Midsummer's Hike - The Week Ahead

Ian Lyngen:

This is Macro Horizons Episode 232, Midsummer's Hike presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of July 24th. And as the FOMC prepares to vote on another rate hike, we'd like to take this opportunity to remind anyone who has yet to vote in this year's Institutional Investor survey that a vote for Macro Horizons is a vote for putting the fun back in refundings.

Each week we offer an updated view on the US rates market and a bad joke or two, but more importantly, this 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 got a fair amount of new fundamental information, not enough to necessarily change the prevailing macro narrative. However, it was enough to reinforce the assumption that the US economy remains on strong enough footing as to withstand sustainably higher monetary policy rates for an extended period.

Specifically the control group within the retail sales print was higher than anticipated, and while headline retail sales disappointed as a factor in estimating Q2 real GDP, the takeaway from June spending figures was a positive one. In addition, we saw a definitive shift in the direction of the yield curve, which had been dutifully steepening off the lows. The return of a flattening bias is very notable and we expect that it is a function, at least in part of the proximity to the upcoming FOMC rate hike, where the market expects a 25 basis point increase will bring the upper bound of the policy corridor to 5.50%. The most relevant market debate at the moment is whether or not the Fed delivers a hawkish hike or a dovish hike. We think that the prospects for a hawkish hike were diminished by the June CPI numbers as well as the relatively benign payrolls figures for the month of June.

That being said, solid retail sales and an unanticipated drop in initial jobless claims for non-farm payrolls survey week we'll add has contributed to expectations for Powell to be more balanced at the press conference. And while we did see a notably lower than expected UK CPI print, there's no direct implications for the Fed, although it did contribute to investors’ sense that the next surprise potential on the inflation side is actually going to be the downside, not the upside.

For the time being however, emphasis will be on the FOMC and once the midsummer hike is delivered, we anticipate that volumes will fall off precipitously along with conviction as the period of the classic summer doldrums takes hold. This isn't to suggest that the Fed won't endeavor to ensure that the market doesn't price in rate cuts between now and the end of the year. And in doing so, we expect Powell to emphasize flexibility and a monetary policy stance that is more data dependent than it was in 2022. This isn't necessarily a departure from the Fed's recent signaling, but it is the next logical step as the Fed moves ever closer to the cycle's terminal rate.

Vail Hartman:

It wasn't a week that offered any paradigm shifting macro updates, but we did receive some new information that reminded us the Fed still has ample flexibility in making its policy decisions. We saw the retail sales control group come in twice the consensus estimate and initial jobless claims dropped to a nine-week low on Thursday. These data points contributed to the flattening pressure on the curve that ultimately triumphed over the catalysts for the steepening we've seen as a result of softer US and UK CPI prints. And 2s/10s is now decidedly back below -100 basis points.

Ian Lyngen:

The incoming data also helped investors further refine expectations for Q2 real GDP, which is now tracking at roughly 2%. That certainly pushes back against the near term recession narrative that has dominated the financial media at least for the course of the last several months. With the Fed now benefiting from an even longer runway to make sure that price stability is reestablished in the US economy, Wednesday's FOMC meeting will be closely watched for any indication that the Fed is still seriously considering a rate hike in September or November. Presumably if the data doesn't justify a November move, they wouldn't move in December.

Ben Jeffery:

And with each passing week and each passing month the economy continues to demonstrate resilience, whether that be in terms of the labor market, Vail, as you touched on, initial jobless claims dropped to a nine-week low during July's NFP survey week. Obviously consumer spending remains in a fairly good place and while inflation has moderated in outright terms, it is still much too high versus the 2% inflation target.

And so looking forward, the Fed's ideal framework will be keeping rates where they are and hiking if necessary. And by framing the distribution of risk around the next rate decision, whether that's September, November, December higher rather than lower, that will continue to push out the timing of this cycle's first rate cut, even if the magnitude of that rate cut may ultimately need to be larger than simply a polite fine-tuning 25 basis point endeavor. Now, in discussing this, it is worth acknowledging what we've seen in financial conditions that are back to basically their easiest level in a year, which is a derivative of a stock market that seems to only go one way, up.

Ian Lyngen:

When looking at the fed funds futures curve, what we see is that the first fully priced rate cut of the cycle is June of next year with roughly even odds that we see a cut in May. As we think about how Fed funds futures will evolve over the balance of this year, we're anticipating that continued evidence of the resilience of both the labor market as well as a trajectory of consumption will translate into investors pushing rate cuts further into 2024.

On the flip side, however, any confirmation of weakness on the inflation side as well as any potential cracks in the employment market will translate through first to increased odds of a May rate cut and eventually translate through to the steepening of the yield curve, 2s/10s in particular that investors have been anticipating throughout the bulk of 2023.

Ben Jeffery:

But that is certainly no guarantee that it's going to be a straight line of disinflation from here. Yes, over the next several months, the market's general attitude is that we're going to continue to see 0.2, maybe 0.3 reads in terms of core inflation month over month. But from there the outlook becomes a bit more hazy.

And the risk to the steepening thesis is that some of the progress made in terms of bringing inflation lower is at least partially given back. To put it a different way, a choppy trend of disinflation back toward 2% is going to result in probably fairly significant steepening episodes but also aggressive flattening ones. And so while we are very much on board with the longer term cyclical steepening trend, from a more tactical and trading perspective, given the level of volatility and what's been undoubtedly impressive intraday swings in the shape of the curve and outright yields, the consistent bias we've heard from clients of all types is that keeping positioning light and being a bit more tactical in the current environment seems to be the preferred operating framework.

Ian Lyngen:

And that's very consistent with the general notion that investors have remained largely sidelined and will continue to be so until there's greater clarity on the monetary policy front. Recall that on numerous occasions in 2022, the terminal estimate for the Fed was revised higher and higher and higher, and as a result, investors became increasingly cautious and reluctant to buy the proverbial dip.

We're now clearly at, or very near, the end of the fed's hiking cycle, however, investors have a recency bias insofar as lacking confidence that the Fed is in fact nearing the endpoint. Said differently, there remains investor angst that in the event that we don't see a material downtick in inflation in the fourth quarter of this year that the Fed renews its rate hiking ambitions.

From our perspective, however, we continue to see the most realistic expression of Fed hawkishness extending the perceived period that the Fed will remain at terminal and pushing rate cuts well into 2024.

Ben Jeffery:

We received a good question this week around the efficacy of higher rates from already such high levels and that given from a departure point of 5.25%, what's another 50 basis points of higher policy rates really going to do? Does that give any weight to the argument that there's a risk the Fed decides to say, increase the pace of QT?

Ian Lyngen:

I think that there is a case to be made that the Fed should allow the balance sheet to run off more quickly than it currently has, and the case is relatively straightforward. Given the composition of the Fed's mortgage holdings that aspect of the balance sheet rundown hasn't been as swift as monetary policymakers would've liked to see. The issue quickly becomes however that the amount of coupon and bill maturities in any given month, that composition implies that if the Fed were to increase the monthly runoff of SOMA, that the bulk of the difference would be made up in bills. And while the impact on the very front end of the market might not be that obvious per se, one can assume it would only serve to exaggerate the depths of the curve inversion that has already plagued the bulk of this cycle.

Ben Jeffery:

And there's a liquidity aspect to it as well. Given that the consistent concern when the Fed first began QT was that an already troubling trading environment in terms of liquidity in the longer end of the curve would only become more pronounced,

Vail Hartman:

And the Treasury department mentioned explicitly that in the refunding questionnaire.

Ben Jeffery:

Exactly right. Vail. As we know, the Treasury department is going to begin its buyback program in 2024 and the August refunding questionnaire of primary dealers really drilled down into the details of what such a program would look like. And most importantly, on the liquidity front, what specific issues would not be eligible to be submitted to the Treasury for a buyback. Cheapest to deliver bonds, near off the run bonds, issues that are trading special in repo all seem to be the bonds that the Treasury department is aware or already not all that liquid or play an important role in terms of the futures market.

And so our takeaway from the line of questioning was that the Treasury department is going to want to be very specific and very measured in the impact they're going to be having by conducting buybacks. But all of this being said, in terms of the initial sizing of the program in 2024, at between five and 10 billion a month spread out across the entire curve, it's not a dollar amount that's going to have any significant influence on the outright level of 10 year yields, for example. The most apparent impact will probably be in relative value space and frankly even there at just a billion dollars per maturity bucket, it will probably in the beginning at least be a background factor at best.

Vail Hartman:

So if the Treasury department wants to improve liquidity, why would they exclude the bonds that are deemed the most illiquid?

Ian Lyngen:

Vail, that's a good question, and that's actually some of the feedback that the street has given the Treasury department. And one of the reasons that I think that they're excluding the less liquid bonds is this notion that if they took more of the float out of the market, the street would be less willing to provide liquidity in those particular CUSIPs. Moreover, when the Treasury department buys these bonds, it's not equivalent to the Fed's QE where they go on the fed's balance sheet and then are available via the SEC lending program. When the Treasury buybacks an issue, it's completely retired.

Ben Jeffery:

And so that means, along with some of the other criteria we've already talked about, there's also probably going to be stipulations around the issues that will be eligible to be bought back as it relates to the amount of any given QSIP that is privately held. AKA if SOMA holds a meaningful percentage of an off the run Treasury that doesn't really trade that much to begin with, purchasing and retiring that bond via a buyback is probably not going to help the liquidity situation. If anything, it would make it worse. And that's why we anticipate, especially in the early days, that the Treasury department is going to want to be very measured and very specific about the bonds that they're willing to buy back.

Ian Lyngen:

And there's also an underlying issue as you point out, Ben, that the market has questioned the effectiveness of this program frankly from its conception. And it will be fascinating to see how the market ultimately responds when it's rolled out in the new year. That being said, we're certainly sympathetic to the optics around the Treasury secretary wanting to show support for the most liquid fixed income market in the world to make sure that the Treasury market continues to have access to low cost borrowing up to 30 years.

Ben Jeffery:

Ian, 30 years assumes a lot. It's a long time.

Ian Lyngen:

For context, 30 years from now, we'll be on episode 1,762 for Macro Horizons, assuming we take one week off a year.

Vail Hartman:

Talk about condolences for making it this far.

Ian Lyngen:

In the week ahead the highlight will unquestionably be the FOMC rate decision on Wednesday afternoon. The consensus holds that we'll see a 25 basis point rate hike, and we're very much on board with that. All else being equal however, we expect that this will be the last 25 basis point rate hike of this cycle. After all, June's CPI data and expectations for July and August to be benign as well will make it difficult for the Fed to justify moving in September.

And so that means that the last truly live meeting of 2023 will be November, and that provides a lot of time for the economic outlook to dim significantly. Recall that traditional thinking holds that there is a six to nine month lag between monetary policy action and when it becomes evident in the real economy, and therefore the data, and the Fed didn't actually shift into truly restrictive territory until Q4 of 2022.

And so the fact that we saw downward pressure on June’s CPI numbers is very consistent with two key points from investors’ perspective. First monetary policy still works, and second, the traditional assumption of the length of the lag period continues to hold. Now that implies that the trajectory of inflation over the next several months will be key, but so will any further evidence of cooling in the jobs market.

Historically, it is very difficult for monetary policy makers to engineer a soft landing. That being said, at this precise moment, it appears that Powell has accomplished just that. We have continued job gains, we have core CPI printing at two tenths of a percent and a low two-tenths of a percent at that, and the FOMC readying to shift into a wait and see mode.

The week ahead also offers the market its first glimpse at GDP during the second quarter. Expectations are for roughly a 2% print in that regard, but we'll also see personal consumption data as well as core PCE for Q2. This release will be followed by Friday's ECI figures as well as core inflation for the month of June. It's worth noting that Friday's numbers will be embedded in the quarterly figures from GDP. However, they could still prove a tradable event insofar as they give us context for the trajectory of spending, income, and inflation as the second quarter came to an end.

Let's not forget there is supply on the horizon, $42 bn two years on Monday, followed by $43 bn fives on Tuesday, and then capped with sevens at $35 bn on Thursday. The timing of the FOMC decision has obviously shifted forward twos and fives.

Our trading bias remains intact. We do see the market shifting from a sell strength to a buy weakness mentality, and while the incremental curve impulse at the moment appears to be toward deeper inversion, we ultimately expect that the -111 basis point level in 2s/10s holds at least on a closing basis, and eventually the curve restarts its journey steeper.

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 just one week left in this year's institutional investor survey, we cannot promise much, but we can promise that we'll stop asking for votes, until next year.

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.

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Speaker 4:

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