Much Needed Break - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 288, Much Needed Break, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery and not Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of August 26th. And with so much debate regarding the neutral policy rate at the moment, we decided to take a step back and give our star the week off. Get it?

Each week we offer an updated view on the U.S. 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, in addition to Powell's comments at Jackson Hole, the Treasury market also got the preliminary estimates of the BLS' Annual Payroll Benchmark Revisions, which came in down 118,000 jobs. While this might have been on the upper end of the market's expectations, the Treasury market had largely priced in a meaningful downward revision to that particular 12 months’ period of job creation.

As a result, we did see a little bit of richening in Treasuries in the wake of the data, but the price action remains largely contained. The shape of the 2s/10s curve remains very topical, and the benchmark curve appears to be anchored at roughly negative 15 basis points. The evolution of the macro narrative also benefited from the FOMC minutes, which contained clear messaging regarding the Fed's intention to begin lowering policy rates in September. Now, this wasn't necessarily new information. However, the minutes did reveal that several participants thought that cutting rates in July was a good idea. So the fact that the more dovish members of the committee will have to wait until next month reinforces the market's perception that they're likely to move in September. The notion of being measured and deliberate in cutting rates certainly resonates as the market continues to debate whether or not to expect a cut at every meeting or a cut once a quarter.

If the Fed were to follow market pricing and implicitly the path of least resistance, we'd see 25 basis points every meeting. That being said, the performance of the real economy will ultimately have a vote as well. And as we consider the August payrolls number combined with what we'll see for August CPI, which is expected to print at 0.2% yet again, we think that this is an environment in which the Fed will take a more gradual measured approach, which reinforces our core assumption that it will be quarterly at least at the beginning.

Now, when we look at the most recent cycle of cuts in 2019, what we saw was a few back-to-back cuts and then an extended period on hold. Now, that series obviously ended in cutting rates back to effectively zero because of the pandemic, so it's not the best archetype. This leaves the market split between assuming a series of back-to-back cuts and another pause comparable to what we saw in 2019 versus a longer-term, but more gradual steady reduction in the amount of policy restriction.

Now putting this in the context of the delayed impact of monetary policy, we remain wary of the real economy's ability to outrun the magnitude and severity of the tightening that the Fed needed to enact in order to reestablish price stability. They've been successful in getting inflation back under control. Now, the question is, are they going to be successful in avoiding a hard landing?

Ben Jeffery:

Well Ian, we did eventually, maybe a couple minutes behind schedule, get an important update as it relates to the labor market in the year concluding March 2024. And while the phrase better late than never comes to mind, the BLS did reveal that payroll's growth last year was actually 818,000 jobs fewer than originally assumed. Ahead of Powell's remarks on Friday, that was unquestionably this week's main event. And while there was a lot of discussion around just how much lower jobs were going to be revised, the actual release was more or less in-line with what the market was anticipating, but that was enough to extend the rally in Treasuries backed toward the bottom of the yield range we'd been tracking in 10-year yields ahead of the kickoff of Jackson Hole.

Ian Lyngen:

We also managed to fill an opening gap in 10-year yield space that we had been tracking, which really leaves the next technical level of any significance at 3.665%. That's the lower bound of the range that was achieved in the wake of the global equity sell-off that saw Japanese stocks down 12% only to rebound later over the course of the week. Now, sustainably shifting 10-year yields below let's call it 3.75% would take a more material shift in forward expectations for the real economy.

Given the fact that the initial jobless claims print for nonfarm payroll survey week came in exactly as anticipated at 232k bodes well for a reasonably strong month of payrolls growth in August. Now, translating that to the unemployment rate is a different story, keeping in mind the nuances between the establishment and the household survey.

In fact, with the unemployment rate nine-tenths of a percent off the cycle low already, we've been characterizing the BLS' preliminary estimates of the annual benchmark revisions, i.e. that negative 818,000 jobs, as simply the establishment survey catching up with what the household data was already telling us. Now, that doesn't necessarily have near-term implications for headline payrolls growth. However, in weighing the relevance of NFP versus the unemployment rate, it is a thumb on the scale for the unemployment rate.

Ben Jeffery:

And in discussions with clients this week around what these revisions actually mean for the market, one of the consistent themes that emerged was this is last year's news. Who really cares? And while that might be true from a consumption and growth perspective, after all, consumption in GDP last year was what it was despite the fact that there were nearly a million fewer jobs created than we initially thought. What the update from the BLS does do is affirm the Fed's interpretation of monetary policy as currently being well into restrictive territory.

And frankly, the fact that the Fed had that characterization even before the revisions to the jobs data, that means that in terms of evaluating the effectiveness of higher rates on the labor market, tight monetary policy did an even better job at cooling the economy last year than we initially thought.

This means that looking out over the balance of 2024, the departure point in terms of the pace of hiring and in terms of how well the labor market has held up to rates that continue to hold at their highest level in over a decade means that the demand destruction that the Fed was pursuing last year and into the start of this year actually played out more significantly. Now, does this make a 50 basis point cut in September inevitable? Probably not.

But as the early stages of policy normalization materialize and the Fed begins the process of moving rates from extremely restrictive to a little bit less restrictive, the fact that the labor market is not on as strong a footing as initially assumed undoubtedly will serve as greater justification for the start of rate cuts in September and beyond, even without core inflation back at 2%.

The lagged influence of policy moves obviously works in both directions, and so the fact that we've now seen enough concrete evidence of a slowing in the labor market combined with ongoing disinflation means that even if the Fed cut tomorrow, there would be more downside in hiring and inflation to be realized before any accommodative action would make its way through to the real economy.

Ian Lyngen:

More importantly, in terms of shifting into an accommodative policy stance, by cutting rates 25 basis points at even the next three meetings, the Fed would still be taking the upper bound from 5.50% to 4.75%, and 4.75% is north of anyone's estimate of neutral, so still restrictive. It's not until we get either into the low threes or the high twos that the Fed would truly consider monetary policy accommodative.

And in practical terms, barring a significant crash in the equity market that tightens financial conditions or the U.S. economy unexpectedly slipping into a recession over the course of the next 12 months, by the end of 2025, we're still more likely than not going to be in restrictive territory. At the moment, the futures market is pricing in roughly 200 basis points worth of rate cuts between now and the end of 2025, so that still leaves policy at 3.5%.

For context, the June dot plot showed 100 basis points worth of rate cuts next year, which would, depending on the departure point, put us closer to 4%, also definitively still in restrictive territory. One of the more interesting debates at the moment is how we should be thinking about the November rate cut. We came into this year assuming that once the Fed started normalizing rates, it would be accomplished via quarterly 25 basis point moves.

For the time being at least, we're holding to that logic with a nod to the fact that the futures market disagrees. The futures market is fully priced for each of the next three meetings with an additional 25 basis point rate cut in there somewhere. Said differently, 100 basis points worth of easing between now and the end of the year.

Our take is that the combination of August's payrolls number and August's CPI figures will dictate whether or not we see 25 bp in November, rather than dictate whether we'll see 25 or 50 in September. In an interesting conversation this week, we had a client ask, "So there's zero probability that the Fed doesn't cut in September?" Our response was never say never, and we would assign the probability of the Fed not cutting in September to the same probability that we see a 0.6% increase in core-CPI in the month of August. Very low, but not zero.

Ben Jeffery:

And it's not just policy rates themselves that have dominated our conversations over the past few weeks, but the path of the balance sheet is also garnering an increasing amount of attention given the firming in some money market rates like SOFR that we've seen, some Fed articles discussing the state of reserves, and of course, how QT is fitting in to the overall stance of monetary policy. It's in this context that will offer a potential path forward for the balance sheet and how it relates to the timing of rate cuts.

And that is that given the risk reward of the Fed continuing to run QT say through the end of the year with another 100 or 125 billion run off the balance sheet versus the risk of reserves continuing to drop to an uncomfortable level, what's another $100 bn dollars out of SOMA really worth given the fact that a very large central bank balance sheet is probably going to be a permanent feature of the Treasury market going forward?

Instead, there's a case to be made for an earlier stop to QT than would otherwise be expected. On the one hand, as a way to ensure that the ample reserves regime stays intact. And on the other hand, as we debate the chances and size of the rate cuts to come in September, November, or December, given the potential political ramifications of a rate cut so close to the election, wouldn't a potentially easier dovish solution be announcing the end of QT in November?

After all, for the vast majority of people who are far less interested in money markets than you and I, Ian, saying the Fed has stopped their balance sheet rundown does not hold the same influence as saying interest rates are going lower to the general public around the election. In this way, the Fed could afford to be a bit more cautious in terms of draining liquidity while also taking a step to dial back their level of restriction without actually delivering a rate cut.

The minutes this week hardly offered any concrete guidance on the Fed's thinking around the balance sheet at the moment other than to observe that the Fed is paying attention to what's going on in money markets as it relates to continuing QT, but especially as the Fed speak ahead of the September meeting continues to come in and as we get more communication from the FOMC, when it is exactly that SOMA will stop shrinking will become increasingly relevant.

Ian Lyngen:

It's also important to keep in mind that while one could with a straight face characterize the Fed's balance sheet as enormous, the fact of the matter is that the size of the balance sheet should be considered in the context of nominal, not real GDP. So as we've seen over the last couple of years, the decades high level of inflation has driven a decade's extreme level of nominal GDP growth.

Now, certainly at current levels, the outright size of the Fed's balance sheet is still supportive of the real economy. By ending QT before the end of December, the Fed is essentially doubling down on the assumption that the real economy will be able to grow sufficiently to justify the amount of bonds held in SOMA.

Ben Jeffery:

Soft-landing, could happen.

Ian Lyngen:

Never say never. Vail?

In the week ahead, in addition to an uptick in out-of-office replies, we expect that trading conditions will be relatively choppy, conviction will be low, and volumes will err on the side of being subdued. That being said, the week ahead is not without some events of relevance. First up will be the $69 billion two-year auction on Tuesday afternoon, followed by a $70 billion five-year auction on Wednesday, and then August's coupon supply is capped by a $44 billion seven-year auction on Thursday.

It is a refunding month, and so month-end flows will be relevant. We would expect, all else being equal, that we will see solid duration demand on Friday with the caveat that Friday also offers the personal income, spending, and core-PCE figures. The core-PCE numbers are for July, and the consensus is for 0.2%. On an unrounded basis, the market is looking for 0.18%, give or take, and that would be very consistent with the Fed bringing inflation back to the 2% target over time.

It strikes us that during this cycle, the market has focused on trading core-PCE as it is the Fed's preferred inflation measure. However, we'll highlight the fact that core-PCE tends not to surprise in any dramatic fashion. Now, that's largely because once the market has CPI, PPI, and import prices, it becomes easier to accurately estimate how core-PCE will print.

All of that being said Friday, August 30th, could nonetheless turn into a tradable macro event if there is in fact some surprise on the inflation front. Let us not forget that Thursday sees the initial jobless claims print as well. And coming off of the NFP survey week at 232k, the market will surely respond to claims, although the degree to which they impact payroll's expectations for August will presumably be limited.

It's with this backdrop that our range trading thesis remains intact. We'd play for backup in front-end yields as the market incorporates the balance of risks between now and the end of the year, both in terms of the real economy as well as the monetary policy outlook. There's a lot of information between now and the November and December meetings.

And while a 25 basis point rate cut in September is largely a foregone conclusion, the evolution of the real economy remains very relevant for the Fed's willingness to pull back from its current policy stance. It's certainly not wasted on us that the other major central banks, with the exception of Japan, have already moved into rate-cutting mode, and that is likely to extend during the balance of 2024.

We're reluctant to suggest that the Fed is playing catch-up with the other major central banks. But instead, we'll highlight the fact that monetary policy divergences between the major banks tend to be relatively short-lived as appears to be the case during this cycle. 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 staying cool gives way to back to school, we're reminded that stops are for buses. 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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