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Odd Odds - The Week Ahead

FICC Podcasts Podcasts December 02, 2022
FICC Podcasts Podcasts December 02, 2022

 

Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of December 5th, 2022, and respond to questions submitted by listeners and clients.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Ian Lyngen:

This is Macro Horizons episode 200, Odd Odds presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of December 5th. As we look at the futures market and note the implied probability of rate cuts in 2023 despite the FOMC’s active hiking campaign and commitment to an extended stay at terminal, the expression ‘odd odds’ offers an apropos take on the state of monetary policy expectations.

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, there were two notable events that have defined trading in the US treasury market. The first were comments from Powell on Wednesday that were interpreted more dovishly than market participants had been anticipating. Recall that at the last FOMC meeting, the statement was skewed a bit more dovishly and included the phrase cumulative impact of tightening as well as reference the lagged impact of monetary policy.

At the time, this was interpreted as being net dovish and was associated with a rally in treasuries. What transpired at the press conference however, left the market with the decided impression that Powell was continuing forward with his uber hawkish stance. As a result, the market sold off and he accomplished this by framing the next phase of tightening as more focused on the terminal rate as opposed to the size of each individual rate hike going forward. Powell's messaging in the week just passed was decidedly less hawkish and as a result, the market rallied, 10-year yields ultimately dipped below our 350 target and had been consolidating in a range until the second major event of the week, which was non-farm payrolls. Now, non-farm payrolls surprised on the upside above 200,000 with a stable unemployment rate at three seven. While there was some chatter about the potential for an increase in the unemployment rate, the fact that it didn't increase can at least partially be credited to the fact that the labor force participation rate declined, unexpected, and rather sharply.

With this backdrop, we saw a higher than expected average hourly earnings print for November, which reminded the market that the Fed has plenty of reasons to continue pushing monetary policy rates higher. The biggest takeaway from Friday was that the curve inversion is back on with 2s/10s back below negative 75 basis points and pushing toward that negative 81-82 range. Now we think that there's still additional potential for 2s/10s to invert further, and we're continuing to hold our year end target for 10-year yields at 3.50 and two-year yields at 4.50. As we contemplate how things will play out in the first half of the year, at this stage, it has become relatively consensus to anticipate an economic slowdown of some magnitude. The biggest question is of course, whether it's going to be a soft landing, a hard landing, or uncertain enough while it's occurring that the Fed ultimately needs to temper their hawkishness.

Now we continue to operate under the assumption that the terminal rate for this policy will be an upper bound of five or five and a quarter. Now in the event that the November CPI data fails to deliver another modest 0.3 month over month increase, that will undoubtedly contribute to some upward revisions for the appropriate level of terminal and put five and a quarter, five and a half in play. Nonetheless, the release of the November CPI data is followed the next day by the Fed's decision and the updated SEP. All else being equal, we remain squarely in the peak yields camp for tens and the peak inflation camp for core-CPI and core-PCE.

Ben Jeffery:

Well, Ian, the week began in somewhat slow fashion as the market was waiting for payrolls and it was really Powell's speech on Wednesday and the Q&A that followed that ultimately ushered in the bulk of this week's excitement, namely that despite the expectation for the chair to sound just as hawkish as he did at the November press conference, what we got instead was a much more balanced take as the groundwork was laid for a 50 basis point, not 75 basis point hike in December. And while the chair acknowledged that there will be ongoing tightening, he did suggest that the committee is cognizant of the risk of overdoing it in terms of rate hikes and that they don't want to crash the economy through raising rates too aggressively.

The market took this information as the pivot we've all been waiting for. 10-year yields dropped precipitously to challenge that 350 level we'd been targeting, and 5s/30s steepened back briefly into positive territory. That is until the jobs report was released Friday morning and another strong read on hiring, decline in the participation rate, and massive upside surprise in average hourly earnings reversed the trend and served as a reminder that we still have a lot of rate hikes yet to be realized and the Fed is still leaving the door open for an even higher terminal rate.

Ian Lyngen:

I think that it was a very interesting round of price action. We've been on board with adding duration with a target of 350, however, our assumption was that that occurred with a two year yield at 450 giving us an inversion of a hundred basis points by the end of the year. Now we still think that that narrative holds and we're going to be looking at the December 14th FOMC announcement as an important inflection point to push that narrative. We're going to have an update of the SEP and given where we are in the hiking cycle, the assumption is, both ours and by the market more broadly, is that the Fed will have a much better idea of where terminal actually is at this point. Now we're on board with a 50 basis point rate hike scenario for December followed by a transition to 25 basis points in February and 25 basis points in March.

Now whether the upper bound for terminal is 5%, 5.25 or even 5.50 is ultimately going to come down to whether or not core inflation continues to moderate as we have seen, and within the core inflation series, we've talked a lot about OER and the lagged impact of the decline in home prices flowing through to the realized inflation numbers. What the biggest risk to this not moderating is that as home prices became too expensive, potential buyers were moved into the rental market and that has propped up rents. That could create a backdrop in which inflation doesn't moderate in Q1 and challenge the idea that we are in fact right up against the terminal rate.

Ben Jeffery:

And I would argue the price action this week and the severity of the bull steepening we saw coming out of Powell demonstrates that the market is eagerly looking forward to what we've been characterizing as the next big trade in treasuries, which is that the arrival at terminal will mean that the next move is going to be rate cuts and that in turn is going to disproportionately benefit the front end of the curve. It's with this backdrop that we saw two-year yields drop below 4.20 in the run up to NFP after trading above 4.50 on Wednesday morning.

And Ian, I think it's a great point to emphasize the risk that there's a reasonable probability we make it to the end of the first quarter and what will presumably be at least two 25 basis point hikes in February, in March and still inflation is too high for the Fed to be willing to call terminal achieved.

Now that doesn't necessarily mean that Fed funds is going to continue rising by 75 basis points at every meeting, but it does suggest that the distribution of risk around the path forward for Fed funds is more toward the upside than the downside, even if that upside is probably going to take the form of a more measured cadence of increases, call it 25 basis points at every meeting or even what we saw during the last hiking cycle, which was 25 basis points every quarter.

Ian Lyngen:

Another unique aspect of this cycle that it's worth highlighting is the fact that we have very quickly moved to the stage where effective Fed funds no longer acts as a floor for nominal 10 year yields. Now historically, we know that the funds tens curve does invert, but it primarily tends to invert once terminal has been established and the market moves forward to pricing in a series of rate cuts and there is a collective understanding that what is coming next in the cycle is an economic slowdown of some relevance.

In considering the importance of this inversion, it's less binary i.e. does it happen or not, and what does that signal? And it's more a function of how deep the inversion can get and how persistent that inversion is. The fact that 10 year yields reach 3.50 versus an effective Fed funds rate of 385 is one thing, and when we get the widely anticipated 50 basis point rate hike on the 14th of December, that will have entirely different implications given the depths of that inversion and what that implies for the disconnect between what the Fed is attempting to achieve and what market participants fear.

The other dynamic, which I suspect will be very telling in the near term is what happens in the front end of the curve, when does two's fund invert? So in the context of the front end of the curve, it will be very interesting to see what happens on December 14th or 15th when effective Fed funds goes from 3.83 to 4.33. Now, the recent price action in the two year sector doesn't suggest that an immediate inversion of two's funds is a foregone conclusion. In fact, we are looking for the communication that comes out of the Fed to bolster the upward pressure on two year yields into the end of the year. So there's still more downside to be realized in twos, which when put in the context of the bid for duration implies that while yes, we did breach as inverted as negative 81 basis points in 2s/10s, the cycle lows or the ultimate depths of the inversion have yet to be realized.

Ben Jeffery:

And this brings up one of the most relevant takeaways from our pre-NFP survey this month as the market continues to debate where terminal ultimately will be as we've been discussing Ian, but also what shaped the initial loosening of policy is going to take, AKA the first rate cuts of this cycle that at this point I would argue are broadly expected to take place in 2024. As for one of the special questions in our survey, we asked what investors were expecting in terms of the spread between the 2023 and 2024 median estimate of Fed funds that we'll get in the new SEP in December. There was a wide range of responses with a few expecting a flat path of policy, so rates on hold through the end of 2024 with the most extreme example, 175 basis points of rate cuts expected between the end of 2023 and the end of 2024.

However, most answers in the median result was 75 basis points. And when we think back to 2019's fine tuning rate cuts, 325 basis point cuts, I would argue the market is operating under the assumption that when the time does eventually come for the Fed to lower rates, at least in the early days, Powell is going to attempt to frame it as another fine tuning endeavor. Now whether that is 75 basis points or something a bit larger will of course be a function of how the data performs between now and then, not to mention what will also need to be some more communication on the balance sheet and whether or not the Fed will continue doing QT in the background even while lowering rates or if stopping balance sheet normalization will be the first action the FOMC takes to stop tightening policy.

Ian Lyngen:

I'll argue that what it comes down to, at least to some extent is the nature of the slowdown and what the magnitude of the ultimate excess demand destruction is. If we find ourselves in the middle of next year and the unemployment rate has gone from 3.7 to 4.7, but inflation has drifted back toward the Fed's 2% target, now obviously core CPI on a year over year basis isn't going to get to 2% by the middle of next year. Nonetheless, there is a reasonable chance that on a three month annualized basis, the Fed can look at the trajectory of inflation and claim victory, especially if we're starting to see signs of major stress throughout the broader system.

When we looked historically over the last 40 years, what we saw excluding 2020 was that on average when the real economy is in a recession, the quarterly annualized rate of contraction is 3%. Fast forward to the middle of next year, if GDP has fallen between 2 and 3% or 1 and 2% in Q2 or Q3, the Fed can look at that and still characterize that as the soft landing that they were hoping for. It's once we get over that threshold of 3% that we anticipate that the market will become increasingly anxious about whether the Fed has gone too far and will ultimately need to recalibrate policy.

Ben Jeffery:

And taking a more near term view about the necessity for an adjustment of policy, we found ourselves in a lot of discussions this week about what's happened in financial conditions since 10 year yields reached that peak we saw in mid-November. Specifically financial conditions have eased fairly significantly, and along with and related to that has been the bounce inequities from the low and the Dow formally reentering a bull market. While yes, this is certainly positive for the individual outlook and the wealth effect, remember that the Fed is still trying to push financial conditions tighter and while yes, they want to keep that in orderly process, the fact that we've seen the market ease financial conditions implies that the Fed has more room to be aggressive and in fact may need to be more explicit as Williams was in his unscheduled interview on Thursday that there's more work to be done to bring down inflation.

And Ian, as you touched on earlier, really what this implies for the Treasury market is higher front end yields and a flatter curve. We've already seen the evidence of duration looking increasingly attractive and especially after the end of the year when balance sheet constraints fade, it's not unreasonable to expect that those investors who have been waiting to reach further out the curve and purchase longer dated treasuries will then be willing to do so in an effort to get ahead of a more material turn in the economic data that will materialize sometime in the middle part of 2023.

Ian Lyngen:

It's an understatement to say that the market is at a very important inflection point, and as we make the rounds and talk to clients, it is very clear that there is a significant subset of the market that has been sidelined and is actively attempting to gauge the appropriate moment to get involved. Now, as we think about the bias of market participants, there are investors who tend to err on the side of seeing value in being earlier rather than later to a move, and there's also the flip side, investors who are willing to risk the first 25 basis points of a rally to make sure that they don't get caught with a 25 basis point selloff on the other side. It's this back and forth that we expect will define the first quarter of 2023 as the market comes to grips with the reality of the Fed's terminal signaling and the potential ramifications for the real economy both domestically and abroad.

Ben Jeffery:

And as a complete non-sequitur and a programming announcement for changes on the FOMC, we did learn that Austin Goolsbee will be replacing Charlie Evans as head of the Chicago Fed, and we wish Charlie Evans a happy retirement and look forward to welcoming the great Goolsbee on January 9th to his new post, who will be voting in 2023.

Ian Lyngen:

I'm sure he's never heard that before, but he has now.

Ben Jeffery:

In the week ahead. The treasury market has remarkably little new information from which to derive trading direction. On Monday, we do see ISM services for November. Expectations are for a 53.9 print there, and within the details we'll be looking for any indication that inflation might be slowing. The calendar on Tuesday through Thursday is effectively blank with Friday's release of PPI being the capstone for the week. Now, given the prevailing inflationary environment, PPI will be a tradable event. The uncertainty is, of course, whether or not we see a continued moderation comparable to what we saw in October or if there's an upside surprise that would, of course, rekindle conversations about the wage inflation spiral given the average hourly earnings figures from November. Let us not forget that the University of Michigan's sentiment survey is published, first look that we're going to have at December. Within the details we'll be watching for any indication that forward inflation expectations remain anchored or have drifted lower, this is an important touchstone for monetary policy makers.

Recall the evolution of Fed speak around inflation this year, at the beginning of 2022, we were in an environment in which there was very little distinction made between headline and core inflation. As we transitioned to mid-year, and we started to see some divergence begin to emerge between headline and core inflation, as headline begun to moderate, but core remained stubbornly high, we saw both the responsive market participants and monetary policy makers shift to an emphasis on core. Now, as we transition into the end of the year, this emphasis on core will persist. However, given some of the recent upside surprises in the survey based measures of inflation expectations, we are increasingly cognizant that the Fed could reframe the conversation going forward to message that inflation expectations need to move materially lower before the Fed can claim mission accomplished.

So in practical terms, this means that as realized core inflation begins to moderate, we could see the Fed be more hawkish than the actual data might imply, and it's that underlying tension that leaves us anticipating there's still more upside to be realized on two year yields, and embedded within that is the asymmetry around the risk associated with the terminal rate in 2023 and the Fed's willingness and ability to hold that rate in place into 2024 or even beyond.

Ian Lyngen:

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 in keeping with the wisdom of boy bands of yore as the economy slows and terminal approaches ain't no lie. Bye bye bye.

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:

The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

 

Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy

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