Four Percent Down - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 212, 4% Down, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring your thoughts from the trading desk for the upcoming week of March 6th. As Powell heads to Capitol Hill for his first testimony in front of the 118th Congress, we are reminded of the sage wisdom from The Who. Meet the new boss, same as the old boss. Who's on first? No, Who's on the radio, or Spotify, for Gen Z.

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 past, the US Treasury market put in a remarkably bond bearish performance. We saw 10 year yields backup above 4%. While still shy of the levels seen in October 2022, the backup in rates has brought in, at least initially, some buying interest from a variety of different accounts. As was always going to be the case in a backup of this significance, the question then becomes how much higher can 10 year yields move before reversing and establishing a local high? Now, we've been tracking the daily stochastics, both fast and slow measures, and they've been decidedly oversold for the last roughly week and a half. The fact that we have now seen fast stochastics cross over slow stochastics suggests that the path has been cleared from a technical perspective for a move toward sustainably lower rates. Now, the nature of the price action in this zone will be very telling. If we find ourselves in a situation where longer dated yields continue to consolidate in a defined range, that would suggest a period of habituation on a higher rate plateau.

That being said, we continue to expect 2023 will be defined as a year in which the 10 year rate holds a range of roughly 120 basis points, give or take, and the center point of that range is going to be 3.5%. So in practical terms, that means we're well within the trading range, even if 10 year yields manage to make it above 4.10 and take a shot at 4.25. We'd view those levels as extremes, and we continue to anticipate that the 4.34% yield peak established in October will represent the high water mark for this cycle. Embedded in our rates outlook, however, is the idea that the Fed will continue to do whatever it takes to combat forward inflation expectations, and that Powell will have a degree of success in containing realized inflation. Now, as we think about the February data, it's notable that core CPI is expected to print at 0.3%. That's a slight downshift from the 0.4% that we saw in January, and will conform with the idea that the Fed has been making progress on re-anchoring realized inflation.

That being said, as evidenced by the market's reaction to the January data released in February, there is an ongoing debate as to exactly how successful the Fed can be in the current environment at getting inflation back toward its 2% inflation target. One of the biggest risks that we continue to contemplate for the year ahead is the potential for the Fed to revisit that inflation target. We do not expect that that will happen, although we are certainly cognizant that there are market participants anticipating that a revision to the Fed's objective in this regard would be warranted. Warranted or not, from a credibility perspective, if nothing else, the Fed needs to continue leaning in on the hawkish bias until the trend of realized inflation comes closer in line with the longer term objective.

Ben Jeffery:

Well, not a lot happened this week, but at the same time a lot happened this week. We got several important pieces of fundamental information, and probably most importantly was the Treasury market's latest leg of a bearish repricing that got 10 year yields finally beyond that 4% level we had been watching, and back to their highest level since before the release of October's CPI data that triggered the, quote, unquote, "pivot trade", which now has been all but entirely reversed.

Ian Lyngen:

I'd say that the reversal of the pivot trade really has defined 2023 thus far. We came into the year with a bias for lower rates as the market looked past the current hiking cycle and began to contemplate what aggregate demand will look like once the Fed reaches terminal and manages to keep it there for an extended period. Obviously that initially had bond bullish implications, which is why each of the nominal coupon auctions stopped through, and in some cases, rather dramatically so. We then subsequently saw January's data, which re-crafted the narrative, and if nothing else, it brought the market back to a wait and see stance as it relates to monetary policy. As we've made the rounds and met with investors, one of the biggest takeaways at this stage is that people are simply waiting for either terminal or a better sense of where terminal will ultimately be before they come back into the Treasury market off the sidelines and add duration exposure.

Now, to some extent, there are a subset of investors for whom the yield itself will be enough of an inducement, which is why, at least on the initial break above 4%, we did see some buying interest during the overnight session. Now, the sustainability of the sell-off is an important question. And all else being equal, we are open to a retest above 4%, even 4.10, but still expect that 4.34 will represent the upper bound for 10 year yields during this cycle. And our logic here is relatively straightforward. That yield peak was reached on the 21st of October of 2022, and that was a moment at which policy rates were arguably just slightly above neutral. Effective Fed funds was at 3.08, and the Fed had recently delivered a 75 basis point rate hike. So in the first month of being in restrictive territory, the Treasury market was still decidedly bearish accounting for the selloff that brought 10 year yields to 4.34.

We then subsequently saw confirmation that prior rate hikes were in fact impacting the direction of core CPI. The last four core CPI prints have averaged 0.35%. That's in contrast to the prior four, which averaged above 0.5%. Said differently, the market has renewed confidence in the Fed's ability, not only commitment, to contain inflation pressures going forward.

Ben Jeffery:

And that, I think, is going to ultimately be the critical difference between 2023 and 2022, which is that coming into last year, the Fed and the market were skeptical that the Fed would be willing to push rates meaningfully beyond 3%, let alone 5%, and even a conversation around the potential for a 6% terminal rate, and that was the primary driver of the bearishness and the flattening we saw across the yield curve that got 10 year yields to that peak you touched on, Ian. Looking ahead to this year, while yes, January's data was unquestionably strong and painted a picture of a real economy that's on very good footing to begin the new year, the lagged impact of monetary policy tightening means that the pace of the expansion will almost certainly begin to slow as we move toward what will also likely be the end of the Fed's hiking cycle in the second quarter of this year.

So yes, that certainly leaves room for yields to rise from here, but the fact that the error bands around terminal estimates now are measured in 25 basis point increments and not percentage point increments means that there's going to be increased conviction to take advantage of backup in yields, as we saw with that first break of 4%, and as we expect, will be increasingly relevant as the data comes in. And especially given the point in the calendar, and the point in the calendar in Japan, given the proximity to the new fiscal year in Tokyo and the Bank of Japan that will now be under the leadership of Governor Ueda, the relevance of Japanese flows, which we've already started to see some evidence of through the MOF data and also within some of the auction stats, will also be crucial in assessing where the yield peaks ultimately emerge, assuming we do still have some bearish potential left.

Ian Lyngen:

I think it's also relevant that with a new governor of the Bank of Japan comes an increase in the conversations, and to some extent speculation, that yield curve control will be abandoned and the 10-year JGP will allow to float freely. Now, one of the questions that we've received on several occasions is what is the end of yield curve control worth for 10 year Treasury yields? The December surprise widening of the yield curve control band of 25 basis points was accompanied by an initial selloff of 12 to 13 basis points that ultimately proved to be a fade on the day Treasury yields closed eight or nine basis points higher. Eventually, that was all given back, and recall 10 year yields in January reached as low as 3.30. Fast-forward to a April or May abandonment of yield curve control and we anticipate that the impact on the Treasury market will be much more muted, if for no other reason than it has been relatively well telegraphed.

And it also begins the conversation about the Bank of Japan moving away from negative rates. In the event that we find ourselves in the second half of this year, and the Bank of Japan has transitioned back to positive policy rates, that would be the final major central bank that has been absent during this hiking process being engaged in tightening overall financial conditions in the global context and indirectly doing more of the heavy lifting for the Fed.

Ben Jeffery:

And while obviously we've talked a lot about the Fed and what it is that Powell has done over the past year, let's not forget that the global tightening has moved policy rates around the world much higher and at a far faster rate than we've seen at any point in recent history. The RBA, the BOC, the BOE, the ECB have all brought their respective policy rates into restrictive territory, and while the ECB has more tightening to do, there's other central banks that are arriving at their terminal rate and their transition to a period on hold.

So in discussing the strength of the economy to start this year, and the relatively solid footing that the US finds itself on, for Treasuries, it's not only the US fundamentals that matter. And while economic performance domestically may hold up relatively well for a lengthier period of time, that doesn't mean that every developed market economy, or frankly, emerging market economy too, is equally well-equipped to handle rates at these levels.

After all, the longer interest rates stay this high, the greater the influence that they will have, both in terms of borrowing on the household level, but the corporate one as well. There remains a lot of refinancing activity that needs to be conducted across the globe, and the fact that the era of very subdued inflation and very low interest rates has now been replaced by the exact opposite prevents a significant risk going forward that's only going to become more pronounced the longer it is that we see policy rates in the US, but also around the world, this high.

Ian Lyngen:

And the ECB certainly does have their work cut out for them. Recall that we saw a higher than expected Eurozone inflation print for the month of February, as well as higher than expected German inflation. Now, we came into the winter concerned that energy prices would prove problematic for many parts of Europe, and the comparatively mild winter has allowed Europe to avoid more significant fallout from the energy complex. That being said, there is still clear headwinds emerging in Europe as a result of the policy tightening that the ECB has already conducted, and let us not forget that, much like the Fed, the ECB still has several rate hikes yet to execute before achieving what will likely be their version of terminal.

Ben Jeffery:

And away from the long end of the curve. We also did see a noteworthy front end development this week, which was that the Treasury Department did not come out and issue a cash management bill that many were expecting, and also trimmed the size of their three month bill auction as the impact of the debt ceiling and Yellen's necessity to run down, the cash balance begins to materialize in front end auction sizes. As it presently stands, the current assumption around the potential for the drop dead date around the debt ceiling is centered at some point in late July or early August, although there is the risk that as tax receipts begin to come in and the general expectation for them to be on the softer side, that timeline gets pulled forward to the middle or early part of July.

But nonetheless, over the next four months, we expect that bill auction sizes are going to continue to decline as a way for the Treasury Department to run down the TGA, and that's going to increase the amount of cash in the very front end of the curve while also cutting bill supply, and that should mean downward pressure on bill rates, with the exception of those maturing around the assumed drop dead date, which will help offset the impact of the Fed's tightening via policy rates, but also QT. We still have $60 billion a month in Treasuries running off of SOMA, and that removal of liquidity from the system is currently being offset by the Treasury Department's injection of liquidity into the system as cash leaves the TGA and finds a home elsewhere in the market.

So once we see a debt ceiling agreement reached and the cash balance starts to grow once again, presumably in the later part of summer, that will be a period during which we're going to be especially attentive on funding market rates and bill yields, given what will probably be some upward pressure on short-dated yields, at a time when presumably the economic data will not be as strong as it has been to start this year. So a combination of factors that means August might not be so boring after all.

Ian Lyngen:

And it's not just the Treasury Department that is working against, albeit unintentionally, the monetary policy objectives of the Fed. What we've also seen is we've seen the period of stability that has been witnessed in the equity market weigh on equity volatility, and as a result led to what Powell has characterized as unwarranted easing of financial conditions. Now, this was more topical at the beginning of the year, and the fact that the Fed hasn't pushed back against the easing momentum in financial conditions speaks to the fact that financial conditions might be well off of their extreme seen in October. They're still tighter than they were when Powell started the hiking campaign. That being said, we continue to see equities as vulnerable in this environment, given the profit compression that begun in 2022 and is likely to extend into this year. Higher input prices along with higher labor costs will continue to weigh on profitability, and as the Fed pushes back against the prospects for an early pivot or a rate cut in 2023, equity investors will cease to view any bad economic information as good for the stock market.

Ben Jeffery:

Bad is good, up is down, and right is left.

Ian Lyngen:

Well, at least three rights are.

The week ahead will be definitive for the Treasury market on a number of different levels. First, Tuesday morning's testimony by Powell in front of Congress with a monetary policy and economic update. It goes without saying that this will be a closely followed event, if for no other reason than there is, at least ostensibly, a debate as to whether or not the Fed will hike 25 basis points when it meets on the 22nd of March or continue with the quarter point cadence. We see very little path to a 50 basis point rate hike. If the Fed wants to err on the side of being more hawkish, they can simply add an additional quarter point to what the market expects to be a terminal dot revealed in the SEP of 5.4%. In addition, the dot plot on the 22nd of March will be an especially tradable event. Obviously, all prior estimates of terminal have had implications for the market.

However, in this particular installment, the proximity to the endpoint of the rate hiking cycle will give the market confidence in the Fed's estimate of where that number might actually be. Had the expectation been that terminal was still another six or eight meetings away, then investors would be more willing to fade the Fed's guidance. As it presently stands, the assumption is that we will get a 25 basis point rate hike in March, May, and June. This implies a degree of accuracy to March's update.

Let us not forget, it is also non-farm payrolls week. Expectations are for a 200,000 increase in jobs during the month of February accompanied by an unchanged unemployment rate at 3.4%. Within the data, we'll also be watching the average hourly earnings component, which is seen increasing three tenths of a percent. This would be relatively benign, all things considered, and point toward contained nominal wage gains, certainly not a declining bias on the wage front, but simultaneously incrementally less troubling for the Fed, and of course, an offset to any concerns about a longer term wage inflation spiral.

The week ahead also contains three key Treasury auctions, including the three year of 40 billion on Tuesday, followed by the 32 billion 10 year on Wednesday, and capped with the long bond auction of 18 billion. Given the strong reception to the 10 year supply and the comparatively higher rates in the present environment, we would expect a reasonably strong takedown for the 10 year sector. The three year note is a bit more of a wild card, given Powell's testimony on Tuesday morning and the potential for tone shifting headlines to emerge from the event. All of that being said, we generally expect that the underwriting process for Treasuries will err on the side of revealing solid ongoing demand, albeit perhaps not as impressive as we saw in the month of January when all of the nominal coupon auctions stopped through.

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 within the details of the employment report, the participation rate promises to be in focus. In this context, we'll note that worker participation is judged on the aggregate level, thankfully, because we all know how individual labor force participation, or at least productivity, has been on the strategist level. Don't we, Ben?

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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