and the corporate one.

As a theme to start September, corporate borrowers have clearly acted to take advantage of the decline in 10-year yields to lock in rates at attractive levels, and it's this pickup in activity that is high on the list of risks facing a continued softening and inflation back toward 2%. It doesn't necessarily mean we're in for a repeat of 2021, but given that 2% is and will likely remain for the time being the Fed's inflation target, each day we see yields move lower. It's a complicating factor for the FOMC to consider.

Ian Lyngen:

One of the many surprising aspects of the last year or so in the real economy has been not only the resilience of the labor market, but also how well consumption has managed to continue apace. Recall that one of the key risks to this year's macro narrative was that having depleted the excess savings accumulated during the pandemic, households would struggle to keep up with sticky inflation and higher prices in outright terms. Nonetheless, what we have seen is that aggregate consumption has continued to expand. Now, obviously we'll be watching August’s retail sales figures for further confirmation of this trend, but in part what has transpired is that household balance sheets are in such good shape because many homeowners refinanced during the pandemic, locking in historically low mortgage rates for 30 years. This created a cushion for consumers to absorb higher prices. Now, this dynamic didn't unfold precisely in the same way for the bottom quartile of consumers.

However, the bottom quartile of consumers benefited the most from a tight labor market that favored low wage, low skilled employees for those frontline service sector jobs that were so difficult to fill immediately after the pandemic. Now, as we contemplate the next 12 months, it'll be interesting to see whether the struggles facing the bottom quartile of higher prices, higher housing costs, etc., start to become more thematic for the middle two quartiles as the delayed impact of higher rates finally begins to work its way through the broader economy. We'll reiterate that the next two quarters are without question the make or break period for the soft landing narrative. If we find ourselves going into the second quarter of 2025 and we haven't seen a spike in the unemployment rate and we haven't seen real growth expectations deteriorate, then perhaps Powell has been successful in orchestrating the ever elusive soft landing.

Ben Jeffery:

And implicit in that uncertainty and how the second and third quartiles are going to fare over the next 12 to 18 months is going to be a crucial aspect of consumer confidence that has been nothing if not thematic over the course of this cycle. To look at measures of labor demand like outright jobs opening in jolts or the quits rate within the same series or measures like the conference board's labor differential, what we've seen is a steady decline in workers' confidence that there's plenty of jobs and so they can either be actively looking for a new one to secure a wage increase or if one were to get laid off, there's ample opportunities elsewhere where a substantial pay cut would not be required. To look at job changer wage gains within ADP, quits rates, labor differentials, all of this is continuing to trend in the softer direction, which while not yet a signal that is flashing red, does suggest that individuals are becoming increasingly wary of job security.

And so what this means is that as leverage swings back in favor of employer versus employee, wage growth will be more difficult to come by and instead of being content with a job that's delivering sizable pay gains year over year, the collective mindset of the consumer is arguably shifting more toward being content to have any wages at all. And that is hardly an environment that suggests we're on the precipice of another upsurge in consumption. But if we can say one thing in this world of rate changes, cost changes, and just general uncertainty, we take solace that one thing is constant at least.

Ian Lyngen:

The price of macro horizons. Still free.

Ben Jeffery:

You get what you pay for.

Ian Lyngen:

In the week ahead, the main event without question will be the first rate cut of the cycle. Expectations have solidified on 25 basis points as the first move, and the discussion has quickly become how many rate cuts the Fed will signal for 2024 as well as 2025. In terms of the SEP, the unemployment rate in June for 2024 was 4.0%. That's a number that simply needs to be revised higher, particularly given the recent trajectory of the employment market. Core PCE at 2.8% for 2024 seems to be reasonable with a trajectory of inflation and even a small adjustment lower might be warranted. GDP, which in June was estimated to be 2.1%, could ultimately be skewed a bit higher given the context of a resilient consumer, despite the recent increase in the unemployment rate. The most tradable new piece of information to come out of the updated SEP will be the dotplot itself, specifically the 2024 dot.

Given the proximity of the September meeting to the end of the year, i.e. there are only two more meetings, the market will focus on the 2024 dot for any signal indicating whether or not the Fed intends to cut at November and December or just at the December meeting. Now obviously this comes in the form of signaling 25 basis points lower or 50 basis points lower by the end of this year. Perhaps even more relevant for the market as a whole will be the spread between the 2024 and the 2025 dot. Recall that in June that spread was 100 basis points, which most interpreted to indicate 25 basis points per quarter, so a gradual move lower in rates. At present, the market is pricing in a 25 basis point rate cut at each of the next six meetings. Now, that clearly indicates that the market is looking for a more dramatic lowering of policy rates than the Fed had previously signaled.

What will be most notable is the extent to which the Fed chooses to mark to market its dot plot to reflect what the futures market is suggesting or if they stick to the quarterly cadence of 25 basis point rate cuts and surprise the market on the hawkish side. In an ideal scenario for the Fed, they could deliver 25 basis points, retain flexibility to move in November if the data suggests that it will be warranted, and then message a transition to quarterly cuts in 2025. Obviously, the market tends to struggle with the type of nuance that goes into such decisions, so we expect the biggest takeaways will be a focus on data dependency and the fact that the Fed itself hasn't decided on the ultimate cadence of lowering rates.

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. With 25 basis point cut expectations solidly in place, now the market is bracing for the dotplot heard around the world. Get it? 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 3:

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