Identified Inverted Objects - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 210, identified inverted objects 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 February 21st. With mysterious objects maaking their way unceremoniously back to earth over the week just passed, we'd like to ask the aliens first about the pyramids and then of course, their view on the appropriate terminal rate for Fed funds.

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 most relevant updates of the fundamentals occurred via the January CPI release and the January retail sales print, both of which surprised on the upside while the inflation figures were arguably close to expectations. On an unrounded basis, the core CPI number was a high 0.4 as opposed to expectations for a low 0.4. That might sound like a bit of needless nuance, but it did involve the year-over-year figures coming in above expectations. The developing narrative around the inflation complex has continued to define monetary policy expectations, and as such, in the wake of the updated CPI figures, the market was eager to price in a larger policy response from the Fed.

As it currently stands, we continue to expect quarter point rate hikes in March, May, and increasingly June. The period between the February and March FOMC rate decisions is particularly relevant insofar as it will set the groundwork for the March release of the SEP and the beloved dot plot. The December update showed a terminal rate in the range of 5.00 to 5.25.

As it currently stands, investors are looking for an increase of that range by 25 basis points putting the upper bound for the terminal rate during this cycle at 5.5%. We're certainly open to the prospects for an even higher number in the event that the economic data between now and the March meeting don't at least illustrate some degree of moderation given the recent trends.

That being said, we are certainly cognizant that as the Fed has now moved monetary policy well into restrictive territory, that each incremental quarter point hike becomes more and more difficult for the Fed to justify. In the context of investor's response to higher realized inflation data, it's important to highlight that this is a key transitionary period for monetary policy makers.

The Fed above all is seeking to retain a restrictive policy stance for an extended period of time during this cycle. And on the FOMC it goes without saying that the Fed would rather have an extra quarter at terminal rather than an extra quarter point hike in the process of getting to terminal.

So in the event that the Fed is able to use this strength in the economic data already revealed in January to push forward the narrative of hire for longer, Powell would surely consider that a success. And in keeping with the Fed's messaging, the future's market has albeit reluctantly been pricing out the prospects for a rate cut in 2023 and rolling those forward to 2024.

In this context, we'll be looking closely at the Feds updated dot plot to see the spread between the 2023 and the 2024 dots. Recall that in December, the spread between this year and next year's policy rate expectations actually widened implying that the higher the endpoint for this cycle, the greater amount of rate cuts that we will see next year.

All else being equal, if the Fed increases the terminal estimate by 25 basis points for this year, we would anticipate that the inversion of 2023 and 2024 dots would be 125 basis points. Now it's important to keep in mind that simply because the Fed is signaling that rates will be lower next year versus this year doesn't imply that monetary policy makers are functioning under the assumption that a recession is a foregone conclusion.

In fact, the process of moving from a decidedly restrictive policy stance towards something closer to neutral simply implies that the Fed believes that by the end of next year, they will have done sufficient work in reestablishing the price stability assumption for the US economy.

Ben Jeffery:

Well, Ian, we're coming up on a long weekend, which means we have a short week ahead. And while there are many in the treasury market that are probably waiting for some reprieve from the volatility we've seen over the past several weeks, if the recent behavior of the yield curve is any indication, I wouldn't hold your breath.

This week, we received the next round of meaningful fundamental updates after the FOMC meeting in January jobs report with of course, this week's update on CPI for January as well as a retail sales print that showed very strong consumer spending to start the year pretty much across the board. The headline numbers were well above expectations, as was the control group, which of course is most directly correlated with the consumption sub-component of GDP and has set growth expectations out on relatively strong footing for the first quarter.

Ian Lyngen:

It is an important period for monetary policy expectations. We came into the intermediate period between the February and March FOMC decisions expecting that the four major data releases would define what happened at the May meeting, specifically the period contained two nonfarm payrolls prints as well as two CPI updates.

What we saw was that the first two CPI and Nonfarm payrolls were so strong that the debate has shifted away from whether or not we get a quarter point hike in May and move to whether or not they'll be a June hike.

All else being equal, the data has been strong enough that we are on board with the market's interpretation that the Fed will nudge the terminal estimate slightly higher in March, putting the endpoint for this cycle at 5.5% for the upper bound. Now clearly there are risks surrounding that in either direction, but for the time being, the journey toward terminal appears to be well on track. And if nothing else, the Fed has increased latitude in its ability to deal with elevated consumer prices.

Ben Jeffery:

And just to drill down on some of the CPI figures themselves, remember going into the release, we certainly made the argument that the market was prepped for the potential for an upside surprise in terms of the core reading. So, versus that four tenths of a percent month-over-month consensus, we would've argued that even a five-tenths gain would've been within the realm of conceivable outcomes for the market.

And indeed, that's probably why we saw terminal pricing move so much higher before the figures. And the curve moved flatter earlier in the week before we got the actual inflation figures. Now on an unrounded basis, the 0.412% month-over-month core read was effectively right in line with what economists were expecting.

And so from that perspective, the knee-jerk price response and some of the give back associated with those who were positioned for an even larger gain certainly made sense. That was until the slower more gradual price action eventually took over and resumed yields’ steady grind higher and the curve’s steady grind flatter.

After all, within the details of the CPI report, we saw another strong read in terms of housing with OER still up seven tenths of a percent month on month. Sure, that's slowing from last month's 0.8% increase, but nonetheless, versus the pre-pandemic norms of 0.2 or 0.3, obviously shelter costs are remaining a very important pillar to watch within the core inflation complex.

The one surprising sub-component that some were looking for to be a bit stronger was the medical care basket that actually dropped four tenths of a percent month-over-month from the previous 0.3 read, and we'll give that the most credit in keeping the overall core numbers closer to that 0.4 consensus versus something a bit stronger.

So all of this left treasuries on the back foot coming out of the data. And heading into the second main data event of the week, which was the retail sales report that as we touched on earlier, was nothing if not strong and added to the idea that not only was hiring very strong in January, inflation very elevated in January, but also spending was very robust. And at least during the first month of the year, the real economy is performing in such a way that will give the FOMC ample cover to continue raising policy rates.

And more importantly, there was nothing within any of the data we saw this week that suggests any urgency to begin cutting in 2023. In fact, using the December Fed funds contract as a guide, we saw that proxy for the level of policy rates at the end of the year sell off fairly dramatically well above 5%, and now at a level that certainly resonates more with what we've heard from Fed speakers and also seen in the committee's formal projections.

Ian Lyngen:

It is tempting to say that the market is finally catching up with what the Fed has been messaging for the last several months, but it's actually more of the case that the economic data is reinforcing the Fed's messaging and as you point out, Ben, suggesting that it's still too soon to start pricing in a policy pivot. In keeping with the theme of it still being a bit too soon, the 2s/10s curve inversion persists and we are retaining our negative 100 basis point target.

Now that number was a bit more dramatic back in November when we started talking about it if for no other reason than we reached as low as negative 92 basis points in the week just passed. Nonetheless, we do anticipate that this curve inversion will persist. The big inflection points are obviously going to be the March and may FOMC meetings.

Conventional logic would suggest that the market needs to see terminal achieved before the cyclical bull steepening of the curve occurs. We're somewhat skeptical of that logic if for no other reason than every major trend this cycle has occurred in an accelerated timeline. Recall that the curve inverted more quickly and more deeply than it has in prior cycles, and the market has been very keen to move forward to pricing in rate cuts.

Now ultimately, the strength of the economic data in the beginning of 2023 increases the probability that the Fed is successful in their endeavors to keep policy at terminal throughout this year. The big question becomes, does that mean that there will be greater rate cuts in 2024 to bring policy rates back in line with neutral or does a higher terminal rate this cycle suggest that the Fed is shifting their thinking on where neutral actually is?

And of course, conversations around a higher neutral rate can't occur without revisiting the notion that the structural level of inflation might have changed as a result of the pandemic. We remain remarkably agnostic on that point, and that's not because there isn't a strong argument that between the combination of on-shoring manufacturing and a tight labor market that higher inflation expectations have become embedded in the real economy.

Rather, it's because regardless of whether or not inflation is structurally higher, during this cycle, the Fed's commitment to the 2% inflation target is so strong that we anticipate Powell is willing to engage in excess demand destruction simply to regain some of the credibility that the Fed lost during 2022.

Returning quickly to the January CPI report, it certainly wasn't wasted on us that the super core number i.e. the core services ex-OER and rent decelerated from four tenths to three tenths while still running hot. In a historic context, it was at least directionally consistent with the Fed's objectives and reminded investors of the strong correlation between this core measure of service inflation and overall nominal wages. Recall the January employment report while containing a very strong payrolls print and low unemployment number, did show a moderation in nominal wages.

Ben Jeffery:

And turning away from some of the inflation data and the economic fundamentals we got this week, there's another issue that's being increasingly focused on now that we have some of the data in hand and the topic of the debt-ceiling and what it means both for the risk of a default, and also the overall liquidity situation in the treasury market is coming back into focus at least until the March 10th release of NFP. And outside of the risk of a delayed payment, which we still think is effectively zero, one of the most meaningful fallouts from the debt-ceiling is actually going to come after Congress reaches an agreement and either raises or suspends the borrowing limits, which then in turn will allow the Treasury Department to start to rebuild their cash balance and pull liquidity from the system.

As it presently stands, Yellen is actively in the process of running down the cash balance. So what that means is a net negative bill issuance environment that pulls liquidity from the TGA into the broader financial system, and that ultimately needs to be invested elsewhere, probably primarily in funding markets or in the shortest parts of the treasury curve.

So even as the QT process rolls on and 60 billion a month, month in treasuries roll off the Fed's balance sheet, the infusion of 500 billion dollars, more or less worth of cash from the TGA will help offset any resulting liquidity strains from the QT process. Now the risk here is when the inverse of that logic takes hold and when there's a debt limit agreement reached, that means that bill issuance is going to balloon in order to refill the Treasury Department's coffers in accordance with the Treasury Department's cash balance policy.

Assuming that the drop dead date and in turn an agreement to raise or suspend the debt-ceiling is achieved sometime in July, maybe early August, that means that presumably fairly shortly after the Fed arrives at terminal and telegraphs their intention to leave rates higher than they've been in a very long time, that timeline is going to come along with a still running down balance sheet as well as the Treasury Department removing liquidity from the system via increasing bill auction sizes.

So in terms of funding market stresses and overall market functioning, this is going to represent an especially pivotal point in the calendar during summer months that in the best of times are not characterized by robust liquidity. Now the critical difference between the current episode and what we saw take place in September 2019 is that the Fed has formally implemented a standing repo facility, which will mechanically contain any backup and funding rates.

And we also have just North of $2 trillion in excess capital sitting at the RRP facilities. So unlike the reserve scarcity episode of 2019, there's still capital in the system. It just may be not quite as smooth a reallocation process as the Fed would hope after a debt ceiling agreement is reached with QT continuing to roll on.

Ian Lyngen:

This little question that we've been through a particularly bearish period for the treasury market. January was defined by bringing forward the prospects for an easier Fed and that brought 10-year yields as low as 3.33. Since we've seen these three strong data reports, nonfarm payrolls, CPI and retail sales, we've seen a sharp bearish repricing that brought 10-year yields as high as 3.90. An effectively 60 basis point roundtrip certainly isn't unheard of, particularly given where we are in the cycle.

Our expectation for this year is that the 10-year will hold a range of roughly 120 basis points centered at 3.50. So that means that in the event 10-year yields are able to push above 390, which we view as key support, that a breakout above 4% could be in the offing. Now we'd view this as a strong buying opportunity and suspect that we are not alone in that regard. Given the amount of sideline cash that remains in the market and the amount of policy uncertainty which has slowly been resolved, dip buying is expected to continue to define 2023.

Ben Jeffery:

And it's been a while since we've used our favorite cliche, so I'll say it, no such thing as a bad bond, just a bad price.

Ian Lyngen:

Or a bad strategist.

Ben Jeffery:

As the case may be.

Ian Lyngen:

In the holiday shortened week ahead, the treasury market will have three key supply events, starting with Tuesday's two-year auction of 42 billion, followed by Wednesday's five-year auction of 43 billion and capped by Thursday's seven-year at 35 billion. Recall that the auctions in January universally stopped through. All of the major nominal coupon auctions, received strong sponsorship, much of it from the overseas community.

In the beginning of February however, the auction results were more mixed. We saw a tail at the three-year auction, which we'll argue was largely a function of the fact that Powell was speaking at the precise moment of the auction itself, thereby making a setup and implicitly the underwriting of the three-year note that much more difficult. A greater concession in that regard certainly did resonate.

The 10-year refunding auction, however, was very well received, stopping through and showing the largest non-dealer allocation on record. The 30-year refunding tailed because the 30-year funding almost always tails. All of this leaves an open question, i.e. was January strength the one-off? Was it simply re-allocations at the beginning of the year or is there still underlying demand for treasuries in the primary market?

The week ahead will be very helpful in answering this question. We'll also see Wednesday's release of the FOMC meeting minutes. Now the information will be somewhat dated given the strength of the economic data that we have seen since the Fed downshifted to the 25 basis point hike in the beginning of February. Nonetheless, the conversations that occurred at this year's first Fed meeting as it relates to an appropriate level for terminal policy rates will be important.

It goes without saying that given the proximity to the endpoint for this cycle's hiking efforts that monetary policy makers are actively discussing how far they should go, but even more importantly, for the shape of the yield curve and the overall level of rates, the duration for which the Fed expects to be able to retain terminal will also be very useful context.

Recall that on average, the Fed is only able to hold terminal in place for roughly seven months. That would imply that if June is the final hike for the cycle and the pause makes it through to Q2 of 2024, that they have in fact managed to achieve in a typically long period at terminal. It will be interesting to see if there are more conversations around perhaps keeping restrictive policy in place for a year or more.

Again, while that might be consistent with the Fed's messaging on the topic, that would be a meaningful divergence from what the market is currently pricing.

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 we can't help but be impressed by Bullard's tenacity, voter this year or not, you can't keep a good hawk down. Anything for that negative 100 basis point 2s/10s call, huh Jimmy? 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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