Jobs Juggernaut - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 208: Jobs Juggernaut, 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 6th. And as January's employment data showed payroll's growth in excess of half a million jobs and the lowest unemployment rate since 1969, we expect January will be spent on the case of the missing doves. Perhaps it was the sage of sages that scared them off. We can still see his shadow.

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 passed, the FOMC increased the Fed funds rate by 25 basis points, which was largely in line with expectations and perhaps as should have been expected, the market still managed to read this as a dovish pivot. Now to be fair, we continue to have a fair amount of sympathy to the argument that there's symmetry in going from 75 to 50 to 25 and then to zero in terms of the pace of rate hikes.

That being said, Powell and company have made it abundantly clear that the move to 25 was simply recalibrating the cadence to quarter point hikes, which is much more consistent with the way in which monetary policy adjustments have been made in the past. So going forward, we continue to expect that March will see yet another 25 basis point rate hike followed by better than even odds that there was another move in May. The most important caveat here is that there's a lot of data between now and the March meeting, and so in the event that core inflation moderates more quickly or there's a disappointing employment print on the horizon for the month of February, then we expect that Powell will leave the May rate hike potential well in place, which would bring effective Fed funds to the stated target of 5.08. Now, recall that in the next FOMC meeting, we'll get an update of the SEP or the Fed's projections and within that, the market will appropriately be focused on any revision to the Fed's projected terminal policy rate for this cycle.

The Treasury market did manage to stage a pretty impressive rally midweek that brought 10-year yields as low as 3.33. Now clearly this was an impressive move by any measure. However, it didn't get the US benchmark yield as low as the 3.32 level that we saw on the 19th of January. That being said, the 3.32 and 3.33 levels do represent, at least for the time being, a double bottom, which suggests there should be upward pressure on yields from here. Now the January payrolls report clearly triggered a significant selloff that brought 10-year yields back comfortably above 3.50. All else being equal, the combination of strong payrolls with the upcoming auctions leaves us biased for higher rates in the near term. Now it is notable that the 2s10s curve remains well within the negative 70 to negative 80 basis point range that we've been targeting, and as one of our core themes for this year is to not prematurely scale into the cyclical bull steepening of the 2s10s curve, we take a fair amount of solace from the price action that we've seen over the course of the last week.

It's also worth making the observation that the strength of the January BLS employment data was such that it all but ensures that we're going to get that March quarter point rate hike. Said differently, it's very challenging to envision an employment report for the month of February released in early March that is so bad as to take the possibility of another quarter point off the table. Even a significant moderation in the headline employment growth numbers wouldn't sufficiently offset the lowest unemployment rate since 1969 combined with the increase in the labor force participation numbers, all of which suggests that the economy remains on very strong footing even as the Fed focuses on the potential impact from the cumulative tightening already accomplished.

Ben Jeffery:

Well, it was the type of week where it's difficult to find a place to start, Ian. We got a refunding announcement, a Fed rate hike, rate hikes from the Bank of England and the ECB and of course, Friday's significantly stronger than expected payrolls report that showed half a million jobs added in the month of January. As we head into the weekend, we see 10-year yields back toward that 3.50 level and frankly, the consistent question we heard in the wake of payrolls was why aren't yields even higher?

Ian Lyngen:

To be fair, one of the other questions that we received in the wake of payrolls is why can't anyone get the forecast right? And I think that that actually, in part, contributes to the reason that the selloff has been relatively contained. There is an implied lack of credibility in the number itself. That being said, the Fed is certainly going to look at the stronger than expected employment report and say, "Aha." Whether it had to do with a series of revisions or it had to do with a rebasing of expectations going forward, the fact the matter is that the jobs market remains hot enough as to warrant a tighter monetary policy stance and more importantly for Powell, a restrictive stance for an extended period of time. As we've been on about the fact it's too early to begin the cyclical bull steepening of the curve, this employment report really solidifies that bias on our part and to a large extent, it also helps the Fed immensely insofar as the equity market has sold off that will tighten financial conditions, thereby helping the Fed further its goal of cooling the inflation outlook going forward.

Ben Jeffery:

And within the details of the data, there are two things worth flagging. First is that we saw a decline in the unemployment rate to its lowest level since 1969 and more relevantly, that was accompanied by an increase in the participation rate. So the drop in the unemployment rate was not a result of individuals leaving the labor force when, in fact, we saw the opposite, which adds to the overall strength of the print. Sure, there were some revisions to consider, as well as some chatter around the impact of seasonal adjustments. But no matter how one looks at this read, really what it does is not only cement the likelihood of a 25 basis point hike in March, not that there was ever really the risk that the Fed wasn't going to give us another hike then, but it also increases the odds that we will get that final 25 basis point move in the Fed funds target band at the May meeting to reach a terminal rate with an upper bound of 5.25, which aligns with the forecast that we saw in the December dot plot.

And given the fact that the Fed funds futures market still has a sub 5% terminal rate priced in, that means exactly as you touched on, Ian, that it's still probably too soon to begin scaling into those 2s10s steepeners, even if the tone that Powell struck at his press conference was certainly traded as the early signs of the long awaited pivot from the chair.

Ian Lyngen:

To be fair, the market has been eager to trade a pivot all year. Now granted, we're only a month into the year, but it is safe to say that investors will continue to look to any indication that the Fed is changing its stance on the terminal rate and their commitment to keep it in place for an extended period. Just quickly returning to the data itself, Ben, even within the average hourly earnings series, we saw a 0.3% monthly gain, that was as expected. However, with upward revisions to December, we saw the year-over-year pace at 4.4%. That was slightly above the 4.3% consensus and really challenged the notion that there's been a material moderation in the pace of wage gains. That being said, we remain in the peak inflation camp even if it's becoming difficult to envision a quick path towards the Fed's 2% inflation target.

And let us not forget that stronger than expected ISM services print that further contributed to the bond bearishness that we saw to in the week. The headline printed at 55.2 compared to December's number of 49.6. The actual data even outperformed expectations, which were for a more modest gain to 55.5. Yes, it's key to be above the 50 level because that's consistent with an expansion rather than a contraction. However, the magnitude of the upside surprise did serve to reinforce the ongoing rethink of the recessionary narrative. Now we continue to fret about the potential for a hard landing in 2023, but one thing is clear after this week if and when such a slowdown ultimately occurs, it won't be until we're far further into the year and as a result, upward pressure on rates across the curve with an emphasis in the two and three year sector remain our default position.

Ben Jeffery:

And just to bring some of the conversation to the price action we've seen around the past week's new information, the repricing in 10-year yields was encouraging for our take that at least the first half of this year, if not more, is going to be defined by a range trade in duration as the economic fundamentals are revealed and the Fed slowly moves toward its terminal rate. So coming out of the FOMC and probably sparked by Powell's comment that it is gratifying to see disinflation, we saw 10-year yields drop fairly quickly to challenge the 200-day moving average at 3.33%, which also aligns with that low yield print we got in the middle part of January. Extrapolating that range trading idea to the post payrolls and ISM services price action, we saw 10-year yields climb back up to and then ultimately through 3.50 to cheapen to within striking distance of the support level we've been watching at 3.60.

So in terms of trading opportunities, as we get ready for the CPI release on February 14th, taking advantage of these outsized moves and approaches to the range extremes remains prudent, especially during the upcoming week when the economic data is going to be relatively sparse. Yes, we have Fedspeak, as well as Treasury supply, but there's nothing in terms of updates on real economic performance that holds the needed weight to materially reshape the outlook on what seems to be a very strong start for the domestic economy to begin 2023.

Ian Lyngen:

I will add a bit of nuance to that observation, Ben. I do think that you're correct. The week ahead doesn't carry with it any of the needed fundamentals that would challenge the idea that the year is off to a good start. However, the Fed's reaction function to realized data continues to evolve and more importantly, the market's understanding of how the Fed is going to react in a given scenario continues to be refined the closer we get to the terminal policy rate. Said differently, the market has been anticipating a pivot on the part of monetary policymakers and the Fedspeak contained in the week ahead will, in all likelihood, push back relatively convincingly against that narrative all else being equal. So while we do expect that the net price action will be contained within the prevailing range, and we will look to trade some of the recent extremes as fades, at the end of the day, Powell's objective at this stage is to convince the market that the Fed should be taken seriously when they say that they're going to keep policy in restrictive territory throughout this year and into next.

Ben Jeffery:

And that gets at one of the few words we saw changed within the formal language of the FOMC statement, which was the shift of the discussion on the committee from the appropriate pace of rate hikes to the appropriate extent of rate hikes. And that resonates with exactly what you just said, Ian, that as we reach the end of the tightening cycle, it's no longer going to be a question of 75, 50, or 25 basis point hikes, but how many additional quarter point moves we're going to receive and more importantly, how long the Fed will stay at terminal. Looking ahead to the release of the minutes of this latest meeting, it's going to be extremely telling to see how much of the FOMC's discussion was centered around exactly where it needs to be that terminal emerges. Is it a 5% upper bound? Is it a 5.25 upper bound, or is there even the risk that will need to go slightly higher with an additional 25 basis point move?

The fact that the FOMC went as far as to make that formal change from pace to extent means that at this point, 25 basis point hike should be the operating assumption. And so while yes, it's still too soon to think about getting into those 2s10s steepener trades, as the official rhetoric begins to shift and that transition to on hold takes hold, it will be telling to see just how aggressively the market will be in trying to push that 2s10s curve steeper, of course predicated on the realized data and specifically an ongoing moderation in core inflation.

Ian Lyngen:

Let us not forget that the feedback loop between the equity market and overall financial conditions is going to be in focus as the quarter plays out. Now while our retirement plans might not be benefiting from the price action in risk assets over the last week, the Fed can certainly take a large degree of solace from the response in the equity market to the remarkably strong employment data. Stocks have shifted back into the good news is bad mode. Insofar as the stronger the economic data comes in, the more justification the Fed has to remain restrictive for an atypically long period of time. Now as we think about other potential impacts on the market from the week ahead, the obvious touchstone will be the underwriting of the refunding auctions. Given the performance of the auctions in January, all else being equal, one would anticipate a reasonably seamless underwriting process. That being said, the jobs data certainly complicates the outlook for tens and thirties in particular.

Ben Jeffery:

And aside from the headline result in terms of a stop through or a tail, we'll also be looking at the underlying bidding statistics, specifically that indirect bidder allocation that has started this year on very, very strong footing, record highs in some cases, and what that implies about the increase in foreign demand that we've been discussing during the year so far. Especially given what we tend to see at new issue auctions for tens and thirties versus reopenings, the historical trend is that foreign buyers tend to take a greater share of refundings versus reopenings, and that adds to our expectation that we'll see a solid underwriting process for this week's auctions. Not to mention the fact that an extension of Friday's bearishness into the auctions themselves would incorporate a very solid concession from the post Fed yield lows at 3.35%. A 25 bps discount over the course of just a few sessions is not such a bad buying opportunity at the liquidity point provided by the Treasury department.

Ian Lyngen:

And as with every Treasury refunding, for those who might miss it at the auction, don't worry, they'll make more. Well, until we hit the debt ceiling.

In the week ahead, the Treasury market will have remarkably little economic data from which to derive a trading direction of any relevance. We do have $40 billion in three year notes being auctioned, as well as the rest of the refunding, which includes 35 billion 10 years and 21 billion thirties. Now given the price action that we've seen so far in 2023 combined with the strength of January's auctions, all else being equal, we would anticipate a strong sponsorship from the overseas investor base for the new issue Treasuries. Now recall, these will be the first new CUSIP tens and new CUSIP thirties of the year, and given the evolution of the macro narrative, at least until Friday's employment report, a smooth take-down of new supply was our operating assumption. That being said, the BLS data showed a remarkably strong start to the year in terms of the jobs landscape.

This will keep the employment outlook front and center, and if anything, it contributes to the Fed's case to continue hiking rates at a quarter point cadence until we get through the May meeting. That would bring the effective Fed funds rate to the 5.08 target that they stated in December. And then the transition to keeping policy on hold for an extended period of time truly becomes the centerpiece for Powell's monetary policy stance in 2023. It's with this backdrop where we continue to favor fading any attempt to resteepen the 2s10s yield curve. Note that 2s10s have returned to their preferred habitat of negative 70 to negative 80 basis points. That said, our favored expression of the steepener at this stage in the cycle has been, and it continues to be the 5s30s curve. The 5s30s benchmark curve moved out as steep as 9.6 basis points on Thursday only to reverse then in the week at effectively zero based on the price action that followed the incredibly strong January employment report.

Let us not forget that we also hear from Powell on Tuesday, who's being interviewed by the Economics Club of Washington. Now prior to Friday's employment figures, Powell might have had a bigger task of talking the market out of pricing in the amount of dovishness that we have seen. That said, the repricing that occurred on Friday, owing to the jobs data, has done a fair amount of heavy lifting for Powell and the need to re-craft the messaging that the market took out of the Fed's meeting has lessened at least on the margin. All of that being said, we continue to expect that the theme that will emerge from the Fedspeak in the week ahead will be a reiteration of the Fed's hawkishness, combined with an emphasis on the strong labor market as a reason to continue hiking rates and more importantly, retain a higher terminal rate this cycle for a longer period than the market is currently anticipating. This should translate through to upward pressure on Treasury yields, and we would continue to fade any attempt to resteepen the curve.

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. With Groundhog Day leaving us hopeful for an early spring, we'll approach this week's upcoming Treasury auctions with the goal of putting the fun back in refunding.

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 Podcast 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:

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 bmocm.com/macrohorizons/legal.