On Tee for N.F.P. - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 276, On Tee for NFP, 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 June 3rd. And with T+1 Settlement now in place for equities and corporates, we'd like to welcome other market participants into the reality that has long been in place for Treasuries, early start times, real deadlines, and no long lunches. Like they say, there's no time for fun when you're T+1.

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, without question, the most exciting thing that happened in terms of economic data was the PCE figures for the month of April. Here we saw core-PCE come in on an unrounded basis at 0.249%, which, quite frankly, was almost precisely what the market was anticipating, and as a result, it follows intuitively that there was very little specific price action tied to the event. That being said, it is worth noting that on an unrounded basis, the year-over-year core-PCE number was 2.754%, which was as close to a 2.7% without actually printing there as possible.

We'll also note that on an unrounded basis, core inflation as represented by the Fed's favorite measure, i.e., core-PCE was the lowest since March of 2021. Now, there was nothing within the details on the inflation side to suggest that the Fed would have any urgency to bring forward rate cut expectations. However, it does reinforce the notion that for all intents and purposes, a rate hike remains off the table.

One of the surprises within the PCE series was the disappointing real consumption figures that came in at -0.1% on a month-over-month basis for April. Now, this is consistent with the disappointing retail sales figures that we've recently seen, and it also demonstrates some of the mounting headwinds for the consumer. Higher and increasing prices have defined the last two years for the US economy. We are now starting to see some evidence of a flagging consumer.

While we haven't seen a dramatic drop in the pace of consumption, the gains have been smaller and smaller, and this highlights a key risk for the economic outlook, especially for an economy that is so heavily weighted toward consumption.

The week just passed also showed a somewhat disappointing print on the personal consumption side for Q1. Revisions brought the pace down to just 2.0% on a quarterly annualized basis. Again, this feeds into the growing sense that the real economy is finally starting to begin to show strains as a result of the tighter monetary policy that has been in place.

Now, it wasn't particularly surprising to see the net price action on the week was relatively subdued, although 10-year yields did back up above 4.61% for a moment before rallying back towards 4.50%. The front end of the market continues to find support with two-year yields at 5%. Anytime that the front end benchmark has backed up to 5% or anywhere close, frankly, there's a stabilizing bid that comes in.

Now, we're certainly on board with the idea that five-handle twos will not be sustainable in an environment where Fed hikes are truly off the table, which is precisely where we believe the market is at the moment. So it's with that backdrop that we continue to see a period of range trading consolidation until Friday's payrolls figures.

Vail Hartman:

The treasury market is heading into the pre-FOMC radio silence period with an understanding that policymakers largely believe inflation isn't re-accelerating as a result of April's relatively moderate pace of consumer price gains in the wake of Q1. While the recent trajectory was encouraging, one month of better data has not changed the fact that policy makers are insufficiently convinced that inflation is on a sustainable path to 2% to seriously consider lowering policy rates.

A number of talking Feds have kept the market focused on the three and six-month annualized rates of core PCE by acknowledging that inflation doesn't need to be at 2% to continue cutting rates. In this context, it was encouraging to see April's 0.249% core PCE gain bring the three-month annualized measure down from 4.4% in March to 3.5%. However, the six-month gauge climbed from 3% to a nine-month high of 3.2%. With the annualized rates still above 2%, the more recent trends in inflation still suggest additional months of inflation data are needed to conform with the 2% inflation target.

Ian Lyngen:

And that's an open debate, and in conversations that we've had, one of the most frequent questions has come to be how many months of cooler inflation data does the Fed need to see before they are sufficiently convinced that inflation is moving back toward the target? There's no obvious answer, although it goes without saying that it's more than two months and less than six. There is also the consideration of how the employment market performs in the background. If we have a spike in the unemployment rate and a drop in non-farm payrolls or a significant underperformance, the Fed could take as little as two months’ worth of cooler inflation data to justify cutting rates. On the flip side, as long as the employment market continues to demonstrate the amount of resilience we've already seen, then the Fed has plenty of runway to make sure that inflation is sufficiently anchored.

This leaves the focus on the combination of May's employment report and May's CPI data as well as the updated dot plot. By the time Powell is done with his press conference on the 12th of June, the market will have a much better understanding of whether or not the Fed intends to cut rates in September and December or simply in December. Perhaps what's more important for monetary policymakers to communicate to the market at this moment isn't necessarily the departure point for rate cuts, although we're cognizant that that is the driving force in the two-year sector at the moment, but instead, whether the market should be prepared for a series of rate cuts, let's call it at 25 basis points per quarter until rates are back to neutral, or simply a truncated series of three or four rate cuts that lessens the degree of tightening currently in place.

Ben Jeffery:

And now that we have April's core PCE data, to circle back to something you highlighted, Ian, it's not necessarily the case that the only justification the Fed needs to cut rates is continued disinflation and maintaining the progress that we've seen already in bringing consumer prices lower. And that's a function of what you touched on, Vail, in that core inflation is still so far above the 2% target that holding all else equal, there's not a compelling reason for the Fed to begin cutting solely as a function of softening inflation. Instead, we've reached the point in the cycle where the catalyst for rate cuts and the Fed's focus is increasingly shifting toward the labor market and the general strength of the consumer. Obviously, payrolls are the data highlight of the upcoming week, but remember, we got softer personal spending data, April's retail sales figures were notably weak, and last month's jobs report was lackluster as well.

And so given that the trajectory of the inflation data has cemented the idea that another rate hike is currently off the table, it's going to be up to some more material softening in terms of the labor market data to justify a rate cut. Now, given the departure point of an unemployment rate that is still very, very low, does that justify a cut in September? I think there's a lot of labor market data to be revealed between now and then before having a truly high conviction take on that particular meeting. But nonetheless, we've started to see enough of an inflection in some of the more important economic indicators that a rate cut at some point this year should still be a reasonable base case. It is for us, and for now, it is for the Fed.

Ian Lyngen:

We also heard from Bostic in the week just passed, and he has historically been one of the more hawkish voters on the FOMC. Even his base case includes a Q4 rate cut. So if in fact the hawks are openly discussing a rate cut, the assumption then should be that two rate cuts is part of the broader discussion on the committee.

It's also notable that market conversations around a September rate cut being off the table simply because of the proximity to the election have lessened significantly. Generally speaking, market participants are viewing the fact that the Fed has started the discussion already about normalizing rates really does sufficiently separate it from the presidential election process at least enough to give the committee the flexibility to cut in September, if as, you point out, Ben, we do have enough data to justify the move.

Vail Hartman:

And on the hawkish end of the continuum, while the Fed's baseline for the next rate move appears to be downward, it is notable that some of the hawks have acknowledged a non-zero probability of a rate hike. Specifically, this week we heard from Minneapolis Fed President, Kashkari, who said that he doesn't think anybody has totally taken rate increases off the table. And he went on to say that the odds of the committee raising rates are quite low, but he doesn't want to take anything off the table. Kashkari's low odds comment resonates with Powell's comment at the post-FOMC press conference that a rate hike moving forward is unlikely.

Ben Jeffery:

And to overlay this conversation on the price action we saw this week, specifically in treasuries, it was telling, I would argue, as to the market's current positioning to see the week begin with a very dramatic selloff across the curve that got two-year yields back up to that 5% level and 10-year yields to nearly 4.65%, but the lack of any obvious fundamental driver behind that move, aside from the impact of this week's treasury auctions, that all required a greater concession and some decent tails for twos, fives, and sevens reinforces this dynamic that with each passing month that we see data which is broadly conforming with the FOMC's assumption of a slowing growth profile, softening labor market, and moderating inflation, that represents another month closer to a rate cut and another month closer to what was generally expected to be the game plan for trading Treasuries this year, namely the curve starting to bull steepen as a rate cut approached.

Here, I'll emphasize the bullish rather than the steepening aspect of that trade, and what it means for investors' behaviors going forward in terms of their willingness to step in and buy. In April, that threshold was clearly above 4.7, where we saw rates top out before more buying interest emerged, and in May it appeared that level was 4.63. So now that the market has successfully made it through another month of 2024 where everything is starting to go more according to plan, that means that going forward, for those investors that were first waiting for 5% 10-year yields to reengage long positions and then missed the sell-off, and then were waiting for 4.9% 10-year yields and then missed that opportunity again.

Presumably, the eagerness to buy dips over the balance of this year is going to be greater, barring a material surprise in terms of the economic data or something shockingly new from the Fed in terms of a reaction function to where the economy currently stands. So that means that a 4.75% buy target is probably now more likely to be a 4.65% or 4.70% buy target. And in the event the May payrolls report shows any more signs of a deteriorating labor market situation, it's reasonable to assume those buy targets are going to be dropped to lower yields once again, if not viewed as a green light to capture rates that are still very elevated in any historical context over the last 20 years.

Ian Lyngen:

And it's interesting that on the flip side, we haven't seen a corresponding decrease in sell targets. We have seen a market that's become comfortable with allowing 10-year yields to dip below 450, but not significantly. We haven't retested 425 in a while, and instead what we've seen is a narrowing of the range with the upper bound for rates moving lower and lower and lower. Traditionally, this has been a setup for a more significant breakout. In this case, it would be a breakout in favor of lower rates. And as we think about potential fundamental triggers, they're obvious, the economic data, the Fed, and of course, the performance of risk assets, which have managed a remarkably good run so far in 2024.

Ben Jeffery:

And on the topic of risk asset performance, stocks specifically, we saw a buyback of another variety this week for the first time from the Treasury department as the first buyback operation, which was announced at the mayoral funding announcement took place with relatively little fanfare in the very front end of the curve out to the two-year sector as Yellen retired $2 billion worth of less liquid securities.

As the details of the buyback program were formed and the mechanics of it were discussed, it was interesting to see, in the first operation at least, that the vast majority of the buying took place, not in the cheapest bonds in the sector as one would assume would be the case had it been a QE operation, but instead it was one of the richer securities that the Treasury department stepped up and purchased during their first foray into liquidity support. And we see a little reason that this will change at the weekly operations going forward, spread across various tenors, given that in terms of liquidity support, liquidity can be found for those looking to buy cheap bonds. It's finding someone to buy the rich bonds that is the challenging part, clearly something that the Treasury department has recognized and something to keep in mind as we watch the results of the buyback program going forward.

Ian Lyngen:

So the takeaway from Yellen's program is that the rich get cheaper and the cheap get richer.

Ben Jeffery:

Yeah, something like that.

Ian Lyngen:

In the week ahead, the Treasury market's focus will be appropriately on the May non-farm payrolls figures. Headline expectations are for 180,000 jobs to have been created in the month of May with the unemployment rate at 3.9%. We'll be watching very closely the average hourly earnings figures, which are seen printing at 0.3%. Certainly not flat or negative, but well off of the peak seen during the pandemic.

In the run-up to the jobs report, we'll have the typical anecdotes, the JOLTS data, which is for April, but nonetheless, the Fed's focus on the quits rate in particular will leave Tuesday morning's JOLTS release as a tradable event to be sure.

We also have ADP on Wednesday morning, Challenger, Thursday morning, as well as Thursday morning's initial jobless claims release. In addition, investors will benefit from the two ISM reports, Monday sees Manufacturing, which is expected to print slightly below 50, and Wednesday sees services, which is anticipated to come in at 50.5.

On net, we're anticipating that the market will be comfortable absorbing these releases while maintaining the prevailing trading range, particularly in 2s and 10s before Friday's number. Now, Friday's number will offer either evidence that the employment market remains resilient or challenge this assumption. The latter scenario would only reinforce some of the weakness already seen in the trajectory of consumption and provided impetus for buying duration.

The caveat that we'll add in this context is it's difficult to overstate the importance of June 12th in the Treasury market. Not only do we hear from the Fed, and Powell's press conference, but we also have the May CPI data. And within that series, core services ex-shelter will be the focal point for monetary policymakers, if not for the market as a whole.

In addition, the FOMC will publish an updated dotplot. There is an active debate about whether or not the Fed chooses to signal 50 basis points or 25 basis points worth of rate cuts during the balance of 2024. All else being equal, 50 basis points at the moment appears to be the path of least resistance, although investors currently haven't seen the May payrolls or CPI numbers.

So in short, we anticipate that specific expectations for the SEP and the dotplot will be contingent on the trajectory of the real economy in May. From a medium-term perspective, we continue to like Treasuries and expect that over the course of the next several months, 10- and 30-year yields will drift a bit lower. Our year-end forecast for 10-year yields remains at 3.95% as it has throughout the year.

Now, that isn't necessarily predicated on a significant slowdown in the real economy. Rather, it's a combination of the fact that the Fed is about to commence a rate-cutting cycle, and as the data unfolds on the inflation side, we expect break-evens will drift lower, which in turn will compress nominal rates.

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 a second Treasury buyback on Wednesday, all we can say is that it's nice to see tax dollars being invested into a recycling program.

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 1:

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