Identified Flying Objects - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 233: Identified Flying Objects, 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 July 31st. It's been a critical week for the world as we've learned, A, we are not alone, B, Fox Mulder is right to believe, and C, the decision to rebrand Twitter as x.com was truly out of this world.

Each week, we offer an updated view on the US rates market and a bad joke or two, but more importantly, this 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 Treasury market put in a very choppy performance consistent with the incoming information and monetary policy decisions. We saw a widely anticipated 25 basis point rate hike from the FOMC, which brought the upper bound of policy rates to 5.5%. At the moment, we are anticipating that this will be the terminal rate for this cycle, given the fact that all indications suggest that the Fed will take September off and there's a lot of data between now and the November 1st meeting. Obviously, as Powell has articulated, in the event that the economic data doesn't conform with expectations, inflation ticks up rather than moderating over the summer months, then a rate hike would come quickly back on the table for the end of the year.

All of that being said, we're content with the interpretation that this is the final hike of the cycle. The question then becomes, if July marks terminal and the average time of terminal is roughly seven months, then that implies that retaining terminal for an atypically long period of time means that the Fed won't be considering a rate cut until the second quarter of next year and that's precisely what the market is pricing in at this point. We'll make the observation however that it's very typical once the Fed ends a cycle either tightening or hiking that the market is content to price in the prevailing policy stance for the foreseeable future, which in this case translates into the next six or eight months.

So as with the rolling recession narrative, i.e., a recession is always six months out on the horizon, there is similarly a rolling rate cut dynamic that we expect will continue to be relevant. Said differently, every monthly data cycle that we pass without evidence of a more dramatic impact from the cumulative tightening that's already occurred in the system will be a month or a meeting further into next year that will be required for the market to have full confidence in a rate hike.

We also heard from the Bank of Japan, which increased the range of yield curve control from plus or minus 50 basis points to plus or minus a hundred basis points. Now this was telegraphed through the financial media on Thursday and largely priced in before the event itself. It was a classic by the rumor sell the fact dynamic that unfolded and Treasury subsequently rallied. It's also notable that the inability of 10-year JGB yields to move beyond 59 basis points implies that in practical terms, there's probably no difference between having a band of a hundred or 150 or even 200 basis points because yields are unlikely to get that high. The ECB also moved rates, very much in keeping with expectations, and as with the Fed, left the market with a collective sense of uncertainty as it relates to the potential for a September move in Europe. All of this translated into bearish price action for the bulk of the week, but once 10-year yields moved above 4%, buying interest became evident and we saw a bullish tone, albeit one of questionable length emerge as the week came to an end.

Our core calls for 2023 remain intact. We are constructive on the Treasury market. We anticipate that the path to lower Treasury yields will ultimately prove more achievable than a retesting of the 409 or 425 levels. The timing of the resteepening of the curve however has become increasingly delayed and we're now anticipating that a range of negative 80 to negative 110 basis points will define 2s/10s until we have the results from the September meeting and presumably more guidance via the SEP.

Vail Hartman:

The July FOMC didn't leave investors in a position to take a high conviction view on where the terminal rate for the cycle will be and when it will be achieved and that is because we learned the FOMC will continue to make data-driven decisions on a meeting-by-meeting basis. And fed funds futures pricing suggests investors are not convinced another hike will be delivered this cycle, though Powell is certainly open to the prospects for another hike if the data justifies it.

Ian Lyngen:

And that's consistent with where we would expect to be at this point in the cycle because the fact of the matter is that the Fed's most reasonable expression of hawkishness at this stage is by simply avoiding cutting rates for the foreseeable future. The Fed has been successful in communicating to market participants that no rate cuts should be on the horizon, and as we look at the futures market, it's evident that investors aren't expecting cuts until well into 2024.

Now this creates an interesting dynamic in the context of the yield curve as 2s/10s continues to trade in a range of negative 80 to negative 111 basis points that we anticipate will define the curve for the coming months. It won't be until it's abundantly clear that the Fed will need to start cutting rates and presumably more significantly than the SEP guidance already implies that the cyclical resteepening of the curve will ultimately occur.

This means that in the interim, the big question will be whether or not the market will continue to aggressively buy 10-year yields every time we move above 4%. Our base case scenario is that, in fact, that dynamic will continue to hold and as we move into the balance of 2023, we will realize that the typical 110-to-120 basis point range for 10-year yields will in fact hold and be centered at 350. That implies that we're more bullish on the Treasury market from current valuations with a nod to the fact that price action, as with monetary policy expectations, will be appropriately data-dependent.

Ben Jeffrey:

And on the idea that the market is reaching the point where bonds are starting to find their footing, I would argue that the Fed was maybe the least exciting monetary policy decision we got this week, with Powell choosing to take the data-dependent stance that you emphasized, Vail, and the excitement of the language itself limited to changing the characterization of the economic expansion from modest to moderate. But we also heard from the ECB, and if the price action is any guide, the much more exciting Bank of Japan meeting where Governor Ueda delivered an adjustment to yield curve control policy, saying that the 50 basis point ban for 10 year JG BS is no longer a rigid constraint but instead just a reference point and the BOJ will only conduct purchases at a hundred basis points in the 10-year JGB.

So for all intents and purposes, a widening of the target band for yield curve control from plus or minus 50 basis points to plus or minus a hundred basis points, and while it wasn't that long ago that unquote sources saw a little chance of a policy change, the day before the BOJ decision, other sources came out and hinted via the financial media that a change to yield curve control was going to be debated Thursday evening Eastern Time and that acknowledgment from the press was enough to get 10-year yields back through 4% in the wake of the stronger-than-expected US GDP data. But nonetheless, the price action coming into Friday's session was a textbook sell the rumor by the fact as the shock value of widening the YCC bans was actually traded on Thursday, not after the decision was actually made.

Ian Lyngen:

Setting aside the quality of sources for familiar with the matter, it's worth making the observation that the Bank of Japan, by increasing the band to a hundred basis points, effectively abandoned yield curve control and we didn't see 10-year JGB yields go up to a hundred basis points. In fact, at 59 basis points, that is for all intents and purposes fair value at the moment and I think that that's interesting context for those in the market who had been anticipating that when the Bank of Japan gave up yields curve control, that that would be a significant impulse for higher rates globally, not just for JGBs, and if it's only worth an additional nine basis points in 10-year JGBs, it falls intuitively that investors would want to buy US treasuries above 4%.

Ben Jeffrey:

And this gets at something we talked about frequently around the start of Japan's fiscal new year, but also more recently with clients in terms of Japanese investor behavior and the willingness on one hand to buy Treasuries or not as the case may be, but also the relative attractiveness of JGBs to the Japanese investment community. After all, it's not an entirely dissimilar market dynamic where there's a lot of capital in the US as exemplified by the cash in the RRP, but also around the world that is in search of places to be deployed, and if in fact the BOJ is going to let 10-year JGBs cheapen to as much as positive a hundred basis points, there's clearly going to be significant enough demand between 50 and a hundred basis points that the upper bound of that target band probably won't even need to be defended. There's enough end user demand for JGBs for the market to take care of that itself.

And Ian, the observation you make about US 10-year yields at 4% is especially relevant coming into this upcoming week where we get the August refunding announcement and what is debated to be the increase in coupon auction sizes. We're expecting that auction sizes are going to start growing by 2 billion a month in front-end securities, except for sevens, which may be a bit more modest, and we also see tens and thirties growing by 2 billion for their quarterly reopening and then refunding process. So while on the margin, higher supply will be bearish for treasuries, given the demand that we've seen so far and the fact that treasuries still remain the benchmark safe haven asset, supply isn't going to be the determining factor between 350 and 450 10-year yields. Instead, it will be more of a 10 basis point question and the size of auction concessions that are going to be needed to take down the new issues in a not dissimilar fashion to what we saw over this past week's front-end auction series.

Vail Hartman:

This week, we saw a trio of tales across twos, fives, and sevens, and this made July the second most tailing month of the year behind February, and I think this speaks to the uncertainty around terminal from what had been generally strong sponsorship across May and June’s supply. And after the 1 bp tail for sevens after the Fed, I think it will be telling to see if the new information translates to a more durable trend in sponsorship for US debt moving forward.

Ian Lyngen:

I'd also add that the tail on the seven-year auction occurred following a stronger-than-expected real GDP report for the second quarter. Headline growth printed at 2.4% in the second quarter and that was accompanied by lower-than-expected inflation that then subsequently translated through to a core PCE print for the month of June that was on an unrounded basis, 0.158% leaving the year-over-year core PCE number at just 4.1%.

Putting this into the perspective of the price action and Powell's endeavors to re-establish price stability, one can say it's certainly been a successful second quarter for the Fed as they appear to be on course to engineer either a no landing or a soft landing scenario. We maintain that it's still too early to offer a definitive conclusion in terms of economic performance between now and the end of this year, but nonetheless, we're certainly sympathetic to the argument that the Fed might ultimately have pulled off the no landing.

Ben Jeffrey:

And to circle back to one of the most important things we learned from the FOMC given the relatively unchanged statement was that Powell was explicitly asked the question whether or not the Fed would continue to run down the balance sheet if it was also cutting rates. And the Chair's response was very clear in this regard, a definitive yes that the Fed would not hesitate to continue running down its holdings even if they needed to bring policy rates lower in the event that the economic situation develops in such a way to warrant that specific policy response.

Ian Lyngen:

I think that there is an embedded nuance in that response, however, and that is that the Fed will allow QT to run in the background if they need to recalibrate policy rates from very restrictive to less restrictive as opposed to moving to neutral or truly accommodative. I would suspect that that inflection point would be accompanied by the end of the balance sheet rundown in the event that the economy slows too dramatically that they have to cut two or below 2.5%.

Ben Jeffrey:

There's also the impact on the financial system that we've obviously been reminded of this year with the regional banking crisis and that is that from a departure point of 550 policy rates, an additional quarter-point hike or two is probably not going to be all that impactful through the lens of consumer behavior, and aside from the signaling aspect, all that influential on consumer behavior and actual economic activity.

What 50 basis points and hikes is very important for is the banking system and the hold-to-maturity portfolios that have obviously come into very sharp focus this year, so by leaning more aggressively on the balance sheet or allowing it to continue to run off even while bringing rates lower, the committee can acknowledge the impact that higher rates are having on banks specifically while also staying committed to removing liquidity from the system via running down SOMA. After all, as we touched on earlier, even after bill supply is increased and we've seen RRP balances drop to 1.7 trillion, that's still 1.7 trillion in excess capital that is sitting at the Fed overnight and is another indication of the inflationary fallout from the stimulus that was delivered in 2020 and 2021.

Ian Lyngen:

So just a sad trillion dollars looking for home.

Ben Jeffrey:

What's a trillion dollars between friends?

Ian Lyngen:

I'll take that.

In the week ahead, the Treasury market will be focused on the incoming jobs data. We see the July BLS Employment Situation report, which is released on Friday with expectations of a 170,000 increase to the establishment survey payroll's number and an unemployment rate at 3.6%. Average hourly earnings are seen up three tenths of a percent, and that could ultimately be the biggest driver of price action in the Treasury market, given its relevance to inflation, specifically the core services' ex-shelter component. Downward pressure on this supercore measure of inflation has been consistent during the last several months, and in the event that nominal wages begin to moderate further, it would be reasonable to expect that the Fed would be increasingly comfortable skipping the September meeting and looking toward Q4 as the next potential for a rate hike. All of that being said, we maintain that 550 will represent terminal and as the summer unfolds, we'll get further confirmation of the impact from the aggregate amount of policy tightening that has already been executed, both by the Fed and by other major central banks.

In the run-up to the official jobs data, we do have the ADP print for July as well as ISM Manufacturing on Tuesday, followed by ISM Services on Thursday. ISM Services has market-moving potential insofar as it is expected to print comfortably above the pivotal 50 level with a consensus of 53.0. There's no coupon supply in the week ahead. However, we do get the refunding announcement and we see three years at $42 billion, 10 years at $37 billion, and 30 years at $23 billion. The August refunding is widely expected to be the commencement of higher coupon auctions, and to a large extent, we expect that this has been an underlying factor contributing to the bond bearishness that defined the week just passed.

Let us not forget that Monday represents month end, and while July was not a refunding month, there still should be incremental indexing demand for duration. The first day of August also sees the release of the June's JOLTS data. The Fed's emphasis on job openings and the quit rate within this series leave the details as something of a tradable event even though it is information for June and we've already seen the June payrolls figures. As a theme, our expectations for the next several weeks in the Treasury market are that conviction will remain low, price action will be comparatively choppy, but within the prevailing range and volumes will slow as the deep days of summer come into focus.

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. August is upon us and the summer doldrums are quickly approaching. With this backdrop, we cannot help but recall the sage wisdom that only boring strategists get bored, and we are running out of things to do.

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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