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January Drift - Macro Horizons

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FICC Podcasts Podcasts January 19, 2024
FICC Podcasts Podcasts January 19, 2024
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Ian Lyngen, Ben Jeffery, and Vail Hartman bring you their thoughts on the U.S. Rates market for the upcoming week of January 22nd, 2024, and respond to questions submitted by listeners and clients.


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About Macro Horizons
BMO Strategists discuss the week ahead in the U.S. rates market delivering relevant and insightful commentary to help investors navigate the ever-changing global market landscape.

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Ian Lyngen:

This is Macro Horizons, episode 257, January Drift, presented by BMO Capital Markets.

I'm your host, Ian Lyngen, here with Ben Jeffery and Vail Hartman to bring our thoughts from the trading desk for the upcoming week of January 22nd. It's been a week dominated by snowstorms and falling temperatures, and looking ahead to the weekend forecast we can't help but feel it's a great opportunity to spend a little time indoors, bundled up reading Fed transcripts, eating Shepherd's pie, listening to Adele, alone in the dark.

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. That being said, let's get started.

In the week just passed, the Treasury Market got another meaningful input for the debate over whether or not the Fed will cut rates in March. Specifically, we saw a higher-than-expected retail sales print for the month of December. The consensus for the control group was +0.2%. The actual number came in at +0.8%, which bodes very well for the pace of consumption during the fourth quarter, and we now see real GDP trackers north of 2% for Q4.

When this is combined with the strong payrolls report, solid core CPI numbers, and the general sense that the real economy remains remarkably resilient, it bodes well for the Fed's efforts to avoid cutting rates until the second quarter at the earliest. As a result, the price action in the Futures Market reflected this with odds of a rate cut now at roughly 50/50 in March.

Now, obviously, January is not expected to see any change to the prevailing monetary policy stance and the most interesting aspect of what we're likely to get from the January 31st Fed decision will come in the form of the tone of the press conference, and of course any conversation around tapering of QT. It's a bit too soon to expect that the Fed will change the pace of its balance sheet runoff, but nonetheless, the market has been closely watching the utilization of RRP.

The week just passed also included a variety of official Fed commentary, all of which left the market with a decided impression that there is no urgency on the part of policymakers to start the conversation about a March rate cut. The Fed is in a decidedly data dependent mode, and the data continues to conform with the resilient economy narrative.

The curve shape has been particularly topical with 2s/10s pushing to the least inverted that we have seen in several months. Now, what makes this price action so interesting is that it was accompanied by a lower probability of a March rate cut, which all else being equal, one would've expected to translate into a bear flattening as opposed to a bear steepening.

To some extent, we'll argue that part of this dynamic was that the selloff in the two-year sector simply ran up against its logical extremes and got into a zone where investors saw fair value in twos. Whereas further out the curve, there's enough uncertainty as it relates to the potential for the Fed being comfortable with inflation at a slightly elevated level versus target as evidenced by the fact that the Fed is widely expected to begin cutting rates sometime this year.

We are less convinced that what's playing out in the longer end of the curve is a macro story and suspect that it's ultimately more about positions and the fact that there's a very strong seasonal bias in the Treasury Market for higher rates in January. And what we're seeing is a textbook tactical trade.

Vail Hartman:

After the market implied odds of a rate cut in March reached nearly 90% in the wake of December's CPI and PPI data, several key developments of the week just passed helped walk back the probability of a move to effectively a coin flip.

First was Waller's comment that he sees no reason to move as quickly or cut as rapidly as in the past with economic activity in the labor market in good shape and inflation gradually coming down. Second was the universally stronger than expected retail sales report where most importantly, the control group quadrupled the consensus forecast. Thirdly, was the sharp drop in initial jobless claims during NFP Survey Week for January to the lowest since September 2022.

Ian Lyngen:

There has been a great deal of consistency within the December economic data. We had a solid non-farm payrolls report followed by a strong core CPI number. It matched expectations at 0.3 and then followed up by better-than-expected retail sales. So, if anything, it's clear that Q4 ended the year on a strong note.

When we think about the implications for monetary policy, it follows intuitively that expectations for a March rate cut have been reduced, not eliminated. Embedded within the roughly 50/50 odds that the Fed actually delivers a rate cut in March is the idea that there's a lot of economic data between now and the March 20th decision. In addition, there's also a strong argument to be made that by the middle of March, it will be clear that there has been sufficient progress on core inflation, that the Fed will feel comfortable beginning the process of normalizing rates lower.

Now as the November core-PCE numbers revealed, the six-month annualized rate is already running at 1.8%, below the 2% target. But the question is, is it far enough below? Or more importantly, has it been below long enough? That's one of the uncertainties that to some extent has kept expectations for a rate cut still on the table. All of that being said, at the moment we're in the no cut camp and we expect that the highest probability for the first cut is in the second quarter, not the first.

Now, the flip side of that is the conversation regarding the tapering of QT. Very reasonable to anticipate that at the March meeting we hear from the Fed that they're going to begin the process of slowing the balance sheet runoff. To some extent, that's going to be an olive branch to the doves, but it will also be a reflection of the amount of reserves that have been drained from the system as well as the interplay between RRP bill issuance and the Treasury Department's borrowing needs.

Ben Jeffery:

And after a week that was so heavily dominated by the debate around whether or not we're going to see a cut or no cut in March, we'll circle back to one of the initial conversations around the contribution of the balance sheet and potentially tapering QT that was kicked off by the minutes of the December meeting.

And then Logan's comments immediately thereafter that it might be appropriate to start the conversation around slowing the pace of SOMA's rundown, and that is whether a less aggressive QT program implies that rate cuts are going to be required earlier, or does a dovish olive branch in the form of a lesser hawkish impulse from the balance sheet mean that the Fed can be more patient in first delivering an initial rate cut, but then as Waller touched on this past week, taking a shallower cut path lower back toward if not to neutral.

In a not entirely dissimilar fashion to what we saw during the regional banking crisis, it's not unreasonable to assume that the rhetoric from the FOMC is going to continue to try to delineate from the impact the balance sheet is having on the banking sector, namely reserves as you touched on Ian, and the overall stance of monetary policy.

Because while yes, QT has the inflation fighting benefit of being restrictive, it also has the unfortunate consequence of pulling banking reserves from the system. The Fed certainly wants to be cognizant of striking the right balance between those two factors.

Ian Lyngen:

Another complicating factor is the way in which a comparatively wide mortgage spread and elevated outright levels of yields has prevented the SOMA holdings of mortgages from running off as quickly as the Fed would have liked to have seen. Now, as we think about the real estate market and its relevance on the household level as a key store of value, it's difficult not to imagine that that's not on the Fed's radar.

While a moderation in the pace of wage and OER increases has been a welcome addition to the macro landscape from the Fed's perspective, Powell is certainly aware that if momentum shifts too quickly and we see greater downside realized in the real estate market that that would be a bigger tightening impulse for overall financial conditions and overshoot what the Fed has been attempting to accomplish in this cycle.

Nominal mortgage rates are coming down, but as we know so many homeowners locked into low mortgage rates during the pandemic that there's become a supply issue. To a large extent, we're sympathetic to the focus on new home supply over existing home supply in this environment, and the degree to which that is interest rate sensitive cannot be overstated. It's with that backdrop that we'll be watching closely Thursday's release of the December New Home Sales data.

Ben Jeffery:

And to go back to something you just touched on, Ian, in terms of what the Fed's actions might mean for financial conditions or what the performance of the real estate market might mean for financial conditions, there was something especially relevant on Tuesday within Waller's comments as it related to the overall level of tightness of conditions.

He highlighted that while yes, the FCI has come down dramatically along with the rally in treasuries from 5% 10-year yields to sub 4% 10-year yields, taking a longer term view of financial conditions, they're still sufficiently restrictive to continue slowing the economy and continue fighting inflation. As we think about what might come to pass on March 20th, Waller's remarks imply that the Fed's concern about triggering a spike tighter in financial conditions by not cutting, even when the market is priced for a cut, might not be as high on the list of worries as one would otherwise assume would be the case.

Ian Lyngen:

This highlights one of the communication challenges for monetary policy makers over the course of this year, and that's drawing the distinction between cutting and easing. Generally speaking, from the Fed's perspective, rate cuts this year are simply normalizing from very restrictive to still restrictive, albeit less so.

From the market's perspective however, it becomes more difficult to separate cutting from easing, and there seems to be an operating assumption that the Fed won't cut unless there is a dire shift in the trajectory of the real economy, which we suspect is simply not the case.

Vail Hartman:

I'll also add that the symmetry implied by the roughly 50/50 odds of a cut in March is consistent with policymakers' messaging that we should not pre-commit to a cut at this stage. I'll point out that this week we heard from Atlanta Fed President Bostic who said that in such an unpredictable environment, it would be unwise to lock in an emphatic approach to monetary policy, and that is why he believes we should allow events to continue to unfold before beginning the process of normalizing policy.

Ian Lyngen:

The impact of the evolution of the global economy is also important in this context. We're watching commodity prices fluctuate since the beginning of the year. We have now seen some pretty disappointing data coming out of the UK, which suggests that the UK was probably in a mild recession at the end of 2023, and the European economy continues to struggle, all with the backdrop of slightly higher than expected core-CPI coming out of Japan.

These crosscurrents have continued to contribute to a broader sense of uncertainty as it relates to the macro landscape, and ultimately it's an open question of whether or not the Fed will be the first major central bank to cut, and frankly, if Powell is simply engaged in a fine-tuning exercise while the rest of the global economy needs to be more stimulative or if it's simply a fresh race to the bottom in rates.

Ben Jeffery:

On that topic, there's two global developments that entered the discourse this week. The first being the ongoing, and while not yet escalating, there's certainly the risk of that, attacks in Yemen against the Houthi rebels, given what's going on in the Red Sea. And while thus far there hasn't been a material reaction in energy prices given the realities of the region, a broader contagion of the conflict is going to continue to simmer as a potential inflationary shock, both from the perspective of oil prices, but also a material disruption to one of the world's major shipping lanes.

On the other side of the oil equation, on the demand side, we also got some significant negative economic information out of China as the region continues to struggle in the post-COVID recovery, despite what was at one time expected to be the great rebound from the pandemic. So, a struggling China, poor consumption, and high inflation in the UK and an ongoing conflict in the Middle East all present the cross currents that the market has to contend with.

As we approach the next pivotal several months for the US rates market, even after the yield curve has ground to the year-to-date steeps and what appears to be the early move toward what is widely expected to be this year's big trade in Treasuries, which is going to be a materially steeper and maybe even positive sloping 2s/10s curve.

Ian Lyngen:

It's certainly not wasted on us that the big macro trade of 2023 was also expected to be the bull re-steepening the curve. The fact that the market is pushing that narrative early in 2024 doesn't necessarily bode well for the big trade.

Ben Jeffery:

As a born and raised central New Yorker, all I have to say is go Bills.

Ian Lyngen:

Three or six months. Maybe cash management?

In the week ahead, the Treasury Market is faced with a few macro developments of relevance, the most notable of which being the first look at fourth quarter real GDP. The consensus is for effectively 2% growth as 2023 came to an end, and we'll be watching along with the market very closely the core-PCE numbers.

Recall that the combination of December's core-CPI and Core-PPI suggests that we'll be looking at a high +0.1% for a core-PCE in December, which in practical terms translates through to the six month annualized rate remaining close to the +1.8% number. Now, in the event that the three month quarterly annualized figures available in the GDP report show a dip below 2%, that will certainly rekindle expectations for a March rate cut.

Ultimately, however, the Fed messaging around the potential for a March cut still suggests to us at least that the bar is high for a rate cut at this point. Let us not forget, the market also has a series of Treasury auctions to take down. We see $60 billion two-years on Tuesday, followed by $61 billion fives, and then capped with $41 billion seven-years on Thursday.

Underwriting supply during the latter half of January can be challenging, particularly in an environment where bearish seasonals combine with what is expected to be a pretty meaningful increase in auction sizes at the February refunding suggests that twos, fives, and sevens might need a more significant concession either outright or on the curve. Certainly, the supply takedown warrants attention, although at the end of the day, we're skeptical that we'll ultimately define the overall direction of rates. For that, the market will rely on the macro influences and monetary policy.

The market is now in the Fed's pre-meeting period of radio silence, so there won't be any official commentary in the week ahead. That leaves investors with little beyond the smattering of data and the influence of external markets. We've been watching very closely the interplay between equities and bonds in this environment, and it seems as though rates are in the driver's seat for the time being.

It is earning season, however, so any sharp change in the trajectory of US equities will potentially have ramifications for rates. All else being equal, in the near term we're anticipating a period of consolidation in treasuries with, if anything, a modest flattening bias.

The fact that 2s/10s has pushed up back toward the steeps of the range speaks to a market that is seeking to embrace some of the bearish aspects that tend to define the start to the year, while at the same time, keeping an eye on the fact that while the first rate cut might not be in March, ultimately 2024 will be defined by a Fed seeking to normalize policy rates off of the current extremes.

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. For all of those we missed in Davos this week, fear not. We've already reached out to the postal service to make sure that next year our invitation doesn't get lost again.

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:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocmm.com/macrohorizons/legal.

 

Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy
Vail Hartman Analyst, U.S. Rates Strategy

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