New Year, Same Podcast - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 306: “New Year, Same Podcast” 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 January 13th. And as the New Year has been rung in and trading conditions are largely back to normal, at least we can safely conclude that we've made it through December. But is everything really going to be okay now? Merle Haggard thought so.

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 sold off rather dramatically. Ten-year yields pushed above 4.75% on what can conclusively be called a very strong employment report. Nonfarm payrolls printed up 256,000 jobs. That was almost a hundred thousand over the consensus of 165, and it was also the highest in nine months. The net revisions were very benign, down just 8,000 for the prior two months. This left private payrolls gaining 223,000 jobs in December. Even the Unemployment Rate unexpectedly dropped to 4.1. On an unrounded basis it was 4.086, so a solid 4.1 as a theme. This occurred with the labor force participation rate being unchanged at 62.5, so that drop in the unemployment rate was made all the more relevant and consistent with a strong headline gain in payrolls.

The household survey also showed an improvement up 478,000 jobs versus the prior decline of 273. So on net, the labor market continues to demonstrate the type of resilience that the Fed has commented on in the past. And moreover, the report was very consistent with the Fed's messaging that they're going to leave rates unchanged in January and reevaluate the prudence of a rate cut at the March FOMC meeting. At this point, skipping January is very consensus, although it is notable that one of the prevailing narratives among market participants is this idea that the Fed is skipping January to see what comes out of the White House and then incorporate that into their forward path towards normalization. But particularly in the wake of the December employment numbers, there's a very strong argument to be made that the Fed would have skipped January regardless of who won the election.

And this is relevant because all else being equal, it should leave the market appropriately data-dependent between now and the March meeting. We've been operating under the assumption that the Fed's primary goal in skipping January was to shift the cadence of rate cuts to 25 basis points per quarter as opposed to 25 basis points per meeting. However, if the realized economic data continues to perform as well as we have seen in the December employment report, it's certainly not inconceivable that the Fed chooses to delay further rate cuts until the latter part of 2025. While no cuts until Q3 certainly isn't our base case scenario at the moment, we are all too cognizant that the incoming economic data can shift not only the market's expectations but also the behavior of the Fed. It's also notable that the recent rhetoric out of Washington has been very consistent with Trump's campaign promises and indicates at least at this point, no willingness to scale back on some of his initiatives, both in terms of tariffs and immigration policy.

Ben Jeffery:

Well, it was the first trading week of the new year, and there really was no shortage of factors that got the Treasury market off to what can only be characterized as a bearish beginning to 2025. Early in the week, heavy issuance on the corporate and Treasury side was enough to break ten-year yields through the range top we had been tracking as support with the added benefit of a solid look at labor demand with November's JOLTS data, an upside surprise in ISM services, and obviously a week that was capped off by a very strong December payrolls report. An upside surprise in headline hiring, an unexpected decline in the unemployment rate to 4.1%, and a modest downside surprise offset on the margin by a downside surprise in average hourly earnings was enough to accelerate the selloff and add further fuel to the narrative that the Fed has ample cover to continue delaying rate cuts until at least the March meeting if not beyond.

Ian Lyngen:

And it is interesting that while it's not our base case scenario that the Fed delays rate cuts until the second half of the year, it is, given the trajectory of the realized data thus far, something that should be on the radar as a potential risk. Now, in a more typical environment, one might assume that that translates through to a curve flattening bias. In fact, if we continue to see the strength within the economic data as well as the stickier aspects of inflation persist, then it's not unreasonable to anticipate that a Fed on hold actually translates into a steeper yield curve. Logic there being relatively straightforward. First it implies at least the perception that there's more inflation that will be running through the system, but it would also be accompanied by a return to the conversations about deficit spending, higher Treasury issuance, positive term premium, and a need for a greater concession to underwrite the amount of Treasury issuance that will most likely characterize the next leg of the cycle.

There's also an active discussion around whether Bessent will choose to term out the Treasury's borrowing profile by issuing more longer-dated treasuries. 10s, 20s, and 30s would obviously be the most impactful for the shape of the yield curve. And also if the duration-heavy sectors did see a disproportionate increase in borrowing, then one should expect not only a consistent return of positive term premium, but also a notably steeper curve even if the Fed doesn't ultimately cut rates until the second half of the year.

Ben Jeffery:

And in several client conversations this week, it was especially informative to hear that while obviously payrolls was going to be pivotal and a crucial input to the overall macro view and state of the market, really one of the biggest unknowns of the first half of 2025, and frankly for the next several years as it relates to the state of the economy, is what will ultimately come to pass in terms of the incoming Trump administration's agenda. Obviously tariffs have been well discussed in terms of the inflationary and growth negative impact on the consumer, but beyond that will be the resolution to the uncertainties around if incoming Secretary Bessent is able to materially change the structure of Treasuries outstanding if there in fact will be a more hawkish fiscal policy stance among lawmakers in the White House. But nonetheless, the fact remains that regardless of who ultimately won the presidential election and the composition of Congress, there's not a great deal of support on either side of the aisle for a material fiscal pullback in Washington.

Obviously, if only to boost the odds of reelection, any politician is going to want the economy to run as hot as possible without restoking inflation. So the fact that we're heading into what is widely assumed to be a government that is pro-growth and pro-inflationary, from a backdrop of an unemployment rate that has now declined to 4.1% and over 200,000 jobs added in December, is going to mean that any boost to the economy and thus further upside in term premium, is going to be coming from a departure point of an economy that's on relatively solid footing and 10-year yields that are increasingly looking to stage a challenge of 5%. So it introduces a different range of outcomes as we look forward over the next several quarters in contrast to how we started 2024 where recessionary angst and Fed cuts were driving the price action.

Ian Lyngen:

It's also notable that fiscal concerns are not limited to the US. In fact, issues in the UK as well as Germany and Europe, more broadly, drove a good portion of the price action in the week just passed, particularly on Monday and Tuesday when we saw such a sharp backup in Gilt yields. And for context, British yields are now at the highest level since the nineties. All of this has rekindled conversations about the bond police or bond vigilantes as market concerns on the fiscal side have become more and more universal in the Western world.

Ben Jeffery:

And playing into this idea that fiscal dynamics in the UK and the US and elsewhere with the backdrop of a solid economy are pushing yields to multi-decade highs, this week's 30-year auction was the highest yielding since 2008. The next leg of the market's reaction function that we're increasingly on the lookout for is what this all means for risk assets. We talk a lot about what higher borrowing costs means for households, but especially this week with so much corporate issuance, let's not forget that higher rates in the belly and longer end of the curve also have a material impact on cash flows in the corporate sector.

And so higher debt service costs, what higher rates mean for equity valuations all add general uncertainty around the justification of risk asset valuations at these levels. Especially looking at the TIPS market and a ten-year real yield that is well above 2%, there will come a point at which equity valuations are deemed too high and a risk-free inflation-adjusted return of two and a quarter or two and a half percent over the next 10 years simply looks too attractive for investors to pass up. Obviously, the labor market is not a near-term factor that we're expecting is going to inflect in favor of a dovish about-face from the Fed, but especially as we monitor equities’ reaction to the upside surprise in NFP, it's something to consider in terms of the feedback loop between equity vol, real yields, and overall financial conditions that are moving tighter, aided by the Fed's hawkish message that began at the December FOMC.

Ian Lyngen:

One of the more interesting exercises that we engaged in this week was attempting to break down how much of the 110 basis point selloff in ten-year yields that has occurred since the Fed's first rate cut was a function of inflation, growth, or other considerations. What we saw was that during that period, roughly 30% of the 110 basis points was a function of widening break-evens. What did occur, however, was we saw term premium swing well back into positive territory with the ACM model most recently printing at positive 50 basis points for the 10-year sector. So we're comfortable with the interpretation that the bulk of the move was in fact a term premium/deficit story, and as further clarity on the performance of the labor market and inflation environment become evident, it'll be very telling to see how the market chooses to address the significant backup in term premium that's already been achieved and whether or not at the end of the day, investors are going to demand even more to underwrite the looming increase in issuance.

Ben Jeffery:

And more on the regulatory side of things, we also got some new information this week in terms of a changing of the guard at the FOMC with Vice Chair for Supervision Barr's announcement that he intends to resign ahead of the incoming administration. Now, over the past several years and since coming out of COVID, there's been a great deal of market discussion around what the regulatory paradigm and specifically bank's ability to hold Treasuries on their balance sheets and what that means for leverage ratio calculations generally implies about demand for Treasuries from this critical buyer base.

To look at the market's reaction to the Barr announcement, particularly the response we saw in swap spreads, the interpretation is that a less stringent regulatory framework or potential exemption of Treasuries from leverage ratio calculations from the financial sector will remove an inhibition from banks’ abilities to buy Treasuries. Now, will this serve as a one-for-one offset to higher auctions coming later this year? Certainly not. But more broadly, the fact that a potential change in policy from the White House and a new Congress along with a new vice-chair for supervision at the Fed should free up at least some marginal demand for treasuries, especially in the belly of the curve.

Ian Lyngen:

All of this comes at a very opportune time for the Treasury Department. Not only is the Fed cutting rates, so front-end financing costs are going to be at least marginally cheaper, but by unlocking another potential sector of demand via SLR, the market will arguably be in a much better position to deal with the looming deluge of issuance.

Ben Jeffery:

And as we've discussed throughout the bulk of this cycle, it's not solely going to be domestic banks that serve as the buyer of Treasuries on any backup in rates going forward. In fact, the takeaway from conversations with clients in the US and Europe and Asia has been a general eagerness to take advantage of any backup in yields. And now that we're back to within striking distance of cycle-high yields, at least in the 10-year sector, it's important to consider that in the context of global rates, 10-year rates at these levels represent an attractive yield to lock in for the next 10 years.

Ian Lyngen:

10 years is a very long time.

Ben Jeffery:

Especially in bond years.

Ian Lyngen:

In the week ahead, the primary focus will be Wednesday's release of core CPI. It’s information for the month of December, and expectations are for a relatively benign two-tenths of a percent, or even potentially three-tenths of a percent increase in the monthly pace. Now, as we saw in November, translating the combination of core CPI, core PPI, and Import Prices into core-PCE can sometimes result in a 0.3 becoming a 0.1 as it were. So the market will be looking with a great deal of scrutiny at the three main inflation gauges next week, PPI, CPI, and Import Prices on Tuesday, Wednesday, and Thursday respectively.

We also see the December Retail Sales figures and all else being equal, one would expect a strong showing, given the impressive labor force statistics, which suggests that consumers will be approaching the holiday spending season with a reasonable amount of confidence, if nothing else.

It's also notable that the January University of Michigan inflation measures, the medium term 5 to 10 year, reached 3.3%. That's the highest that it's been since 2008. So from the perspective of monetary policymakers, that's a unwelcome development, as it were, because it implies a degree of stickiness on forward inflation expectations that wasn't as evident as recently as a few months ago. All of this creates a very bond bearish backdrop. We continue to like the curve steepening trade, especially in 2s10s as the carrying costs for the benchmark steepener are no longer as onerous as they were throughout most of 2024. We're also comfortable with the expression of this trade in 2s bonds or 5s bonds. All three of these trades have plenty of room to run from here, particularly when putting the recent move in the context of the strong bearish seasonal tendencies at this time of the year.

Beyond the inflation data itself, the next big wild card at this stage is the performance of risk assets. Stocks had been up on the year prior to the payroll print, but that has since reversed and with equities underperforming, the question quickly becomes whether or not there's more of this down trade yet to be realized, or if this is simply a modest in-range correction that ultimately resolves in a steady grind higher, which was so definitively last year's trend. And to a large extent, the market's widely held expectations for 2025 and beyond. There's nothing in the price action in the equity market and the implications for financial conditions that would suggest that the move has reached the point of being a monetary policy consideration. But nonetheless, it is certainly something that will be on the market's radar.

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 the yield curve continues steepening, leaving the depths of the inversion behind, it's comforting to know that at least something is returning to normal-ish.

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 3:

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