No Wrong Side of 50 - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 287: No Wrong Side of 50, 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 August 19th. As expectations waver between assuming a 25 basis point rate cut in September or a 50 basis point move, we are a lot closer to 25 than to 50, despite that pesky birthdate thing. After all, you're only as old as your jokes are… uh-oh.

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 the pivotal piece of data that we had anticipated would define trading in US rates for the next several weeks and that came in the form of a largely as expected core-CPI print at 0.2%. Now on an unrounded basis, this was a low 0.2% and very consistent with what the market was anticipating. However, in light of the disappointing PPI figures on Tuesday, the market was primed for greater downside risk than what was ultimately delivered. As a result, the Treasury market has shifted decidedly back into a range trading mode with 10-year yields comfortably below 4%, and 2-year yields slightly above. Now, one of the more notable aspects of the move came in the form of the re-inversion of the yield curve.

The yield curve had at least momentarily moved back into positive territory for 2s/10s. This price action has now partially reversed, and 2s/10s are at roughly -10 basis points. As we've observed in the past, the bull re-steepening of the yield curve was widely assumed to be the big macro trade of 2024. While to some extent that has come to fruition, we haven't moved convincingly back into positive territory for long enough for us to conclude that this trade has run its course. As a result, we continue to anticipate a reasonable steepening bias between now and the end of the year, and we'll look to the period immediately before the September FOMC decision as the real departure point for the cyclical re-steepening. The logic here is relatively straightforward. As the week before the Fed's decision, the market will receive the August CPI print and that will serve to solidify expectations for a series of rate cuts that will ultimately bring monetary policy in the US back to neutral.

We're also nearing the point where it's reasonable to anticipate the Fed will announce the end of QT, whether that occurs at the September meeting or later in the year, we nonetheless anticipate that the Fed will be done allowing the balance sheet to run off by the end of 2024. If nothing else, this will reduce the amount of borrowing that the Treasury Department needs to do in the private space. So on the margin, the end of QT is constructive for the Treasury market as a whole, and that bullishness will more likely be felt further out the curve, which to some extent will limit the degree to which the curve can re-steepen. On the flip side, however, the results of the presidential election risk being a bear steepening event should the outcome leave investors with the impression that they will be more on the fiscal side and more on the deficit spending side, that will ultimately require the Treasury Department to increase auction sizes in the latter half of 2025.

Vail Hartman:

From pricing in well over 50 basis points of rate cuts for the September FOMC meeting amid the post-NFP global equity selloff, investors have considerably backed away from expectations for a supersized 50 basis point rate cut as market pricing has shifted back in favor of a more pedestrian 25 basis point reduction. The argument for a 50 basis point rate cut has been undermined by a couple of recent trends in the US economic data profile. On the inflation side, non-housing services and housing services remain a pillar of strength in the inflation complex, and in light of Powell's acknowledgement that we've still seen a limited set of good data from these sectors, the stickiness is worth mentioning. As for the consumer, the pace of retail spending continues to uphold expectations for solid growth in the second half of the year. And on the employment side, jobless claims have fallen well off the recent peaks and a trend that's helped alleviate the payrolls-inspired concerns that the weakening in labor market conditions is intensifying.

Ian Lyngen:

And as you point out Vail, the sentiment around the Fed's first rate cut of the cycle is now decidedly back in the 25 basis point camp. Keeping in mind, however, we’ll still have two potentially pivotal data points between now on the 18th of September when the FOMC makes its decision. First will be the August payrolls report, which prints during the first week of September, and then August's inflation data. That being said, expectations are benign on both counts, at least for the time being, and we suspect that it will be a fairly clear and uneventful path to a 25 basis point cut. What has just become more interesting in the context of forward Fed expectations will be the pace of rate reductions. We continue to operate under the assumption that the Fed wants to start cutting quarterly at a pace of 25 basis points per move. That means September and December this year, and then continuing the quarterly cadence in 2025 and presumably 26.

Now obviously the risk in this regard is that the Fed sees something more troubling in the data and wants to pull us back from restrictive more rapidly. It is however important to keep in mind that as the Fed considers the timing of rate reductions, from Powell's perspective, there's a significant difference between cutting and easing. Cutting to bring us back from restrictive territory simply needs the justification of more benign inflation. It won't be until a more significant deterioration in the real economy that the Fed will truly entertain the idea of easing i.e. dropping rates below neutral. So, for the time being the no landing or soft landing narrative continues to hold.

Ben Jeffery:

And a big part of that has to do with the fact that while the labor market has started to show some signs of softening, that softening has come from what was arguably a historically strong departure point. Real wage growth remains at levels that are nothing if not typical in the context of the past several years, removing the distortions driven by the pandemic. And as this week's retail sales report highlighted as well, generally speaking, to look at the consumption data and what that means for the aggregate economic expansion, there aren't really many signs that are beginning to flash red in terms of a recessionary alarm.

Sure, the realized progress made in softening inflation and coming back closer to, if not necessarily at the 2% target yet will be the justification for the initial cuts that will still leave policy in restrictive, just less restrictive territory. And especially as we await the monetary policy comments that are going to be delivered at Jackson Hole with what will be some discussion around R* and the actual restrictiveness of policy, it's exactly that narrative that we'll be on the lookout for. Not a great deal of recessionary concern, encouragement that inflation has moderated and enough signs that the labor market has responded to monetary policy, that the time has come to dial back the level of restriction.

Ian Lyngen:

Wait. So, participants are going to be focused on R* at Jackson Hole. How did Vail get the invite and I didn't?

Ben Jeffery:

It really never gets old.

Ian Lyngen:

And as we contemplate changes in monetary policy between now and the end of the year, it's worth observing that a lot of the current angst in the market at the moment is based on the notion that monetary policy affects the real economy with a lag. So whether those estimates are six, nine, or twelve months, for all intents and purposes, the bulk of what will be 421 days spent at terminal has yet to work its way completely through the US economy. This also implies that what the Fed does in September, November (maybe), and December, will be more impactful for the second half of 2025 and beyond. So said differently, the Fed is managing monetary policy for a point in the medium-distant future of the real economy.

Ben Jeffery:

And given the Fed's focus is well out on the macro horizon and especially during the final weeks of summer, that leaves some more technical and flow-driven factors driving a bit more of the price action than would otherwise be expected, especially after the volatility that we've experienced over the past few weeks. Last week when we saw 10-year yields reach 3.66%, the case was being made that not only had Fed pricing gone too far, but also that the market was really looking for any reason at all to extend the process of the move toward lower yields and the push toward a steeper curve. Fast-forward to this week with benign, but by no means outright soft inflation data, the firmer Retail Sales print, and that left what we'll argue was a bull-steepening bias that had some capacity to see positions squared and risk aligned more closely to balanced before the final weeks of August set in.

Especially looking at Wednesday's price action through a microscope, the fact that we got a fairly middle-of-the-road CPI report, and yet the curve flattened in a pivoting fashion, by which I mean 2-year yields ended the day higher while 30-year yields pressed lower throughout the session, points to this idea that perhaps investors were a bit overweight the very front end of the curve, perhaps on the outlook that 100 basis points and rate cuts over the balance of this year were going to get realized only to have the realities of this week's data. And also worth mentioning stocks that have found their footing bring that positional bias a bit closer to neutral, which sets up a relatively cleaner backdrop heading into the week ahead.

Ian Lyngen:

And to your point, Ben, there has been a clear tone shift in the Treasury market. Earlier in the cycle, the question was how far will the Fed need to increase policy rates before they ultimately stop? We now have the answer to that question. It was 5.50% and once we reached terminal and it became obvious to the market that the Fed wasn't going to go any higher, which let's call that 4Q 2023, that created a moment of stability that brought in otherwise sidelined buyers in the Treasury market. And that's why we saw rates decline into the end of last year. We're moving closer to another key inflection point, that inflection point being the first rate cut of the cycle. And while one might argue by looking at the futures market that the move is fully or arguably overpriced in at the moment, the reality is there remains a group of sideline investors who will likely use this inflection point as the impetus to re-enter the Treasury market by buying duration.

Now, once the first rate cut has been realized, the broader debate logically will be what is terminal on the downside? Is the Fed going back to neutral? Is the Fed going to need to go below neutral? Is it going to be a scenario in which the Fed cuts 100 basis points and then pauses during the second half of next year? So with this backdrop, the next major inflection we'll be watching for is investors' confidence in both the cadence and the timeline of the Fed's cutting cycle. If the Fed moves 25 basis points in September and leaves the market with the impression that they're not certain about another quarter point cup by the end of the year, that will undermine the market's perception that we're entering a rate-cutting cycle as opposed to just a few fine-tuning cuts. That's the essential question for the market at this moment.

Vail Hartman:

And while market sentiment has been shifting away from a 50 basis point reduction in less than five weeks, the Fed speak continues to suggest that a rate cut is quickly approaching on the horizon as it's shown greater concern for the employment side of the dual mandate. And when parsing through comments from Atlanta Fed President Bostic, who several weeks ago, I'd say it wasn't clear whether he would endorse a rate cut in September, and in the week just passed we heard Bostic say that he'd actually be open to moving before the fourth quarter, i.e. in September. This suggests that in the wake of payrolls, even the previously more hawkishly-inclined members on the committee are displaying a greater openness to reduce rates in September as the perceived balance of risks have shifted.

Ian Lyngen:

Well, they don't call it the open market committee for nothing.

Ben Jeffery:

Open to 50 or open to 25?

Ian Lyngen:

Eh, I'm open.

In the week ahead, there's remarkably little economic data of any relevance. The Treasury market will be focused on initial jobless claims. Although now that we have had two consecutive declines in initial jobless claims and a relatively clean read when it comes to the data itself, we suspect the claims figures will ultimately be a non-event. The one caveat in this regard, however, comes in the form of the fact that it is claims representing NFP survey week and therefore that much more relevant in estimating the payrolls print for the month of August. There are a few Fed events of note, however, the biggest being in Jackson Hole. Powell's speech on Friday will be the marquee event to be sure, although there will be plenty of other Fed commentary and interviews that will surely lead to headlines. Whether they're tradable or not will ultimately be whether or not the signaling is far enough message as to trigger a policy rethink.

We don't think that the Fed's agenda will really do anything more than start the conversation with the market about a slightly higher neutral rate assumption, which has already been factored into the Fed's SEP. And in opening up the conversation about r-star and the effectiveness of monetary policy, we struggle to imagine that the Fed will want to communicate anything other than the policy objectives are being achieved, and monetary policy still works generally in line with commonly held assumptions. That being said, in the event that the last two CPI prints had showed a re-acceleration of inflation, then the tone from Jackson Hole might have been somewhat different, and more concerning that the Fed would either need to keep policy rates on hold for an even longer period of time or consider allowing QT to run off in the background in 2025. Therefore, the recent progress on the inflation front is surely a welcome development for Powell and the Fed, and Powell's willingness to lay the groundwork for a Fed rate cut also de-emphasizes the potential shock value of anything coming out of Jackson Hole.

Let us not forget, we also see the FOMC Minutes from the last meeting. These minutes will be particularly useful in gauging the Fed's current thinking on pace of rate cuts and how close to lowering policy rates the Fed actually was last month. While our read is that the performance of the economy at this current moment more than justifies starting the process of normalizing rates lower, it'll be notable to see whether or not the FOMC discussion laid out any particular thresholds or objectives that need to be achieved before a September rate cut.

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 Jackson Hole approaches, we continue to search our email for anything from Powell that we might have missed. Maybe 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. 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 4:

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