
One Down, 207 to Go - Macro Horizons
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Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of January 27th, 2025, and respond to questions submitted by listeners and clients.
Follow us on Apple Podcasts, Stitcher and Spotify or your preferred podcast provider.
About Macro Horizons
BMO Strategists discuss the week ahead in the U.S. rates market delivering relevant and insightful commentary to help investors navigate the ever-changing global market landscape.
Ian Lyngen:
This is Macro Horizons, episode 308: ‘One Down, 207 to Go’ 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 January 27th. And as the market continues to digest Trump's first week back in the White House and we can see the end of January and all that implies, it strikes us that this would be a good time for a Diet Cola. Now where is that button?
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.
The week just passed had a lot of exciting headlines coming out of the White House. Trump re-entered the White House on Monday and we have since learned that he intends to increase tariffs on Mexico and Canada by 25% with a target implementation date of potentially the 1st of February. Similarly, Trump has announced his intention to increase tariffs on Chinese goods by an additional 10% – also targeting an early February implementation. Tariffs on European goods are also seeing increasing, although the details on that front have yet to be fully revealed. The most interesting aspect of what Trump has done thus far is not so much that he's followed through on some of his campaign promises, but rather the response in the Treasury market. What we have seen is we have seen duration rally with 10-year yields getting almost to that 4.50% level.
The price action further in the curve has been comparatively more subdued with the two-year sector underperforming. Now, this isn't to suggest that two-year yields remain completely tethered to the 4.33% effective Fed funds rate, but rather it was difficult for the front end to rally at this particular leg of the repricing. Overall, we'd characterize what has occurred as the market pricing in an even more dramatic outcome on the trade war front than what was ultimately delivered. Said differently, we spent much of the last several months pricing in the go-to Trump trade, which was a bear steepener. Upon the realization of Trump's initial trade overtures, we've seen a reversal which has simply translated into a bull flattening. Now the biggest debate at the moment is how long can that run? Can we get 10-year yields back to 4.25% based on an unwind of trade-related angst? That seems doubtful. Instead, what we expect will emerge is a new range for the longer end of the curve with 10-year yields hovering between 4.50% and 4.65%. The front end however, we do see further scope for a rally with the two-year sector able to drift below 4% as the Fed next week, we presume, makes it clear in the press conference that Powell still intends to lower rates in 2025. And while the uncertainty associated with the trade war has led to a momentary pause on the path towards normalization, at the end of the day, the Fed will likely cut at least two more quarter points between now and the end of the year.
We have those penciled in for June and December, particularly if the administration errs on the side of a more measured implementation of tariffs and that would be both a less dramatic magnitude than has already been announced and a later implementation, i.e. after April 1st. While we suspect that risk assets in the Treasury market would ultimately take solace from a more measured implementation, such an outcome would keep uncertainty in play in the very near term and it's that uncertainty that we expect will prevent the Fed from cutting in January and also if it persists through March, will lead the Fed to err on the side of skipping March as well until the full details of Trump's efforts to recast the world trade stage are fully known and can be incorporated into the Fed's SEP and dotplot.
Ben Jeffery:
It was a short week with a new president and with the economic calendar light ahead of next week's FOMC meeting, the first look at Q4 GDP and December's core PCE print, the market was left largely beholden to headlines coming out of Washington as President Trump has officially taken office and already started the process of deploying tariff rhetoric with everything that means for growth and inflation assumptions in the US economy. Although at this stage even just a few days in, we'll argue that the market's incremental sensitivity to the next tariff headline is already on the decline and instead it will need to be actual policy action that determines whether or not tariffs, in and of themselves, are enough to break 10-year yields from what's become an increasingly well-entrenched range between, call it, 4.5 and 4.8%.
Ian Lyngen:
Well, it was a very interesting setup for Trump's first week. The market came into the week on the heels of a below anticipated core-CPI print, which all else being equal, would've cleared the path for the Fed to cut rates in March. Now, January is clearly going to be a pause and at present, the market is pricing in less than a 25% probability that the Fed cuts in March. Frankly, these are odds that we're comfortable with given all of the uncertainty posed by Trump's initial headlines, at least associated with his attempts to recast the global trade stage. Now, the initial 25% tariffs floated on Canada and Mexico were arguably a bit higher than the market was anticipating, although China at 10% tariffs was a market undershoot versus his 60% rhetoric from the campaign trail.
Now, Trump also did signal that he'll be increasing tariffs on EU imports as well although the details are yet to follow. At this stage, there are two primary questions that the market is grappling with. First, whether these tariffs are implemented on the 1st of February as Trump hinted or as the broader trade review report isn't due until April 1st, there's an argument to be made that levies won't increase until then. The second debate is whether or not new tariffs will be gradually increased over the course of the year or if the increases will be a one-time price adjustment. From a political perspective, we're certainly sympathetic to the argument to gradually increase tariffs to avoid voters seeing a sticker shock as prices adjust. On the flip side, however, a gradual increase over the course of a couple quarters or even potentially throughout the balance of 2025 would certainly complicate the Fed's efforts of gauging the extent to which it should slow the normalization process.
PAUSE
The market is currently pricing in roughly 30 basis points of rate cuts between now and the end of the year. We think that that is undershooting what the Fed will ultimately deliver, although the market seems content to wait until March when the FOMC will update the SEP to really push that trade, at least at the moment. We've seen a reasonable performance of the front end of the curve, although the price action in the week just passed was a net flattener. We are characterizing this as nothing more than a modest reversal of the Trump trade. The Trump trade throughout the last couple months has been a bear steepener. Given the fact that the trade headlines haven't been so dramatic, the fact that we would have a bull flattener certainly resonates in that context.
Ben Jeffery:
And on the issue of larger tariffs on a one-off basis or a gradual increase over the course of the next few quarters or even the next year, it's also worth considering the consumer's departure point to withstand the impact of higher prices that are a function of higher import taxes. During Trump's first administration, obviously the economy was in a much different place than it is now. The Fed was actively in the process of raising rates as the first trade war kicked off, and so the flattening of the curve in that instance was principally driven by the fact that the Fed was in the process of tightening policy to last cycle’s terminal rate, which led to front end underperformance as the growth outlook dimmed as a function of tighter monetary policy, but also the impact of tariffs. The long end benefited on a comparative basis and that was the trigger to that impressive curve flattening we saw during the last economic cycle.
Fast-forward to the current environment and even after the dramatic repricing we've seen in terms of Fed expectations and the pricing thereof in the front end of the market, Powell is maintaining an easing bias and we've even heard from the likes of Governor Waller that he still sees a case for three or four rate cuts this year. With that monetary policy backdrop, we still have the latest evidence of the state of the labor market via the upside surprise in NFP and strong look at the unemployment rate with everything that means for wage gains and household balance sheets. And it's not unreasonable to assume that while tariffs might be growth negative, consumers are in at least a decent place to absorb the potential shock relating to potentially higher prices.
Ian Lyngen:
It is interesting that while the departure point for the consumer and the real economy is, as you point out Ben, relatively strong footing, it's not quite as obvious that the consumer will be willing to, perhaps they're able to, but will be willing to absorb a fresh round of higher prices. Certainly nothing comparable to what we saw in 2022 and 2023. Recall that in the most recent episode of decades-high realized inflation, consumers were afforded the opportunity to refinance mortgages at extremely low levels. That allowed households, as well as corporations, to lock in low borrowing costs that then created a cushion to absorb some of the inflation that worked through the system.
In the current environment, prices are already high. It's not as though prices have gone down, even though the rate of inflation has decreased and therefore a fresh round of reflationary angst might not meet the same reception on the household level. Now obviously some price increases will simply be passed through. However, there's also an argument to be made that it doesn't have to be the end user that pays for all the price increases. Profit compression, both from the perspective of the importer as well as profit compression from the exporter, should all be on the table as potential fallout. And as you pointed out, Ben, that means that there could be growth negative certainly from a global perspective implication from Trump's new efforts on the tariff front.
When we think about the details of the data, we're cognizant that headline CPI is certainly biased to outperform as is core-CPI. However, the Fed's favored supercore measure is a wild card, because goods inflation increasing will not immediately translate through to core services ex-OER and rent. There are some pass-throughs – insurance premiums, for example, particularly in the auto sector are an obvious touchstone for potential pass-through, but that won't be immediate and instead what will most likely occur is there'll be a divergence between realized headline inflation and the super core measure, and that will complicate the Fed's job if nothing else.
Ben Jeffery:
And as we evaluate what this all means for the path of Treasuries, there's another variable to consider and that is the performance of risk assets. And despite rates settling in at this new higher plateau, it seems that equities are undeterred. We obviously had some high profile earnings reports this week and equities, as a whole, continue to grind higher despite 10-year yields north of 4.50% and even with the backdrop of Trump's tariff threats. Now the implications for the wealth effect obviously tie through to the surrounding higher wages and what it means for the household outlook. But in addition to that, there's also the easing implication on financial conditions that's associated with equities that continue to rally and with credit spreads that continue to be bought on any widening as was exemplified by the pullback we saw around issuance to start the year. So no shortage of risk appetite is having the benefit of keeping financial conditions easy, which is in turn doing some of Powell's work for him.
After all, if financial conditions are easing, then there's not really a need for the Fed to cut in the near term. And frankly, it's this paradigm that we expect is going to continue for at least the next several months. Although in keeping with our longer term constructive take on Treasuries and expectation that the curve is going to continue its steepening push, there will eventually come a point when rates at these levels, the impact of tariffs, and the overall uncertainties surrounding the state of the expansion will bring in more material buying interest and likely inspire a more significant tone shift on the FOMC, but clearly, we're not there yet.
Ian Lyngen:
It is an interesting observation that you make regarding the performance of equities and risk assets more broadly. In an environment where the argument was being made that lower rates and a less restrictive monetary policy was the driver for record high equity prices, we've now reversed both of those influences. With just 30 basis points worth of cuts this year priced in, that's a meaningful downshift from what the market was expecting as recently as October of last year, and with 10-year yields hovering above 4.50% and mortgage rates close to 7%, our take is that once the Fed finally does resume normalization, there might still be upside to be realized, at least in domestic equities.
Ben Jeffery:
And it's not just bigger picture policy and market developments in the long end of the curve that has taken the market's attention this week, but the Treasury Department has also enacted extraordinary measures as this round of the debt ceiling debate gets underway. Now, the X Date in this particular episode isn't expected to really approach until May at the earliest, but nonetheless, the Treasury Department has started the process of amending its bill issuance schedule and the drawdown of the TGA as the new Congress and executive branch start the negotiation process of either raising or suspending the debt limit. Now, it's early enough in the process that we're not really starting to see any distortions in the bill market or funding rates, but as we move closer to a potential drop dead date, and despite the Republican sweep, given the realities of the political division even within the GOP, we're skeptical that a swift and timely resolution to the debt ceiling is going to define this particular episode.
Sure, maybe we don't make it quite to the eleventh hour before an accord is reached, but there will likely at least be some implications either in bills maturing around the potential day of a delayed payment or in terms of capital leaving the TGA and flowing into other parts of the market. And while this is not going to dictate where 10-year yields trade in the coming week, as we evaluate the FOMC decision, it is important to keep in mind that the process of negotiating the debt ceiling is underway and we will all have the privilege to discuss ‘what if…’ for at least the next few months.
Ian Lyngen:
Having gone through the debt ceiling debate, the potential for a downgrade, or a missed payment several times over the course of our career, one of our favorite semantic nuances, let's call it, of the process is how cutting back ancillary treasury issuance is extraordinary. It implies that it's a good thing. That would be like me saying, "Hey Ben, you're extraordinary," and it being negative.
Ben Jeffery:
And you, Ian, are extraordinary.
Ian Lyngen:
Don't I know it?
In the week ahead there are a few key macro events that are of relevance, the biggest of which is obviously Wednesday's FOMC rate decision. Our expectations are for no change in policy rates and frankly, we don't see any particularly compelling reason to anticipate that the statement itself is materially altered. Within the press conference however, we expect that Powell will re-emphasize the notion that the Fed is still on the path towards lowering rates and so on net this will likely be interpreted as a dovish pause.
A dovish pause is certainly in keeping with the most recent Fed SEP, which showed that the committee continues to expect to cut at least two more times by 25 basis points each this year, but members acknowledge the uncertainty created in terms of global trade with Trump retaking the White House. Now that we have Trump's initial tariff estimates, which frankly the market appears content to interpret as the upper bound for what could ultimately be realized, it will be very interesting to see the degree to which Powell is comfortable moving the conversation forward and beyond the tariff figures and focusing on the recent cooling of core-CPI as well as supercore CPI. The week ahead also contains three Treasury auctions of note, which have been weighted earlier in the week to account for not only the FOMC on Wednesday, but also month-end on Friday, creating that buffer settlement day.
There's $69 billion two-year notes on Monday in the morning, followed by $70 billion 5-years in the afternoon, then on Tuesday, the $44 billion seven-year auction hits in the afternoon, and that will take care of all of the nominal supply for the month of January. On the data front, the market also gets the first look at Q4 real GDP. Expectations there are for a 2.6% quarterly annualized gain, which represents a solid pace by any measure, and caps out a impressive performance of the real economy in 2024.
We also see the December core-PCE numbers, which are forecast to print at 0.2, but a low 0.2, and that would be in keeping with the Fed's 2% inflation target. We also see Q4's employment cost index, which is currently seen at a positive 1%. All of the economic data and monetary policy events occur with a backdrop of a market that remains diligent on the headline front as Trump continues to announce some of his initial policy changes and investors are very much in the mode of reacting to these changes, incorporating them into forward expectations and moving on to what could change next. This is very reminiscent of Trump's first four years in office. And while the social media platforms might have changed, investors remain wary of after-hour posts and the implications for the market either during the overnight session or very early in the following trading day.
It's certainly too early to have a concrete forecast on the implications for realized inflation as well as the trajectory of overall global growth, but for the time being, we are erring on the side of anticipating that the impact on realized prices is distinct and contained, if not muted, but it will ultimately serve as a tax on consumption and undermine performance of the real economy, both globally and to some extent in the US, all of which reinforces our medium-term bullishness on the Treasury market, and we continue to anticipate that by the end of the year, the market will be far more comfortable with 4% Treasury yields than with 5% or even five and a half.
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. While technically the days have been getting longer since December 21st, apparently no one communicated that to the falling mercury. Although for context, temperatures reached 43 degrees in Davos this week. Not that we would know.
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.

One Down, 207 to Go - Macro Horizons
Managing Director, Head of U.S. Rates Strategy
Ian is a Managing Director and Head of U.S. Rates Strategy in the BMO Capital Markets Fixed Income Strategy team. His primary focus is the U.S. Treasury market with…
US Rates Strategist, Fixed Income Strategy
Ben Jeffery is a Strategist on the U.S. Rates Strategy Team at BMO Capital Markets. He focuses on fixed income investment strategy, specifically on interest ra…
Ian is a Managing Director and Head of U.S. Rates Strategy in the BMO Capital Markets Fixed Income Strategy team. His primary focus is the U.S. Treasury market with…
VIEW FULL PROFILEBen Jeffery is a Strategist on the U.S. Rates Strategy Team at BMO Capital Markets. He focuses on fixed income investment strategy, specifically on interest ra…
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Ian Lyngen and Ben Jeffery bring you their thoughts on the U.S. Rates market for the upcoming week of January 27th, 2025, and respond to questions submitted by listeners and clients.
Follow us on Apple Podcasts, Stitcher and Spotify or your preferred podcast provider.
About Macro Horizons
BMO Strategists discuss the week ahead in the U.S. rates market delivering relevant and insightful commentary to help investors navigate the ever-changing global market landscape.
Ian Lyngen:
This is Macro Horizons, episode 308: ‘One Down, 207 to Go’ 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 January 27th. And as the market continues to digest Trump's first week back in the White House and we can see the end of January and all that implies, it strikes us that this would be a good time for a Diet Cola. Now where is that button?
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.
The week just passed had a lot of exciting headlines coming out of the White House. Trump re-entered the White House on Monday and we have since learned that he intends to increase tariffs on Mexico and Canada by 25% with a target implementation date of potentially the 1st of February. Similarly, Trump has announced his intention to increase tariffs on Chinese goods by an additional 10% – also targeting an early February implementation. Tariffs on European goods are also seeing increasing, although the details on that front have yet to be fully revealed. The most interesting aspect of what Trump has done thus far is not so much that he's followed through on some of his campaign promises, but rather the response in the Treasury market. What we have seen is we have seen duration rally with 10-year yields getting almost to that 4.50% level.
The price action further in the curve has been comparatively more subdued with the two-year sector underperforming. Now, this isn't to suggest that two-year yields remain completely tethered to the 4.33% effective Fed funds rate, but rather it was difficult for the front end to rally at this particular leg of the repricing. Overall, we'd characterize what has occurred as the market pricing in an even more dramatic outcome on the trade war front than what was ultimately delivered. Said differently, we spent much of the last several months pricing in the go-to Trump trade, which was a bear steepener. Upon the realization of Trump's initial trade overtures, we've seen a reversal which has simply translated into a bull flattening. Now the biggest debate at the moment is how long can that run? Can we get 10-year yields back to 4.25% based on an unwind of trade-related angst? That seems doubtful. Instead, what we expect will emerge is a new range for the longer end of the curve with 10-year yields hovering between 4.50% and 4.65%. The front end however, we do see further scope for a rally with the two-year sector able to drift below 4% as the Fed next week, we presume, makes it clear in the press conference that Powell still intends to lower rates in 2025. And while the uncertainty associated with the trade war has led to a momentary pause on the path towards normalization, at the end of the day, the Fed will likely cut at least two more quarter points between now and the end of the year.
We have those penciled in for June and December, particularly if the administration errs on the side of a more measured implementation of tariffs and that would be both a less dramatic magnitude than has already been announced and a later implementation, i.e. after April 1st. While we suspect that risk assets in the Treasury market would ultimately take solace from a more measured implementation, such an outcome would keep uncertainty in play in the very near term and it's that uncertainty that we expect will prevent the Fed from cutting in January and also if it persists through March, will lead the Fed to err on the side of skipping March as well until the full details of Trump's efforts to recast the world trade stage are fully known and can be incorporated into the Fed's SEP and dotplot.
Ben Jeffery:
It was a short week with a new president and with the economic calendar light ahead of next week's FOMC meeting, the first look at Q4 GDP and December's core PCE print, the market was left largely beholden to headlines coming out of Washington as President Trump has officially taken office and already started the process of deploying tariff rhetoric with everything that means for growth and inflation assumptions in the US economy. Although at this stage even just a few days in, we'll argue that the market's incremental sensitivity to the next tariff headline is already on the decline and instead it will need to be actual policy action that determines whether or not tariffs, in and of themselves, are enough to break 10-year yields from what's become an increasingly well-entrenched range between, call it, 4.5 and 4.8%.
Ian Lyngen:
Well, it was a very interesting setup for Trump's first week. The market came into the week on the heels of a below anticipated core-CPI print, which all else being equal, would've cleared the path for the Fed to cut rates in March. Now, January is clearly going to be a pause and at present, the market is pricing in less than a 25% probability that the Fed cuts in March. Frankly, these are odds that we're comfortable with given all of the uncertainty posed by Trump's initial headlines, at least associated with his attempts to recast the global trade stage. Now, the initial 25% tariffs floated on Canada and Mexico were arguably a bit higher than the market was anticipating, although China at 10% tariffs was a market undershoot versus his 60% rhetoric from the campaign trail.
Now, Trump also did signal that he'll be increasing tariffs on EU imports as well although the details are yet to follow. At this stage, there are two primary questions that the market is grappling with. First, whether these tariffs are implemented on the 1st of February as Trump hinted or as the broader trade review report isn't due until April 1st, there's an argument to be made that levies won't increase until then. The second debate is whether or not new tariffs will be gradually increased over the course of the year or if the increases will be a one-time price adjustment. From a political perspective, we're certainly sympathetic to the argument to gradually increase tariffs to avoid voters seeing a sticker shock as prices adjust. On the flip side, however, a gradual increase over the course of a couple quarters or even potentially throughout the balance of 2025 would certainly complicate the Fed's efforts of gauging the extent to which it should slow the normalization process.
PAUSE
The market is currently pricing in roughly 30 basis points of rate cuts between now and the end of the year. We think that that is undershooting what the Fed will ultimately deliver, although the market seems content to wait until March when the FOMC will update the SEP to really push that trade, at least at the moment. We've seen a reasonable performance of the front end of the curve, although the price action in the week just passed was a net flattener. We are characterizing this as nothing more than a modest reversal of the Trump trade. The Trump trade throughout the last couple months has been a bear steepener. Given the fact that the trade headlines haven't been so dramatic, the fact that we would have a bull flattener certainly resonates in that context.
Ben Jeffery:
And on the issue of larger tariffs on a one-off basis or a gradual increase over the course of the next few quarters or even the next year, it's also worth considering the consumer's departure point to withstand the impact of higher prices that are a function of higher import taxes. During Trump's first administration, obviously the economy was in a much different place than it is now. The Fed was actively in the process of raising rates as the first trade war kicked off, and so the flattening of the curve in that instance was principally driven by the fact that the Fed was in the process of tightening policy to last cycle’s terminal rate, which led to front end underperformance as the growth outlook dimmed as a function of tighter monetary policy, but also the impact of tariffs. The long end benefited on a comparative basis and that was the trigger to that impressive curve flattening we saw during the last economic cycle.
Fast-forward to the current environment and even after the dramatic repricing we've seen in terms of Fed expectations and the pricing thereof in the front end of the market, Powell is maintaining an easing bias and we've even heard from the likes of Governor Waller that he still sees a case for three or four rate cuts this year. With that monetary policy backdrop, we still have the latest evidence of the state of the labor market via the upside surprise in NFP and strong look at the unemployment rate with everything that means for wage gains and household balance sheets. And it's not unreasonable to assume that while tariffs might be growth negative, consumers are in at least a decent place to absorb the potential shock relating to potentially higher prices.
Ian Lyngen:
It is interesting that while the departure point for the consumer and the real economy is, as you point out Ben, relatively strong footing, it's not quite as obvious that the consumer will be willing to, perhaps they're able to, but will be willing to absorb a fresh round of higher prices. Certainly nothing comparable to what we saw in 2022 and 2023. Recall that in the most recent episode of decades-high realized inflation, consumers were afforded the opportunity to refinance mortgages at extremely low levels. That allowed households, as well as corporations, to lock in low borrowing costs that then created a cushion to absorb some of the inflation that worked through the system.
In the current environment, prices are already high. It's not as though prices have gone down, even though the rate of inflation has decreased and therefore a fresh round of reflationary angst might not meet the same reception on the household level. Now obviously some price increases will simply be passed through. However, there's also an argument to be made that it doesn't have to be the end user that pays for all the price increases. Profit compression, both from the perspective of the importer as well as profit compression from the exporter, should all be on the table as potential fallout. And as you pointed out, Ben, that means that there could be growth negative certainly from a global perspective implication from Trump's new efforts on the tariff front.
When we think about the details of the data, we're cognizant that headline CPI is certainly biased to outperform as is core-CPI. However, the Fed's favored supercore measure is a wild card, because goods inflation increasing will not immediately translate through to core services ex-OER and rent. There are some pass-throughs – insurance premiums, for example, particularly in the auto sector are an obvious touchstone for potential pass-through, but that won't be immediate and instead what will most likely occur is there'll be a divergence between realized headline inflation and the super core measure, and that will complicate the Fed's job if nothing else.
Ben Jeffery:
And as we evaluate what this all means for the path of Treasuries, there's another variable to consider and that is the performance of risk assets. And despite rates settling in at this new higher plateau, it seems that equities are undeterred. We obviously had some high profile earnings reports this week and equities, as a whole, continue to grind higher despite 10-year yields north of 4.50% and even with the backdrop of Trump's tariff threats. Now the implications for the wealth effect obviously tie through to the surrounding higher wages and what it means for the household outlook. But in addition to that, there's also the easing implication on financial conditions that's associated with equities that continue to rally and with credit spreads that continue to be bought on any widening as was exemplified by the pullback we saw around issuance to start the year. So no shortage of risk appetite is having the benefit of keeping financial conditions easy, which is in turn doing some of Powell's work for him.
After all, if financial conditions are easing, then there's not really a need for the Fed to cut in the near term. And frankly, it's this paradigm that we expect is going to continue for at least the next several months. Although in keeping with our longer term constructive take on Treasuries and expectation that the curve is going to continue its steepening push, there will eventually come a point when rates at these levels, the impact of tariffs, and the overall uncertainties surrounding the state of the expansion will bring in more material buying interest and likely inspire a more significant tone shift on the FOMC, but clearly, we're not there yet.
Ian Lyngen:
It is an interesting observation that you make regarding the performance of equities and risk assets more broadly. In an environment where the argument was being made that lower rates and a less restrictive monetary policy was the driver for record high equity prices, we've now reversed both of those influences. With just 30 basis points worth of cuts this year priced in, that's a meaningful downshift from what the market was expecting as recently as October of last year, and with 10-year yields hovering above 4.50% and mortgage rates close to 7%, our take is that once the Fed finally does resume normalization, there might still be upside to be realized, at least in domestic equities.
Ben Jeffery:
And it's not just bigger picture policy and market developments in the long end of the curve that has taken the market's attention this week, but the Treasury Department has also enacted extraordinary measures as this round of the debt ceiling debate gets underway. Now, the X Date in this particular episode isn't expected to really approach until May at the earliest, but nonetheless, the Treasury Department has started the process of amending its bill issuance schedule and the drawdown of the TGA as the new Congress and executive branch start the negotiation process of either raising or suspending the debt limit. Now, it's early enough in the process that we're not really starting to see any distortions in the bill market or funding rates, but as we move closer to a potential drop dead date, and despite the Republican sweep, given the realities of the political division even within the GOP, we're skeptical that a swift and timely resolution to the debt ceiling is going to define this particular episode.
Sure, maybe we don't make it quite to the eleventh hour before an accord is reached, but there will likely at least be some implications either in bills maturing around the potential day of a delayed payment or in terms of capital leaving the TGA and flowing into other parts of the market. And while this is not going to dictate where 10-year yields trade in the coming week, as we evaluate the FOMC decision, it is important to keep in mind that the process of negotiating the debt ceiling is underway and we will all have the privilege to discuss ‘what if…’ for at least the next few months.
Ian Lyngen:
Having gone through the debt ceiling debate, the potential for a downgrade, or a missed payment several times over the course of our career, one of our favorite semantic nuances, let's call it, of the process is how cutting back ancillary treasury issuance is extraordinary. It implies that it's a good thing. That would be like me saying, "Hey Ben, you're extraordinary," and it being negative.
Ben Jeffery:
And you, Ian, are extraordinary.
Ian Lyngen:
Don't I know it?
In the week ahead there are a few key macro events that are of relevance, the biggest of which is obviously Wednesday's FOMC rate decision. Our expectations are for no change in policy rates and frankly, we don't see any particularly compelling reason to anticipate that the statement itself is materially altered. Within the press conference however, we expect that Powell will re-emphasize the notion that the Fed is still on the path towards lowering rates and so on net this will likely be interpreted as a dovish pause.
A dovish pause is certainly in keeping with the most recent Fed SEP, which showed that the committee continues to expect to cut at least two more times by 25 basis points each this year, but members acknowledge the uncertainty created in terms of global trade with Trump retaking the White House. Now that we have Trump's initial tariff estimates, which frankly the market appears content to interpret as the upper bound for what could ultimately be realized, it will be very interesting to see the degree to which Powell is comfortable moving the conversation forward and beyond the tariff figures and focusing on the recent cooling of core-CPI as well as supercore CPI. The week ahead also contains three Treasury auctions of note, which have been weighted earlier in the week to account for not only the FOMC on Wednesday, but also month-end on Friday, creating that buffer settlement day.
There's $69 billion two-year notes on Monday in the morning, followed by $70 billion 5-years in the afternoon, then on Tuesday, the $44 billion seven-year auction hits in the afternoon, and that will take care of all of the nominal supply for the month of January. On the data front, the market also gets the first look at Q4 real GDP. Expectations there are for a 2.6% quarterly annualized gain, which represents a solid pace by any measure, and caps out a impressive performance of the real economy in 2024.
We also see the December core-PCE numbers, which are forecast to print at 0.2, but a low 0.2, and that would be in keeping with the Fed's 2% inflation target. We also see Q4's employment cost index, which is currently seen at a positive 1%. All of the economic data and monetary policy events occur with a backdrop of a market that remains diligent on the headline front as Trump continues to announce some of his initial policy changes and investors are very much in the mode of reacting to these changes, incorporating them into forward expectations and moving on to what could change next. This is very reminiscent of Trump's first four years in office. And while the social media platforms might have changed, investors remain wary of after-hour posts and the implications for the market either during the overnight session or very early in the following trading day.
It's certainly too early to have a concrete forecast on the implications for realized inflation as well as the trajectory of overall global growth, but for the time being, we are erring on the side of anticipating that the impact on realized prices is distinct and contained, if not muted, but it will ultimately serve as a tax on consumption and undermine performance of the real economy, both globally and to some extent in the US, all of which reinforces our medium-term bullishness on the Treasury market, and we continue to anticipate that by the end of the year, the market will be far more comfortable with 4% Treasury yields than with 5% or even five and a half.
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. While technically the days have been getting longer since December 21st, apparently no one communicated that to the falling mercury. Although for context, temperatures reached 43 degrees in Davos this week. Not that we would know.
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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