Landing Soon - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 207, Landing Soon, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of January 30th. As the fourth quarter's GDP report revealed solid growth during the final months of last year, the debate remains, as to the nature of the looming slowdown in the real economy. Hard, soft, medium, or emergency, a landing is coming. Don't forget your trays and seat backs.

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 treasury market was focused on supply. We had the two year, the five year, and the seven-year auctions, all of which performed remarkably well, stopping through at every offering. And as a result, we have now seen every coupon auction, including 10 year TIPs, stop through, and in some cases rather dramatically. This represents a meaningful amount of support for treasury securities in the primary market.

Now, there's an argument to be made that this is simply a reflection of reallocations as 2023 gets underway. We're certainly sympathetic to that argument. After all with the new year, we often see a revisiting of investment strategies as money is put to work. And given that the Fed is two or three rate hikes from terminal, it does follow intuitively that investors are positioning for the next major trade, which is universally seen as a bull resteepening in the curve. This happens at the end of every cycle. And we anticipate that by the end of the year, 2s/10s will be out of or nearly out of negative territory.

Our forecast, however, isn't based on a massive recession in the US economy, per se. In fact, if we look historically, two year yields are comfortable trading well below effective Fed funds as the time at terminal is perceived to be coming to an end. Now, there is an active debate as to precisely the level of terminal this cycle. The market has priced in an upper bound for the Fed funds corridor at 5%, whereas the December Fed projections suggested that the upper bound would be 5.25. We remain squarely in the 25 basis point height camp for the February 1st meeting, followed by another quarter point in March.

Now, May is a bit more of a wild card. And given the amount of economic data that we will see between the February and March meetings, we expect that the market will have greater clarity as to the likelihood that the Fed delivers that final 25 basis point move of the cycle conforming with the December SEP projections. That being said, we do get updated Fed projections in March, and as a result, we are open to a transition to terminal during the first quarter. And that then will trigger a more relevant debate for monetary policymakers.

Specifically, once the endpoint of the hiking cycle is reached, how long will monetary policy makers want to be in restrictive territory? All else being equal, as long as the unemployment rate doesn't increase materially above the 4.5-5% range, and real GDP conforms with the estimates of being effectively flat in 2023, we'll air on the side of assuming that the Fed will try to keep policy on hold into 2024. Caveat there being that the most important aspect of our bias is that during the first half of the year, there won't be sufficient evidence for the Fed to pivot or to even signal that they have an intention to reevaluate monetary policy in the second half of the year.

As a result, while two year yields have and will continue to trade comfortably below effective Fed funds, we do see a floor for two year yields that is not going to be relevant for tens and thirties. So while, as noted earlier, the macro trade of the year will be the timing of the bull resteeping in the curve, we continue to think that it's a bit too soon to scale into that trade in any material size. Now, that pertains only to the 2s/10s curve, which remains below negative 65 basis points. And we expect we'll continue to trade there until we have greater clarity as far as the end of the Fed's hiking cycle. Further out the curve, we're continuing to lean toward a 5s/30s steepener, with any dip below the zero level being a good opportunity to scale into a core steepener for fives bonds during this cycle.

Ben Jeffery:

While it wasn't a super consequential week from a macro perspective, sure, we did get the GDP numbers and durable goods, what was extremely telling this week was the conclusion of January's supply series, namely three stop throughs for twos, fives, and sevens driven, as has been the case thus far for every auction in 2023, by higher indirect bid allocations and everything that suggests about more robust demand from foreign investors for Treasuries in the primary market.

Ian Lyngen:

I also think it's notable that we did spend Thursday trying to search down the lowest allocation on record for primary dealers at not only a seven year auction but at any coupon auction. And while the seven year didn't quite make the cut, it is very relevant as the Treasury supply at this stage is going into the hands of end users. Now, that's important as we think about Tuesday and the potential for month end buying. Much of last year was spent with the market being comfortable underweight the duration benchmark, and as a result, month in, saw fewer flows than we might have otherwise expected. Fast forward to January, while it might not have been a particularly large month for the extension of the benchmark itself, i.e., it wasn't a refunding month, the fact that we expect investors to be less comfortable being short the benchmark, and in fact might look to actively outweigh treasuries, suggest that we'll have a bias toward a flatter curve and the outperformance of duration immediately ahead of the Fed's February 1st meeting.

Ben Jeffery:

And it's extrapolating this logic onto the departure point for yields that is especially informative in terms of framing the outlook for potential yield levels coming out of not only February's meeting, but also in the run up to the March meeting and the updated SEP, namely that 3.50 10 year yields has been traded through several times in both directions over the past week, but nonetheless is exerting a degree of magnetism, and any significant deviation from that level is triggering a reversal in terms of the price action. So, a sell-off being viewed as a buying opportunity while any outsized rally is seen as a chance to sell or get short. Given that we're coming up to the first Fed meeting of the year where a 25 basis point is effectively a done deal, we're going to be transitioning to the point when the two additional NFP and CPI reads that we're going to get between the February and March meetings are going to be instrumental in determining how the real economy performed in the early months of the new year.

Yes, we saw a solid read in terms of the aggregate GDP figures to conclude last year, but as the lagged impact of 2022’s tightening endeavors continue to flow through to both the inflation complex and the jobs market, we're entering an environment where NFPS relevance is on the rise, and any additional information that reinforces the decelerating CPI narrative is going to become less and less tradable. So from that perspective, and returning to that 3.50 level in tens, I would argue the magnitude of the dip we need to see to be considered viable is getting smaller and smaller as more and more economic information is revealed.

Ian Lyngen:

One of the developing dynamics that is certainly consistent with that notion, Ben, is the idea that the Fed has made significant strides in reestablishing its credibility as an inflation fighter. Had the Fed delivered the extensive rate hikes that it did in 2022, and we not seen nominal wage gains start to decelerate or the month over month CPI figures that we have, I suspect that we would be in a much higher rate environment. After all, breakevens would need to be well above the 200-225 range that they're in at the moment, because the market would lack the confidence in the Fed's ability to contain realized inflation going forward. Now, the Fed is faced with a unique set of circumstances and risks as it meets on Tuesday and Wednesday. And the decision, coupled with the official communique, will be notable on a number of different levels.

First, the Fed has seen realized inflation start to moderate, both on the headline and core side. However, forward inflation expectations, at least the survey based measures, are still at or near the highs in many cases. Now, when we think about some of the unique aspects of this particular cycle, it is notable that the Fed is very focused on household level expectations of inflation, not the market based measures. So in skewing the prospects for a hawkish hike versus a dovish hike, first, I'll note that it is still going to be a hike, even if it's 25 basis points, and each incremental hike this far into restrictive territory is more difficult to justify. So, my base case is that Powell will go out of his way to make sure that the market sees the justification for continuing to hike even beyond the February 1st move. After all, if nothing else, the Fed needs to retain the flexibility to move again in March if the economic data is consistent with another quarter point.

Ben Jeffery:

In extrapolating that conversation onto the shape of the curve and what we're still characterizing as the big trade for 2023, that is the bull steepening of the 2s/10s curve, really what this advocates for is patience. Because as the Fed fund's futures curve currently shows there are two important pieces of Fed communication that the futures market does not reflect. Firstly, a terminal rate above 5%. That's been a fairly consistent target among monetary policy makers. And secondly, no rate cuts in 2023, and a prolonged period on hold to evaluate how the real economy performs to rate so far in restrictive territory. So in contemplating what this means for the shape of the curve, it's going to be challenging to see a true material outperformance of the very front end in the event the Fed's messaging doesn't change to turn and match the market. That means that there's still limited capacity for the front end to outperform, which in turn will continue to keep the 2s/10s curve very deep in inverted territory.

It's not until we get beyond the March, and frankly, the May meeting, when there's enough time captured by the maturity window of a two year note to really start considering the size and impact of rate cuts in 2024 is going to have on front end valuations and the overall steepness of the curve. So, it's not really until that point we would argue that, one, we want to add those steeper positions very aggressively. There's also the consistent lament we've heard in conversations with clients over the past several weeks, which is that the carry profile of steeper positions means that scaling in early to steepeners is a very expensive proposition.

Ian Lyngen:

And to be fair, we are operating under the assumption that this next Fed rate hike won't be the final Fed rate hike. There is a compelling argument to be made that the Fed is willing to trade a lower terminal for effectively communicating to the market that they are in fact going to stay on hold for an extended period of time. I suspect if Powell were given the trade off between ending with one more 25 basis point rate hike and needing to cut sometime in the fourth quarter as the futures market is currently pricing, that he would take the former if it allowed for policy to remain restrictive into Q1 of 2024, if not beyond. That being said, I think the most prudent course is to assume a hawkish 25 basis point rate hike. And let us not forget that we also have the payrolls data on Friday.

The market is looking for a downshift in the pace of payrolls growth, but only a modest increase in the unemployment rate. Recall that the Fed is not only projecting a year end unemployment rate at 4.5%, but they have stated that reestablishing price stability does require a cooling of the jobs market. And given that we are at 3.5% on the unemployment rate at this point, this cooling will be pretty significant. And as we have seen historically, once the trajectory of the unemployment rate starts the increase, we tend to see a domino effect that suggests that it will be an easier task for the Fed to get the unemployment rate from three and a half to four and a half percent than it will be to stop the unemployment rate from going from four and a half to five and a half percent or beyond.

Now, it's clearly still a bit early to have any skew on whether or not the Fed has over tightened and we're in for a hard landing versus a soft landing, but as the 2023 data has started to come in, it is safe to say that our baseline assumption is that real GDP in the first quarter of 2023 will represent a material downshift from the pace of consumption that ended last year.

Ben Jeffery:

And it's not just going to be the Fed's rate hike that is delivered on Wednesday. Before the 2:00 PM policy decision, we also received the treasury department's refunding announcement and another update on issuance plans from the government for another quarter. We're not expecting any changes to coupon auction sizes, and more intriguing within the details of the statement will be any additional information on how the treasury department is thinking about the question they posed in their survey of primary dealers. What I'm talking about here is the potential for the issuance schedule in twos, threes, fives, and sevens to shift from a new issue auction every month to a quarterly refunding new issue that is then twice reopened. So, a change to make the front end supply cadence match what we already see in the long end of the curve with the February, May, August, and November refundings of tens, twenties, and thirties that are then reopened in the two subsequent months following each new issue auction.

While liquidity in the Treasury market has improved meaningfully from the worst days we saw last year, it nonetheless remains a top concern on the mind of both market participants but also the official sector as well. And remember, the initial inquiry on a potential policy change to bolster liquidity was to conduct treasury buybacks. We got that question in the November refunding. However, the feedback from the dealer community and the market as a whole was not supportive enough to give anything other than an acknowledgement that the issue of buybacks warrants further study. The fact that the following quarter, aka the current refunding period, followed that up with a question about reopening twos, threes, fives, and sevens; suggest that the treasury department is still looking for a potential change to be made in order to bolster liquidity. We're of the opinion that such a change to reopening front end auctions rather than having monthly new issues would certainly help improve on-the-run liquidity.

After all, there'd be much larger issues in the front end, and that would help alleviate some of the scarcity that's been experienced. In terms of sourcing bonds for trading that was such a consistent theme of 2022. That would be the benefit of such a decision, while the cost would likely be a further erosion and off-the-run liquidity, as bonds that were issued with maturities in months that are no longer the new issue months, assuming the changes made, would likely see a drop off in trading activity, just given that the outright size of those cusips would, in comparison to an issue that had been twice reopened, be much smaller. So, I don't think it's particularly likely that we see any policy implemented around such an idea on Wednesday morning, but it will be telling to see what the feedback the dealer dealer community gave means for Yellen's comfort with moving forward with such a change.

I would also say keep an eye on the T-back charges as well for any additional clarity on how we might see this structural change come to fruition in the later part of this year or in early 2024.

Ian Lyngen:

Well, there's no question that the Cusip debate, i.e. to reopen or not, has certainly become very topical, although not necessarily adding to any directional skew in the treasury market. The one observation that I will offer is that Yellen certainly has put the fun back in the refunding.

In the week ahead. The treasury market will continue to digest the strong fourth quarter GDP print. We will offer the caveat that the 2.9% headline did mask a decline in personal consumption to 2.1%. As a result, it was the inventory rebuild that contributed to the bulk of the upside surprise, and as we know, inventories over time that out to zero when it comes to overall GDP growth. Nonetheless, the market was content to read fourth quarter growth figures as providing ample room for the Fed to continue unabated on its rate hiking process. For the time being, the market will continue to debate a terminal at 5% or 5.25 with a nod to the incoming data.

The week ahead has several marquee events, the most relevant, of course, being Wednesday's FOMC rate decision. Our expectations are for a quarter point, and we'll argue that that's fairly consensus now. The more potentially market moving uncertainty is how investors interpret Powell's press conference, and whether or not at the end of the day the FOMC's actions are read as a hawkish quarter point hike or a dovish quarter point hike. We're biased toward the former. After all, the Fed is already into restrictive territory. There will be a downshift, but given where we are in the economic cycle, each incremental rate hike does become increasingly difficult to justify. And if the Fed has designs on keeping terminal in place throughout 2023, Powell will need to continue the messaging of higher for longer on the policy rate side. There has been chatter about the Fed delivering one final rate hike on February 1st in an effort to trade off a lower terminal rate for the implied ability to keep that rate in place longer.

Now, had that been the Fed's intention, we suspect that we would've had more concrete messaging in the run up to the Fed's moratorium on public comments, which took place at midnight on January 20th. The fact that the only guidance we received was related to the downshift in the pace of rate hikes suggests that the committee still has more than a single hike left, or at least that's their intentions for the time being. The week ahead also contains the January non-farm payroll report at which investors are expecting to see a sub 200,000 gain in headline payrolls, coupled with an increase in the unemployment rate. Now, as we saw in early January, the market is hyper-focused on the pace of nominal wage gains. In this context, it's notable that the average hourly earnings print in January is expected to increase just three tenths of a percent, very much in keeping with the trend that appeared to be developing in December. And if we see nominal wage gains continue to moderate as 2023 got underway, monetary policy makers will surely take a reasonable amount of solace from this development.

Moreover, the shift that we have seen that has led to net bond buying has come in the form of confidence, not only in the Fed's intentions of keeping forward inflation expectations contained, but their ability to do so. Recall that as 2022 played out, there was a fair amount of criticism regarding the Fed's ability to contain the type of inflation that was running through the US economy. Regardless of the realities of the impact of the cumulative tightening of financial conditions that Powell has already delivered. The simple fact that inflation appears to have peaked and is heading in the right direction has, at least incrementally, helped the Fed reestablish its credibility as an inflation fighter. As we ponder the next 11 months, we continue to see downside potential for breakevens and anticipate that nominal rates will hold a range, in 10 years, of plus or minus 60 basis points centered on 3.50. This means that a four handle and a two handle are on the agenda, with the former being an attractive selling opportunity and the latter being ideal for buying.

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 January comes to an end, we're reminded that there are only 11 more months to go, nine if you're Canadian, and just two if you're Japanese. Get it? It's a fiscal thing.

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.

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