Janet vs. Jay - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 246, Janet vs. Jay, 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 October 30th. Halloween has arrived, and in keeping with the American slasher classic "Freddy vs. Jason", we're looking forward to Janet vs. Jay as the refunding is poised to "Krueger" the FOMC announcement. A hockey mask would help, right?

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 passed, the most striking development came in the form of a very sharp selloff in the Treasury market that brought 10-year yields back above 5%. Now, this was met with a pretty sharp reversal in rates as the market managed to consolidate between 4.85% and 5%. An extended period of consolidation as the market absorbs some of the upcoming events is our base case scenario. The yield curve attempted to move back to positive territory, getting as far as -11 basis points in 2s/10s.

Now, while this year's big macro trade was always going to be the re-steepening of the yield curve, it has come in a bond bearish form, which has been somewhat surprising given that the typical end of the cycle trade has been a bull steepener led by the front end of the curve as the market realizes the Fed has completed its hiking process and starts to look forward, focusing on the timing of the first potential rate cut.

What has made this cycle so unique is that the decades high level of inflation has led to a decades extreme response on the part of monetary policymakers. However, they've only delivered part of that response. The first was starting the balance sheet runoff, the second was bringing rates up to terminal, and the third will be holding a restricted monetary policy for an extended period of time. It's this third stage that monetary policymakers are currently entering, and the one that involves the most uncertainty for market participants at the moment.

Ultimately, we expect that investors will be surprised by how resolute the Fed is at retaining terminal for an extended period of time. This will become most relevant when we finally see some signs that the economic data has turned toward the downside and risk assets come under further pressure. The poor performance of equity markets recently certainly has not been wasted on us, particularly given the ramifications for tighter financial conditions and what that implies for Powell and the committee needing to do less in terms of future rate hikes.

We are operating under the assumption that the Fed has reached terminal, and the likelihood of a final quarter point move from here will ultimately be contingent on the trajectory of the data. But as long as nominal rates don't shift back below 4.5%, then the Fed can be comfortable with the perception that the market is doing a fair amount of heavy lifting for monetary policymakers.

In the week just passed, we also saw a remarkably resilient consumption print. Q3 GDP came in at 4.9% above expectations, and perhaps more importantly, personal consumption printed at 4.0%. Now, these are inflation-adjusted figures, and so this confirms that the consumer has continued to expand spending in real terms and reinforces the Fed's messaging regarding the potential for a no landing or soft landing scenario.

Vail Hartman:

It was a week that saw 10-year yields achieve a five handle for the first time since 2007. Early Monday morning as the passage of the event risk associated with being long Treasuries over a weekend amid the war in the Middle East was enough to achieve the milestone. And remarkably, on Monday we saw a roughly 20 basis point peak-to-trough rally in 10-year yields, which represented the largest intraday high to low move in benchmark rates since March 2023 in the wake of the regional banking crisis. And this all occurred on effectively no new fundamental information. The bid federation on Monday also pushed the 2s/10s curve to -11 basis points, which represents the steepest the curve has been since July 2022.

Ian Lyngen:

Well, there's certainly no question that it was a week of extremes, and it's also interesting to keep in mind that given that this was the first attempt at a five handle for 10-year yields, we did see a reasonable amount of dip buying interest come in. Now, obviously with the backdrop of the geopolitical tensions in the Middle East, the choppy nature of the price action wasn't particularly surprising.

It's important to keep in mind that the recent moves have not elevated trading volumes, per se. In fact, we've seen at or below average trading volumes in the cash market as investors largely remained sidelined. Looking forward to the week ahead where we'll have greater clarity on the monetary policy front and, of course, as it's related to the upcoming issuance via the refunding announcement.

Ben Jeffery:

And that has really been the dominant force in terms of the macro discussion over this past week. Yes, Vail, you touched on the milestone valuations we've achieved both in outright yield terms and also the shape of the curve, but it's very telling what's on investors' minds given the fact that we got Q3 GDP, we're getting ready for a Fed meeting, not to mention the payrolls report, but all anyone really wants to talk about is what's going to come first on Monday when the Treasury department releases its financing estimates, and then on Wednesday when auction sizes for the coming quarter are confirmed.

First, on the overall financing estimates, remember, in July it was the upward revision from $730 billion to a trillion dollars in forecasted borrowing over the last quarter from the Treasury department that reignited term premium in the long end of the curve and operated as the catalyst for the impressive bear steepening that's defined the last quarter. When those numbers were released, the Treasury department expected that in the current quarter, AKA, the one that we'll be receiving the numbers for on Monday, they needed to borrow $850 billion worth.

So any meaningful revision to that figure on Monday afternoon at 3:00 PM is going to be the first thing to watch and help set the stage for what's going to be growing coupon issuance confirmed on Wednesday, but probably more importantly, whether or not we're going to need to see continued upsizing into 2024. So clearly this risk, the memory associated with August's refunding announcement, and the overall level of uncertainty now that term premium is back firmly into positive territory, has dampened the market's conviction such that we can get a 20 basis point move in 10-year yields on nothing at all in one direction, only to give that move back and then some, only to reverse it again and then some, in what was undoubtedly a very choppy trading week in the Treasury market.

Ian Lyngen:

This brings us to one of the more frequently asked questions, which is, "Who is going to be the buyer of last resort in an environment where Treasury auctions continue to increase in size, the real economy as evidenced by the strong third quarter GDP print remains remarkably resilient, and the Fed has no intention of cutting rates for the foreseeable future?" Traditionally, we tend to think of overseas sponsorship, whether it's from real or official money, as a reasonable backstop for underwriting Treasury auctions.

Given the trajectory of the global economy, we have seen a decreasing percentage of new Treasury auctions going to overseas bidders. In part, that also has to do with the global monetary policy landscape as the Bank of Japan readies to, at some point, pull away from yield curve control and even potentially bring rates back into positive territory. What has been fascinating is that the new buyer of last resort has become US investment managers. So the traditional real money players, whether they're mutual funds or pension funds, have become more active.

And this has, to some extent, complicated the auction process as these tend to be the most price-sensitive participants in US rates. To a large extent, this is one of the reasons that we are focused on and continue to have discussion about term premium, and therefore the underwriting of the upcoming supply will be more pivotal to the overall direction of rates than it might have traditionally.

Vail Hartman:

I'll admit, I was a bit surprised that twos and sevens went so well considering the event risks in the week ahead with the Treasury financing estimates, the refunding announcement, and NFP on Friday. But still, the weak result for 5s does point to a lack of conviction at this point in the cycle. But that event did come ahead of Q3's GDP release. However, the fact that we did still see decent demand at this stage in the cycle for 2s and 7s is consistent with the idea that we've cheapened up enough that these are at least reasonable levels to buy.

Ben Jeffery:

Absolutely, Vail. And keeping with that idea, and to touch on something that you said, Ian, we also got some new information from Japan this week in the fact that several large life insurers from the region came out and made the observation that their investment plans will start to shift, both over the balance of the fiscal year in Tokyo, but also, probably more importantly, into 2024 as the combination of the increase in rates around the world, and also the price action we've seen in the yen, has now sparked the conversation of, on the one hand, becoming more interested in foreign bonds, not explicitly Treasuries, but obviously Treasuries are included in that conversation, and also a larger willingness to buy on an unhedged currency basis, which is something we've heard a bit of anecdotally, but not seen with enough magnitude to really justify a total sea change in the longer end of the Treasury curve.

But as we begin to think about our outlook for the Treasury market in 2024, the fact that there are some early signs that Japanese investor behavior and presumably other foreign buyer behavior may be shifting from unequivocally bearish for duration to marginally less bearish for duration in the year ahead, means that as the labor market begins to turn more significantly and the growth regime comes under a bit more significant pressure, unlike in this year when there was simply no interest from foreign buyers to own Treasuries, next year and specifically after the first quarter, once the Japanese fiscal year changes, there's some reason to think that despite all this issuance and the collective unknown as to who the marginal buyer will be for all this net supply, Treasuries may find more support from Japan and from the foreign buyer community more broadly than was the case in 2023.

Vail Hartman:

Transitioning to the feedback loop between higher borrowing costs and equity valuations, with the S&P 500 back below the 200-day moving average, and this week moving below 4,200, recall at Powell's speech at the Economic Club of New York, the chair acknowledged that rising bond yields have played an important role in the recent tightening of financial conditions, and the FOMC will remain attentive to this dynamic given the potential implications for monetary policy.

In this context, looking to the press conference on Wednesday, we'll be curious if the further declines in equity evaluations has led to a greater willingness on the part of policymakers to swap higher nominal rates for Fed hikes.

Ian Lyngen:

It's interesting that this implies that the easiest route for the Fed is if 10-year yields stay near 5%. It would become more complicated in the event that we have a significant flight to quality rally that brings 10-year yields back close to, let's say, 4.5. If the Fed believes that the roughly 100 basis point increase in 10-year yields since midsummer is sufficient to avoid cutting rates in November, and potentially even December as well, what happens if that gets partially reversed into the December 13th meeting?

If nothing else, monetary policymakers have to be somewhat pleased to finally see the reintroduction of term premium flatten the curve, not back to zero, but a lot closer than one might have otherwise assumed.

Ben Jeffery:

And it's very telling that we've made it to this point in the discussion without effectively any mention of the final important event of the upcoming week, which is October's payrolls data, where the consensus is for a headline job gained below 200,000 after last month's impressive upside surprise, and an unchanged unemployment rate at 3.8%.

Now, the aggregate of the new information we've gotten since the last jobs report, which kicked off a renewed round of soft landing optimism and market pricing, probably means that investors and the Fed will discount a disappointment in hiring at least somewhat, but nonetheless, as the refunding announcement and the FOMC decision are traded and the next big unknown comes to whether or not the Fed will hike in December, clearly the two payrolls reports and two CPI prints we're going to get before the December Fed are the primary things that are going to determine whether or not we get another hike this cycle.

Ian Lyngen:

That, and of course, the feedback loop between stocks, financial conditions, and the overall perception that the US economy is on the precipice of a more significant downturn than has yet to be realized.

Ben Jeffery:

So in thinking about all of this and what it means for the wealth effect, 401k balances, general consumer behavior, at least we never wanted to retire anyway.

Ian Lyngen:

Let's face it, retirement's overrated. All people do is sit around, watch the equity market, complain about savings rates, and complain about the Fed. And make podcasts.

Vail Hartman:

Whoa. Well, I was never much of a golfer anyway.

Ian Lyngen:

In the week ahead, the Treasury market will be faced with a variety of potential market-moving developments that could recast the overall perception of the direction of US rates. First, on Monday afternoon will be the Treasury department's financing estimates. Recall that this was the trigger ahead of the August refunding and the ultimate selloff that brought 10-year yields more than 100 basis points off the lows.

In addition, we'll have Wednesday morning's refunding announcement, where we're anticipating the three-year auction size will be $48 billion, the 10-year will be $41 billion, and the 30-year will be $25 billion. Now, within the refunding announcement itself and the conversations around that, it will be notable if the Treasury department signals that in light of the recent backup in term premium, they might be favoring issuing more bills, or rather, expanding the percentage of the overall issuance represented by the bill market.

Let us not forget that we still have the Fed on Wednesday, and while the market is not anticipating a rate hike on Wednesday, the press conference that follows will be closely watched for any indication that a December rate hike is the market's default assumption. In light of the ongoing Fed rhetoric, reiterating the wait and see stance, we're not anticipating anything from Powell that changes that messaging, which, to some extent, is why we think that the refunding announcement will be the biggest event of the week ahead.

Second in line will be Friday's release of non-farm payrolls. Expectations in this regard are that October will see a 260,000 job increase to the headline number, and the unemployment rate will be unchanged. Recall that now that the unemployment rate is more than four tenths of a percent off the cycle lows, i.e., it's at 3.8%, and it got as low as 3.4% in April, investors have been increasingly focused on this figure, the assumption being that if we do see upwards trajectory emerge, that that will undermine the no landing or soft-landing scenario.

And also contained within the week ahead is month-end. Month-end extension demand will be averaged for a non-refunding month. But given the choppy nature of the price action in the week just passed, the potential is high for incremental flows to push the market through technical levels of significance, and therefore create price action that builds on itself. Investors will also be attuned for any insight coming from Washington DC now that the House has elected a Speaker.

There are still roughly three weeks to cobble together a budget deal or a stopgap bill to avoid a government shutdown on the 17th of November. Given how long it took the House to elect another Speaker and the general sense of discord among lawmakers, we're skeptical that there's a clear path to compromise, although hopeful, if nothing else, that the government does manage to avoid a shutdown.

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 as we look forward to the trick-or-treat induced sugar high, we cannot help but draw the parallels with monetary policy. Vail, too much QE will rot your teeth.

Vail Hartman:

I got a rock. And when does the Great Pumpkin arrive?

Ian Lyngen:

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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