Measuring March - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 217, Measuring March. 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 April 10th. As attention shifts to the pace of consumer inflation in March, the impact of housing remains front and center for core CPI, leaving us to ponder that if there's no place like home, perhaps such scarcity makes it so costly. Just a thought.

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.

The week just past was a relatively definitive one for the Treasury market. We spent the bulk of the week pricing in the potential downside risk for non-farm payrolls. Now ultimately, what was seen was a remarkably as expected update from the BLS, specifically headlined, "Non-farm Payrolls Increased 236,000 compared to the Consensus of 230,000." February's number was revised slightly higher to 326k from 311k and the net two-month revisions were down 17,000. What is perhaps notable about the report was that the headline payrolls numbers were accompanied by a decline in the unemployment rate to 3.5% from 3.6%. This represents a partial reversal of the two-tenths of a percent increase off the cycle lows that we saw in February and gives the Fed more than sufficient runway to deliver a rate hike in May in the event that the inflation data dictates. Other details from the report include an increase in the participation rate to 62.6%, representing the highest level since March 2020, i.e. the bulk and the reduction of the overall size of the labor force caused by the pandemic has been fully reversed.

That's an important milestone and reinforces the prevailing narrative that the real economy remains on strong footing. From the Fed's perspective, there was some good news contained in the report, insofar as the yearly pace of average hourly earnings slipped lower to 4.2% from 4.6%. Now, this represents the lowest print since June 2021 and is certainly consistent with Fed's broader objective of containing inflationary pressures. Let us not forget that the price action in and of itself was remarkable. In the week just passed, we saw an extension of the cyclical resteepening of the yield curve, both in 2s/10s, which remains in negative territory as well as in 5s/30s, which pushed well into positive territory and reached levels that investors either chose to book profits on a core steepener or simply fade for a tactical flattener. Now, as the market comes fully back online in the week ahead, which frankly will be Tuesday, we anticipate that there will be a moment the market retrades the payrolls report and the setup for CPI begins in earnest.

Ben Jeffery:

Wasn't it worth coming into work today?

Ian Lyngen:

You know, Ben, it certainly was. And we have SIFMA and the BLS to thank for the opportunity to come in on Good Friday to watch the non-farm payrolls release. Not only did headline NFP effectively match the consensus at 236,000 jobs, but the net revisions for the prior two months only accounted to negative 17,000. So said differently, it was a remarkably as expected payrolls report that really clears the way for the Fed to hike or not hike in May, depending on how the March inflation numbers play out.

Ben Jeffery:

And coming into the data, the error bands around headline hiring, wages, the unemployment rate were probably so wide that almost regardless of what the figures on Friday morning showed, it really was going to be a function of Wednesday's consumer price update to determine whether or not the Fed will be comfortable delivering another 25 basis point hike in May. NFP didn't take it off the table, but it also didn't cement it, and that simply means that data dependence will have to wait another several sessions for the next top tier piece of information.

Ian Lyngen:

One of the least surprising conversations to follow non-farm payrolls was whether or not we should take it at face value, given the timing of the survey occurred in the middle of March at the moment in which all of the headlines and drama coming out of the regional banking sector were beginning to impact the market. Our short answer is, of course, hiring decisions that made it through to the establishment survey numbers were in the works long before the middle of March when they actually hit the books. This means that as we think about any potential fallout from tighter credit standards resulting from the banking turmoil that will play out over the course of the second quarter, not as immediately as investors would have liked to have seen.

Ben Jeffery:

And aside from the headline numbers at 236,000 jobs added with some impressive upward revisions to last month's data, we also saw the unemployment rate decline to 3.5% versus the expectation for an unchanged 3.6%. And that would simply be encouraging by itself, but that detail is made all the more positive by the fact it was accompanied by an increase in the labor force participation rate, which is now back to match its highest level since March 2020. So not quite entirely undoing the drop in the participation rate that resulted from the pandemic, but almost there.

And while there's sure to be a degree of explaining away this strength as a result of the banking turmoil, as you touch on, Ian, nonetheless, the unemployment rate is still just one tenth of a percent off of this cycle's lows. And that means using the rough approximation that we like to lean on, which is that once the unemployment rate is three tenths or higher off the lows, that's when a surge toward a materially higher unemployment rate almost becomes inevitable. We're still in an environment where the labor market is nothing if not solid, and is certainly not giving the Fed any meaningful inspiration to begin cutting rates.

Ian Lyngen:

Even within the nominal wage figures, what we saw was a three-tenths of a percent month-over-month increase in average hourly earnings, that was as expected, and a slight increase in the pace versus February's 0.2% number. What's notable, however, is that the yearly pace declined to 4.2% from 4.6% and was also lower than the 4.3% anticipated and marked the lowest since June of 2021. So the notion that nominal wages are beginning to conform with the Fed's objective of reestablishing price stability certainly offers some solace to monetary policy makers. Now the bigger question quickly becomes does that translate into a slower trajectory of price increases in the super core measure of services ex-shelter? Now, recall that February saw an increase in this subcomponent to a pace of positive 0.427% for the month.

Now, as we contemplate March's figures, we'll be eager to see the details within the CPI series and whether or not there has been some moderation in this super core measure. Now I'll also note that it is some interesting context that, Ben, as you pointed out, the payrolls print was strong, the unemployment rate is low. We have the highest labor force participation rate since March of 2020, and still 10-year yields are trading at 3.33 in the wake of payrolls. To be fair, 10-year yields got as low as 3.25, give or take, and that was when the Treasury market was open. So as we think about how the shape of the curve and nominal yields are going to play out over the course of the next several weeks, one thing becomes evident very quickly, and that is March's employment report was neither a game changer nor contributed to any broader paradigm shift for investor expectations.

Ben Jeffery:

And talking a bit about the levels we reached over this past week, both in 10-year yields and the shape of the curve with 5s/30s steepening back out north of 25 basis points and some more dovish expectations being reflected in the Fed Fund's futures market as well, we've entered the point where the dovish sentiment resulting from the banking volatility last month is arguably reaching as far as it will run without the validation of a meaningfully softer than expected CPI report. So over the short term and more tactically speaking, that probably introduces some capacity for higher rates to play out back toward that 3.50 10s level that we've been watching.

But Ian, I think you're exactly right to flag the fact that despite the positive news we've seen, 4% 10s is still 65 basis points away. And the fact that the initial sell-off we saw earlier this year back toward that level ultimately prove to be a very attractive buying opportunity, probably means that we'll start to see stronger demand come in before we get back to 4%, if only given the fear of missing out on another rally that's driven by the next piece of evidence that will highlight the fact that the economy is slowing.

Ian Lyngen:

And let's face it, Ben, conversations about four handle 10s are so Q1. The reality is that two handle 10s just became a lot more topical and frankly from 3.25 or even 3.35, it's not difficult to conceive a path to get 10-year yields below 3% as the market continues to recalibrate forward monetary policy expectations, and as we've noted in the past, regain confidence in the Fed's ability as well as willingness to do everything necessary to contain forward inflation expectations. We've seen this play out in the TIPS market with relative clarity. OPEC+ decided to cut production by roughly 1.1 million barrels a day, and breakevens momentarily increased but eventually drifted lower, putting that 210 level back on the radar, even if not immediately achievable.

Ben Jeffery:

And on the topic of the banking volatility, the impact it might have and the risk that the contagion has not yet been completely contained, we also got an update on the Fed's balance sheet this week and specifically the evolution of the utilization of the discount window as well as the Bank Term Funding Program. What we saw was that in aggregate, the usage of the two lending facilities dropped by roughly 30 billion on a week-over-week basis, and all of that decline was a function of money not being drawn from the discount window. And instead, the BTFP saw a modest increase of $5 billion in uptake.

So what this suggests is that the stigma risk surrounding banks being willing to tap the BTFP appears to be waning and the overall necessity to take the Fed up on its position as the lender of last resort is also on the decline. And so as we discuss Wednesday's inflation update and what it means for the size of May's hike and the path of Fed Funds thereafter, the fact that the macro prudential tools that the Fed has implemented seem to be working as designed should give the FOMC cover to set monetary policy based on employment and inflation, not the risk of a broader financial crisis. At least it seems that way for now.

Ian Lyngen:

We are certainly trading in an environment where crisis averted seems to be the collective sense. This week brought an interesting client question, which was, "Will Treasury investors need to simply become accustomed to the lower degree of liquidity that is currently demonstrated in the market?" Our knee-jerk response was liquidity is not as bad as it was in November, but we continue to see some sectors in which trade sizes that might not have historically moved prices do have a discernible impact in the outright level of nominal rates.

In the context of how things have evolved over the course of the last six months, what we have seen is that moments of policy clarity have been associated with a decrease in the stresses in the system and an increase in liquidity. Whether that's from the primary dealer community or other liquidity providers, the reality is that as we get closer to terminal and there's more policy rate certainty that a wider variety of market participants are willing to come in and make prices. This isn't limited to the Fed however, and we would expect that as the ECB gets closer to terminal and there's confirmation that Q1s turmoil has delayed any plans from the Bank of Japan to abandon yield curve control in the near term, that we will see liquidity conditions continue to improve.

Ben Jeffery:

And there's also the potential for public sector support for liquidity as well. While it's still probably a bit early to begin talking about the May refunding process, remember what we saw in February in that TBAC did a deep dive into the potential for the implementation of a buyback program by the Treasury department to help improve on the run liquidity. So looking to the May refunding announcement along with the size of coupon auctions, probably the most tradable information contained within the update is going to be just how seriously the Treasury department is considering implementing buybacks, or from the Fed's perspective, if we start to hear any renewed chatter about the potential for SLR relief by once again allowing Treasuries to be exempted from banks leverage ratios.

There's a calendar component to this as well, which is that in the event Yellen does want to proceed with a buyback program, if the groundwork is laid in May for say, an implementation in August, that could potentially align with what we're expecting is going to be an agreement on the debt ceiling and the accompanying liquidity drain that will follow as the Treasury's cash balance is rebuilt. So this, combined with high rates and combined with QT is probably going to be a negative from the liquidity perspective during August when liquidity isn't the best to begin with. However, if the Treasury department does decide to step in and begin purchasing less liquid off-the-run securities, that would help support secondary market trading, even if it would also probably increasingly concentrate activity in on-the-runs versus off-the-runs.

Ian Lyngen:

Well, one thing is abundantly clear, that the course of the next several months will put the idity back in liquidity.

Ben Jeffery:

That doesn't mean anything.

Ian Lyngen:

Doesn't it?

In the week ahead, expectations for the Fed's May move will be further refined. There are several key contributors that will help in this regard. First and foremost will be March's core CPI print. As it currently stands, expectations are for a four-tenths of a percent increase in March, versus the half a percent increase that we saw in February. Headline inflation is seen increasing three-tenths of a percent, and in light of the recent fluctuations in the commodities market, investors will be content to dismiss the headline numbers as less policy relevant. We also see PPI as well as retail sales. Perhaps more essential in estimating the May move will be March’s FOMC meeting minutes. Recall that the Fed did move 25 basis points in March, despite the banking turmoil that was unfolding at the moment. The minutes are likely to show the debate between whether or not the Fed should pause or continue with the hiking campaign based on all of the uncertainty that was related to the banking sector.

At the time, we viewed the rate hike as a vote of confidence by monetary policy makers in the ability of macroprudential tools that are already in place or new ones that can be developed to contain any broader banking contagion. As it presently stands, it appears that the Fed was correct in that assessment. And while it might be a bit early to glibly conclude that we are completely out of the woods, the reality is that there has been a sharp decrease in the number of headlines associated with the banking sector. And many of the regionals thought to be vulnerable appear to have survived this period of uncertainty, at least for the time being. Moreover, within the FOMC minutes, it will be informative to see the degree to which expectations for the credit tightening associated with banking sector disruptions will ultimately flow through to the real economy and how that might influence monetary policy going forward.

As part of the conversation, it will be notable if the terminal policy rate is discussed in any detail, as we saw via the SEP, 5.25 is consistent with the current messaging from monetary policy makers. In the event that there's more flexibility around the endpoint for this cycle than the SEP seem to imply, that will be a tradable event that results from the FOMC. The week ahead also contains two key Treasury auctions. First being the 32 billion 10-year on Wednesday afternoon. The timing of the 10-year, which is an hour before the FOMC minutes will certainly complicate the process, limit the setup, and really de-emphasize the results as a bellwether for overall demand in the Treasury market. Moreover, the observation is worth making that 10-year yields made it to 3.25 in the week just passed. There's no question that there is solid demand for us Treasuries. Whether it's in the secondary market or the primary market is a moot point, given that the overall volume traded on a daily basis in US Treasuries exceeds 500 billion.

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. As tradition holds, we're looking forward to a weekend of watching golf, chasing rabbits, and hunting for eggs, not necessarily in that order.

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:

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