Inflation Infatuation - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 209 Inflation Infatuation. 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 13th. And with Valentine's Day on Tuesday, you're welcome for the reminder, we'll recall the sage wisdom of one of Tom Hank's most beloved characters. CPI is like a box of chocolates, you never know what you're going to get.

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 Treasury Market had primarily two influences of relevance. First was the February refunding, the three year auction of 40 billion managed to tail pretty significantly, but that had more to do with the fact that Powell was actively speaking at the time, which made both the setup and the willingness of investors to underwrite the front end auction a bit precarious to say the least. The 10 year stopped through and the 30 year tailed. But let's face it, the 30 year almost always tails at the initial new auction, i.e. the refunding.

On the flip side, we had a fair amount of incoming Fed speak. The emphasis was appropriately placed on Powell and his interview at the Economics Club of Washington. The biggest takeaway was that Powell stuck to the messaging from the post-FOMC press conference, specifically that there are dis-inflationary pressures that are becoming evident. However, he continues to see multiple rate hikes between now and the point in which the Fed is comfortable that they've reached the terminal point in the cycle. Now arguably, the market was expecting something more on the hawkish side from Powell, as evidenced by the price action itself. Since the impressive January nonfarm payrolls print of plus 517,000 jobs, the one enduring trend in the market has been the flattening of the curve, or more specifically the push towards deeper and deeper inversions. We've now seen 2s/10s established new cycle lows, breaking the previous lows of negative 85 basis points to dip below negative 87 basis points.

Now following the move in the reinforcement from monetary policymakers that in fact they are going to continue hiking and keep terminal in place for an extended period of time. Back into the macro conversation has come the idea that 2s/10s could invert as much as negative 100 basis points. This is a conversation that we had been having before January when the market was very quick to price in a pivot and we saw the 2s/10s curve re-steepened back as high as in the negative 50s range. Now that the curve's flattening trend and the inversion has resumed, we expect that this trade will have a fair amount of momentum before it's ultimately exhausted. We've long advocated against prematurely scaling into the bull re-steepening of the 2s/10s curve. With a nod to the fact, however, that that is the 2023 macro trade. Our issue is just that it is still too soon. Even the 5s/30s steepening that we expected would lead the cyclical move to an un-inverted yield curve has yet to come to fruition as 5s bonds unfortunately remains in negative territory.

Ben Jeffery:

So coming into this week, we saw the post payrolls price action extended and really going into Chair Powell's interview on Tuesday, the market as a whole was primed for the chair to walk back what was unquestionably a dovish press conference that he'd delivered last week at the FOMC meeting. And instead what we got was Jay sticking very much to the script and delivering a message that wasn't all that different from what we heard in the press conference. Once that event risk was passed, the market was content to resume pushing the curve flatter, despite this week's long end Treasury supply, and we've now achieved new cycle extremes in the 2s/10s curve after we saw that spread drop briefly below negative 85 basis points around that long bond auction on Thursday.

Ian Lyngen:

In fact, the market's interpretation of Powell I think was one of the more interesting aspects of the recent price action. Ben, you're correct in your characterization of Powell's press conference as striking a dovish tone, after all the number of times in which he mentioned the word dis-inflationary pressures was notable. However, the market was more than happy to take any indication that Powell might be close to a pivot and run with it, and that's what we saw in the price action that followed the Fed.

Of course, this was all reversed in the wake of nonfarm payrolls and the extension of the price action ahead of Powell's interview was effectively the market repricing to what the Fed has been signaling the entire time, which is that that the Fed intends to get the upper bound of the policy rate to 5.25 by the end of this cycle. Now that assumes two additional 25 basis point rate hikes, one at the March meeting followed by a move in May. What this week's price action also revealed was that investors, and perhaps even the Fed, are open to the prospects for another 25 basis point move in June that would put the upper bound at 5.50 for Fed funds.

Now we came into the intermeeting period between the February and March meetings anticipating that the four major data releases would dictate whether or not we got a May hike. Specifically, we have two CPI reports and two nonfarm payroll releases. Now that we've seen January's jobs data, the conversation has shifted to whether or not the data over the next six weeks will lead the Fed to increase its terminal rate signaling via the updated SEP and dot plot. So we'll be watching very carefully to see how the CPI numbers come in on Tuesday and perhaps more importantly how the market trades a potential uptick in the monthly pace of Core CPI.

Ben Jeffery:

And the late week price action, specifically the flattening of the curve that we touched on, speaks to some anxiety that maybe the moderation which the market is looking for in inflation is not necessarily a foregone conclusion. Not to say that over the next several quarters the path of core inflation isn't going to be lower, but rather that it may not be a straight shot and there could be some components of CPI that remains stubbornly high. Obviously housing comes to mind in this context, but the fact that the jobs report, and this is something that you touched on Ian, has now shifted the Fed narrative to a question of a final hike in March or May to the uncertainty now being the final hike in May or June means that anything firmer on the inflation front that's revealed on Tuesday would certainly advocate for greater conviction around a 5.50 terminal, and that would translate to this cycle's final hike being 25 basis points in June.

And let's not forget beyond terminal that's priced in the middle part of this summer, we still have a probability, smaller probability to be sure, but nonetheless, a chance of rate cuts in the second half of this year. Which given the strength of the labor market in January, combined with what's still going to be a very hot CPI read, even if it does come in below expectations, means there's little impetus for Powell to quickly about face and begin undoing policy tightening so soon after reaching terminal, whenever that may be.

Ian Lyngen:

And to your point, Ben, the Fed has done a very good job of signaling their intention to keep policy at terminal once it's reached throughout 2023, suggesting that the first rate cuts won't come until next year. The market on the other hand, has been more than content to price in 50 basis points of rate cuts before the nonfarm payrolls print, and now we still have more than a quarter point of easing assumed by the market. We'll caution against interpreting the 25 basis points of easing seen in the Fed fund's futures market as 100% probability that the Fed is going to cut by a quarter point. Instead, we're content with the interpretation that it's either a 25% probability that they'll need to ease by 100 basis points or a 12.5% probability that they need to cut by 200 basis points by year-end. Now, in the latter scenario that would clearly imply a much more significant economic downturn and a Fed that was forced into action long before they currently anticipate.

Returning quickly to some of the key sub-components within the inflation series that we'll be watching this week, there's been a lot of chatter among market participants around the surveys of used auto prices. January showed a remarkable jump in auto prices in the Manheim Survey, which contributed to higher forecasts for core CPI. Now as we approach the event, it's notable that the estimate for core CPI is up four tenths of a percent and there is a decided collective bias on the part of market participants to anticipate an even higher print. So that suggests that the pain trade is a disappointing core number, which would presumably lead to a reversal of some of the deeper inversion numbers that we've seen

Ben Jeffery:

And not only in the shape of the curve but outright duration as well. We've seen a very impressive backup in 10 year yields from that 3.33 level to 200 day moving average that we saw challenged immediately in the wake of the Fed. And now that 10s have backed up significantly above 3.50 and back to within striking distance of 370, it was very telling to see the strength of the auction on Wednesday. Yes, we saw 3s tail by an impressive amount on Tuesday, but that was while Powell was being interviewed. So there's a meaningful caveat there, and instead we’ll argue that the 10 year refunding result on Wednesday shows that while, sure, maybe 3.33 is a bit rich for 10s, there's going to be significant buying interest that emerges between 3.75 and 4%, especially if there's room for terminal estimates to move higher and for an even more restrictive policy stance to flow through to the real economy. That's going to benefit the long end of the curve as a risk-free rate anywhere north above 3.50, if in fact the global economy is heading into a fairly bleak recession, seems like a buying opportunity.

Ian Lyngen:

Revisiting the auction performance for a moment, January was characterized by very strong underwriting for all of the coupon auctions with every single benchmark stopping through, significantly in many cases. Now, this was associated with an increase in overseas demand and allocations at auction, as we saw via some of the Treasury Department's data. And we even saw within the MoF data that Japanese investors were once again back engaged in buying Treasuries. The net buying was an impressive $8.6 billion. Now, this doesn't necessarily translate one for one into Treasury flows per se, but our operating assumption is that the vast majority of the buying out of Japan was in fact in US Treasuries.

Fast forward to the first week of February and what we saw were two tailed auctions. 3s tailed, and Ben, as you pointed out, that was probably more a function of the fact that Powell was speaking precisely at the time of the setup and the auction itself. So I'm comfortable dismissing that as a one-off. 10s stop through with the lowest dealer allocation on record, suggesting that end users were very interested in owning the new benchmark of all benchmarks and then the 30 year tailed, but the 30 year almost always tails at new issue.

So in keeping with the theme of ongoing demand for Treasuries at auction, we're comfortable setting aside this week as a bit of an anomaly and we'll watch the auctions later in February for a cleaner read on the indication of buying demand for Treasuries at auction.

Ben Jeffery:

And it was the terminal discussion that probably rightfully dominated the bulk of this week's discussion, but there was also something Powell mentioned on the balance sheet in his interview. Remember, while the Fed is raising rates, the Fed is also continuing to run down its Treasury holdings to the tune of $60 billion a month. What Powell said specifically was that he sees the process continuing to run for years, not months, and that means that despite concerns about reserve scarcity, it's the Fed's opinion that reserves remain nothing if not ample, and they don't see any near term risk of the balance sheet rundown triggering the volatility like what we saw in September 2019, the last time we saw the QT process rolling on.

Ian Lyngen:

I think it's important in this context to note that there are different facilities in place now versus 2019, specifically the Standing Repo Facility and RRP. The introduction of these two programs has for all intents and purposes, made it much easier for the Fed to control the wind down of the balance sheet without risking what might appear to be an episode of reserve scarcity, circa September 2019.

Ben Jeffery:

So in terms of sequencing, once we do reach terminal, whether that's 5.25, 5.50, 5.75, even as the Fed shifts to an on hold bias, there still will be the tightening impulse of the balance sheet rundown to consider. So while yes, policy rates will be stagnant, and as we've said many times, we expect the Fed will try to hold them in restrictive territory for longer this cycle than is typical. While we do have that longer period on hold, the balance sheet is also going to be shrinking and that's going to remove liquidity from the system with tightening implications for financial conditions.

Now, eventually as happened the last time around, there will come a point when the real economy's performance has eroded enough that the Fed will start to slow the QT process and then ultimately stop it, which will be the first dovish signal to look out for as the uncertainty around rate cut timing continues to pick up steam.

Ian Lyngen:

Ben, your observation regarding financial conditions is spot on, and I'll argue that the market viewed Powell's interview as a lost opportunity as it relates to the potential for the Fed to push back against the unwarranted easing of financial conditions as equity markets continue to trade reasonably well overall. It's that dynamic and the feedback loop between equities, equity volatility, and overall financial conditions that we expect will define the first and second quarter of 2023, and if anything, only embolden the Fed further to retain a restrictive policy stance for much longer than the market anticipates.

Ben Jeffery:

And on the topic of financial conditions, Ian, what'd you get me for Valentine's Day?

Ian Lyngen:

Ben, we all know it's a very challenging macro environment and I think that we should think of financial conditions as more of a state of being as opposed to a hard number.

In the week ahead the marquee data release will be Tuesday's CPI report for January. The headline is expected to see an increase of half a percent month over month while the core is seen increasing four tenths of a percent. Now, in light of some of the anecdotal evidence in the used auto market, investors in the US rate market appear to be biased for an even stronger print. So this is something that we'll keep in mind as we go through the details of the report itself. Let us not forget that the Fed has been very deliberate in drawing the correlation between nominal wages and service inflation-ex shelter. So that will be a sub-component that certainly garners market participant's attention. The trend between November and December in the sub-component was not in the Fed's direction as it actually accelerated almost a full tenth of a percent.

Now, given that there's a reasonable amount of computation involved in coming up with that figure, we're reluctant to assume that the Treasury Market trades off of anything except the core CPI month over month print, at least initially. That being said, if there is a re-trade of the inflation report, drilling down to that detail will be advantageous.

Beyond the update on inflation, we also see January's retail sales numbers. Recall that there was a downward trend in November and December that led to a fair amount of apprehension on the part of investors as it relates to the state of the consumer. Current forecasts, however, are for the beginning of 2023 to have started with a solid 1.4% increase. Now, part of this is a function of the fact that the retail sales report is not an inflation adjusted number, and with the New year, at least historically, has often come higher prices on a variety of goods and services. This certainly isn't to suggest that retail sales are in a position to overshadow the impact of the inflation numbers on investors' macro expect, but nonetheless, as a tradable event that will be Wednesday's highlight.

Wednesday afternoon also sees the release of the Tick Data for December. Now, it's been a long time since the Tick Data itself elicited a price response in Treasuries. However, given where we are in the cycle and the fact that January was defined by strong Treasury auctions that have been attributed to an increase in foreign participation, December's data will be a meaningful departure point if nothing else, to see what regions of the world were buying and who was selling as the year came to a close.

Now, from a broader perspective, our trading bias remains solidly intact. We expected this year to be defined by a range trade for 10 years centered at 3.50 with a range around the center point of plus or minus 60, 65 basis points. That means it's very reasonable to anticipate that at some point, whether it's via renewed economic optimism or stubbornly high inflation, that a four handle will come to fruition, which will represent an important buying opportunity. On the flip side, whether it is a more quickly decelerating inflation profile and or a higher probability of a hard landing, it's very reasonable to assume that a two handle for tens should be on the table as a risk if nothing else. Similarly, that would be an extreme that would warrant fading, i.e. selling 10s in that environment.

The sector of the curve that we remain more negative on is the two year. We have actually seen a fair amount of bearishness priced in, in the wake of nonfarm payrolls, and to some extent because of the confirmation from Powell that there are still multiple rate hikes to be achieved before the end of the cycle. This leaves us biased for a deeper inversion in 2s/10s with a nod to the fact that negative 100 basis points should once again be on the table.

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 with Grammy season behind us comes another snub for Macro Horizons, maybe next year.