May Day! May Day! - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 220, Mayday Mayday, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey and Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of May 1st. And as late mayor Jerry Springer was want to say, a face made for podcasts, a voice made for newspapers and a command of the English language only suitable for children's books, and talk shows.

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 ahead, there are two major events that will drive trading in the US rates market. First is Wednesday's FOMC rate decision. We are anticipating a 25 basis point rate hike that will bring the upper bound to 5.25% and the effective Fed funds rate to 5.1%. This will be accompanied by an even deeper inversion of the 2s/funds and 10s/funds curve and also serve to reiterate the fact that the effective Fed funds rate does not function as a floor for nominal treasury yields.

The biggest debate surrounding the Fed is whether or not it's a hawkish hike or a dovish hike. Assuming that the Fed anticipates the next rate hike will be the final for the cycle, it would follow intuitively that the language surrounding future expressions of hawkishness will come in the form of retaining terminal for an extended period of time. Now, it's highly unlikely that the Fed would resort to thresholds or anything so specific when offering guidance to the market as far as what it would take to get the Fed to cut rates. Nonetheless, the forward-looking language surrounding the Fed's commitment to an elevated terminal for an atypically long period of time will most likely prove to be the tradable event. We're anticipating that the combination of the FOMC statement and Powell's post-meeting press conference will net to a dovish and more cautious outlook for the intermittent period.

In that context, we will be watching the 2s/10s curve and the potential to re-steepen back above negative 50 basis points as the market transitions to the inevitable next stage, which is more actively focusing on the precise timing of the Fed's first cut of the next cycle. The other major event on the radar will be Friday's release of nonfarm payrolls. As it currently stands, the expectations for April are that payrolls increased by 163,000 jobs.

Within that, the market is also anticipating that the unemployment rate ticked higher to 3.6%, still very low by historic standards, but nonetheless off of the cycle lows, which is consistent with the Fed's objective of cooling the jobs market in an attempt to contain realized inflation and perhaps more importantly forward inflation expectations. We'll also see April's average hourly earnings figures, which are forecast to increase three tenths a percent. That's a relatively benign number and very consistent with what we saw prior to the pandemic, and as a result, the market would read a consensus report as furthering the Fed's objective to contain inflation while simultaneously not revealing enough evidence to suggest that a rate hike in the near term should actually be on the table.

Vail Hartman:

From what we anticipated would be a relatively tame week in US rates heading into the May FOMC meeting ended up being another week of volatile price action as we seemingly reentered another banking crisis that was apparently averted as the market refocused its attention to the macro fundamentals as the week came to a close.

Ian Lyngen:

That's the thing about volatility in the banking sector. It's very difficult to have a precise understanding of the composition of the balance sheets and how that will interplay with market participants expectations for the solvency of the system as a whole. Now, suffice it to say the macro prudential tools that were in place prior to mid-March combined with the fed's new bank term funding program had at least ostensibly solved the problem. Now the issue is once again in focus. That being said, as we learned via the March FOMC rate decision, turmoil in the regional banking sector will not dissuade the Fed from hiking 25 basis points when it meets on May 3rd.

Ben Jeffery:

And yes, we saw another update to the utilization of the discount window and the BTFP totaling roughly 150 billion and exactly as you highlight Ian, even though 150 billion in emergency lending from a central bank is all else equal, not a great thing. The fact that banks are comfortable utilizing the fed's tools continues to give monetary policy makers cover to separate the drivers of Fed funds and other policy tools at their disposal to ensure stability in the banking system. And coming into this week, we saw the market reprice to reflect the probability of a 25 basis point hike on Wednesday as low as 70%. What we ultimately saw transpire was an easing of some of the concerns within the regional banking sector and as Vail touches on a refocus on the economic fundamentals that point to an economy that might be cooling. GDP underwhelmed slightly, but that was mostly an inventory story with final sales to domestic purchasers actually rising. And this means that the economy is still in a good enough place to withstand another rate hike, at least for the time being.

Ian Lyngen:

It certainly isn't lost on us that when we deconstruct what happened in the regional banking sector and we see the assets that took a hit, they were mortgages and treasuries. It's not an episode in which banks were engaged in any particular risky lending practice or that they were grossly mismanaged. The reality is that the Fed and global central banks tightened so dramatically during 2022 and that the flow through to the risk free rate, i.e. higher Treasury yields and the subsequent valuation of bank's portfolios was always bound to happen. But it was the reaction of the market and depositors that really brought regulators to where we are today.

Ben Jeffery:

And as we were monitoring the headlines this week, we had a very insightful client conversation which was centered around the question, what can happen between now and the July meeting or frankly even the September meeting that would be sufficient to get the Fed to turn around and begin cutting as quickly as the market has priced.

Ian Lyngen:

Financial conditions can tighten so dramatically that the Fed would need to recalibrate the policy rate or we would need to see a outsize spike in the unemployment rate that would suggest the data at the end of 2022 and at the beginning of 2023 was artificially low. Neither of those I can foresee at the moment. However, the translation of weaker equity prices through to higher realized equity vol and the impact that that has on overall financial conditions suggests that the very narrow path to a July rate cut would entail a selloff in equities in excess of 25%.

Ben Jeffery:

And on the issue of a surging higher unemployment rate, there's also a timing aspect of how that data is revealed to consider specifically that given the departure point from a 3.4% unemployment rate that was reached earlier this year, which is the lowest and effectively half a century, assuming equity prices are not dropping precipitously, it would take more than a single month's employment data to inspire such a dramatic about face from the Fed.

So what that means is even if we make it to the end of next week and April's jobs numbers come out decidedly weak, while yes, that may ultimately add to the case for a shorter time on hold that terminal, what the Fed would need to see is consistent evidence that the labor market is rolling over. And that means not just one NFP release that's weak, but at least two, if not maybe three or more. It's a version of the same underlying logic that a single data point doesn't make a trend. And so given the fact that we've already made it to the May meeting and it would take at least a few months to see enough evidence in the labor market that would warrant a downward policy adjustment, that would get us at least to the meeting at the end of July. And frankly, the conversation is probably more realistically September.

Vail Hartman:

But isn't the Fed trying to increase unemployment rate?

Ian Lyngen:

Precisely Vail? I think that the nuance surrounding any downside in the jobs market needs to be put in the context of the fact the Fed has already told us they're expecting the unemployment rate to be at 4.6% by the end of this year.

Ben Jeffery:

And a recession.

Ian Lyngen:

A mild one. So even in the event that the next several months’ worth of jobs data brings the unemployment rate from 3.5% up to even four, 4.2, 4.3, that's consistent with the Fed's messaging surrounding the notion that there will be some pain in the real economy as the Fed endeavors to reestablish price stability. In another interesting conversation that we had this week with clients, the question was raised, what happens on the political side if we find ourselves in Q4 and the jobs market has actually deteriorated enough that Washington begins to look to Powell to take some type of action. Now, prior to Powell's renomination, I would've simply said, we have a completely independent central bank and the election cycle is a moot point. That being said, given the clear coordination between Powell and the administration in the combined efforts to contain inflation, one would be remiss to conclude that political pressure on the Fed to cut rates as early as the end of this year won't become a major factor.

Ben Jeffery:

And on the topic of Washington and politics, we also got some important updates around the debt ceiling this week. First being that the house passed a resolution that would raise the debt ceiling by $1.5 trillion and get us to the end of the first quarter of next year without running the risk of a technical default. Now, passing the house is one thing, passing the Senate is another, and then getting President Biden to sign such an agreement is a third thing. We know that this agreement is going to fail in the Senate and President Biden has already said he won't sign it.

So in terms of actually giving some relief around debt ceiling concerns, speaker McCarthy's bill is more just a negotiating tactic than anything. Additionally, there was some more information on tax receipts now that enough time has passed since tax day and there's a building sense of optimism that the Treasury department will be able to make it to early July before there's a risk of a technical default. There's a calendar aspect to this that's worth discussing as well, which is that June 15th is going to be a pivotal day. On the one hand, the Treasury department's going to need to make coupon payments, but on the other they'll also be getting an influx of quarterly corporate tax receipts, and that's going to mean that if they can make it through June 15th, that will give them at least another few weeks of runway that Congress will presumably spend on Capitol Hill debating the issue and running it down to the 11th hour before ultimately reaching an agreement.

Vail Hartman:

But we do think they're eventually going to get a deal. Right?

Ian Lyngen:

I would hope so. More importantly, when putting this in the context of potential price action in the Treasury market, I think it's relevant to observe that almost regardless of how this process plays out, it's going to be positive for Treasuries with the exception of the potentially impacted bills. And the underlying logic there is that increased uncertainty in lawmakers willingness to pay is a decidedly different issue than the ability for the US government to pay back bonds borrowed in local currency i.e. Dollars. This also all comes at a moment when overall economic uncertainty is heightened, so if nothing else, the drama that's bound to unfold in Washington will contribute to the underlying bid for us Treasuries.

Ben Jeffery:

We also did get some uncertainty removed on the macro front and this time in Tokyo, it was Governor Ueda's first Bank of Japan meeting where the ultimate decision was to leave policy rates in negative territory and yield curve control bans unchanged for at least another couple months.

Ian Lyngen:

Any meeting that results in a decision to have another meeting is a good meeting, right?

Ben Jeffery:

I think so in Japan.

Ian Lyngen:

Certainly for the FOMC.

Ben Jeffery:

But the BOJ did remove forward guidance in that they expected rates were going to remain at or below current levels, and this implies that I would say as the market already expected at some point in the not too distant future, we will see greater policy normalization in Japan. That will probably take the form of a further widening or removal altogether of the yield curve control bands and even the potential for an actual rate hike. There's also going to be a broader framework review of the BOJ's operating policies, and what this really means is that while the BOJ will probably still be the most dovish developed market central bank, it will probably be less so at some point in the not too distant future.

Vail Hartman:

On Wednesday, we also get the refunding announcement in addition to the Fed, what do you guys think we'll see?

Ben Jeffery:

Well, the topic of issuance has definitely declined in relevance given everything that's happened over the past two months or so, and we're not looking for any changes in coupon auction sizes this quarter. It's likely that in August or November we will need to see coup sizes begin rising again, but for the next three months, we should see a consistent gross issuance profile in the long end of the curve. This really has to do with the fact that the Treasury department doesn't have a ton of flexibility at the moment in terms of adjusting issuance given the debt ceiling and more in focus on Wednesday morning is going to be any greater information we get on the topic of a buyback program considering that TBAC has continued to dive into the topic and several refunding questionnaires that have sought feedback on how such a program would be structured.

This also contributes to the idea that eventually later this year, coupon auction sizes are going to need to begin growing not only to fund the deficit and run the government, but also to raise enough money by increasing on the run issuance to purchase less liquid off the run bonds.

Ian Lyngen:

In terms of judging the likelihood that the Treasury department ultimately does roll out a bond buyback program, the simple fact that the Treasury department has asked on several occasions what the market thinks of this idea and the feedback has been generally negative, yet still the Treasury department continues to ask a version of the same question, is a clear signal that some type of buyback program will be in the offering this year?

So Vail, you going to be in for the next few days?

Vail Hartman:

No.

Ian Lyngen:

Great work, Yellen.

In the week just passed, the Treasury market saw an increase in realized volatility owing primarily to the resurgence of the regional banking turmoil. Now, there was very little on offer to suggest that the contagion has moved far beyond the initial lenders that were brought into the saga in March. Nonetheless, a reemphasis on the risk was credited for the bond bullish price action. Within this price action, we did see a solid bid for the two year sector, which served to resteepen the yield curve. Although 2s/10s remained in negative territory, that price action was temporary, primarily because as the FOMC readies to deliver the final rate hike for the cycle at 25 basis points on Wednesday, investors were unwilling to fade the potential bearishness for the front end of the curve. This certainly follows intuitively in the short term. However, we continue to expect that this year's major macro trade will be the cyclical resteepening of the yield curve.

To some extent, that has already commenced as evidenced by the positive spread between five- and thirty-year Treasury yields. We anticipate that the 5s/bonds curve will continue to increase from here, and we're targeting a return to 50 basis points or higher from current levels. Also embedded within the bond bullish price action in the Treasury market is uncertainty as it pertains to the amount of tightening that the banking turmoil is doing for the Fed. Investors are currently operating under the assumption that there will be a meaningful round of tighter lending standards based on the developments in Q1. The bigger question is whether or not that's worth 25 basis points worth of rate hikes, 50 basis points or even 75 basis points. Given that the narrative in February surrounding terminal left open the potential for 5.75 or even 6%, we are using the back of the envelope estimate as the Fed believes it's worth roughly 50 basis points of tightening.

That being said, that's nearly an impossible number to estimate, and as a result, it's not unreasonable to assume we could find ourselves in the middle of the summer and the associated credit tightening didn't impact the real economy or lending standards as much as expected. And the potential for another quarter point rate hike would be back on the table, assuming of course that inflation proves sticky in the interim period. On the flip side, if in fact 50 basis points is underestimating the potential impact on the real economy from the looming credit tightening, then the case can be made that the Fed should cut rates by the end of this year to more appropriately calibrate policy rates to the Fed's initially intended terminal rate.

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 extension season behind us and like Old Man Hartman says, "Better to extend and be thought crook than defile and remove all doubt."

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 5:

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