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Out Like a Bull - Macro Horizons

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FICC Podcasts Podcasts December 21, 2023
FICC Podcasts Podcasts December 21, 2023
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Ian Lyngen, Ben Jeffery, and Vail Hartman bring you their thoughts on the U.S. Rates market for the upcoming week of December 26th, 2023, and respond to questions submitted by listeners and clients.


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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.

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Ian Lyngen:

This is Macro Horizons, episode 254, Out Like a Bull, 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 December 26th. And as our final podcast of the year, we'd like to wish everyone a happy holiday, and remember, kindness doesn't cost anything, and eggnog solves a lot of problems.

Each week, we offer an updated view on the US rates market and a bad joke or two, but more importantly, the show is centered on responding directly to questions submitted by listeners and clients. We also end each show with our musings on the week ahead. Please feel free to reach out on Bloomberg, or email me at ian.lyngen@bmo.com with questions for future episodes. We value your input, and hope to keep the show as interactive as possible. So that being said, let's get started.

In the week just passed, the Fed attempted to walk back the dovish interpretation of Powell's press conference, but if there was any takeaway from the week, it is that the bond bullish implications remain. 10-year yields managed to leak a little bit lower, the 2s/10s curve is anchored at negative 50 basis points, and while there was some choppy price action around certain data events, at the end of the day, it's clear that the Fed has started the conversation about cutting rates in 2024, and that's going to guide US rates for the foreseeable future.

Now, clearly, the commentary from the Fed suggests that the Fed's thinking on the timing of rate cuts is not what's being reflected in the Treasury market at the moment. This notion that the Fed funds futures market is a bit ahead of itself was reiterated by several Fed speakers. Nonetheless, we're certainly cognizant that while the Fed might not believe it's going to be cutting in the first quarter, the market has a much higher degree of confidence. We're reminded, however, that there's a very long history in the Treasury market, once policy has reached its upper or lower bound, the market is comfortable pricing in no change for a couple meetings, and then pushing the most logical next move.

In the case of the end of a cutting cycle, that would be two, maybe three meetings on hold, and then starting to aggressively price in rate hikes. Now that we're at the end of a hiking cycle, the market is conforming to this very common behavior, i.e. no cut in January, and some probability that there is a move in March. We anticipate that the simple passage of time will push out rate cuts further into 2024, unless and until there's enough justification in the economic data to suggest that the Fed is readying to lower rates by a quarter point.

The week just passed contained a couple data points of relevance. We had a lower than expected initial jobless claims for nonfarm payroll survey week, which suggests a solid December NFP print. We also saw the final revisions to Q3 real GDP. Now, the headline was revised a bit lower, but that wasn't the interesting aspect. The interesting aspect was the fact that core PCE, on a three month annualized basis, is now at 2.0%. While it's tempting to suggest that Powell can claim mission accomplished at this point, we'll still have a few other data points over the course of the next couple of months that will either dispute or confirm the notion that realized inflation is starting to conform with the Fed's objectives. For context, that was the first time that the quarterly annualized measure of core PCE was at 2% since 2020.

Vail Hartman:

It was a week that saw an array of Fed speakers, including Mester, Bostic, Goolsbee, Barkin, and Harker, offer comments that pushed back against the market's dovish interpretation of the December FOMC. And while the SEP is forecasting 75 basis points of rate cuts in 2024, the futures market is still pricing in slightly over double that, and over 150 basis points of cuts in the year ahead, with the cut fully priced in by May, and roughly 80% odds of a cut in March.

Ian Lyngen:

The debate of whether or not we'll see a March rate cut has really been the most topical one at this moment in the Treasury market. Plenty of market participants, as evidenced by the price action, suggests that in Q1 the Fed will drop policy rates by a quarter point, then again in Q2, Q3, Q4, that gets us to 100 basis points of the 150 that are priced in, and then presumably the market is building in a bit of an insurance policy in case things go very wrong for the real economy. It's certainly not wasted on us that, at this moment, the no landing/Goldilocks scenario still appears the path of least resistance as we look forward to 2024. But it is notable that even with that context, the Fed is still going to be lowering policy rates.

We also saw an extension of the buying in the long end of the curve, with 10-year yields dropping below 3.85%, and this reinforced the notion that what sidelined investors were really awaiting was confirmation that rate hikes were done for this cycle. That has certainly come in the form of Powell's pivot, but we also see similar sentiment overseas, specifically with the ECB, the Bank of England, and of course, the Bank of Canada as well. The conversations have shifted away from whether or not there'll be another rate hike, or even how long they're going to avoid cutting rates, to how significant are the rate cuts going to be in 2024. So I'll argue that that is at least partially responsible for the strong performance of 10s and 30s. And when we saw the weekly update of MoF data from Japan, what we learned was that during the week of the Fed, there was significant Japanese flows into foreign bonds. In fact, it was the most since early September, and the fourth largest of 2023.

Ben Jeffery:

And that's indicative of one of the dynamics that we expect will push rates lower over the later part of 2024, even if we're a bit tactically bearish coming into the New Year. And one of the most important changes we're expecting in the Treasury demand landscape in 2024 versus 2023 is similar to precisely what we've started to see in data like the Ministry of Finance’s; and that is that after this year saw overseas demand for treasuries take a meaningful step back, if one looks at the auction allocation data, for example, as we get into next year, and monetary policy tightening uncertainty around the world is replaced by extremely high conviction in where terminal lies, and similarly high conviction that the next move is going to be a cut, that's going to translate to an increased willingness to buy bonds, both in local markets, but also in the Treasury market as regardless of whether or not the Fed is the first central bank to cut, a global move toward lower policy rates is a reason to like owning bonds.

And it's also worth mentioning that for Japanese investors specifically, given the fact that the BoJ's status as the last dovish central bank standing last year is going to be replaced by one of the last hawkish central bank standing in 2024 as speculation around the potential for a rate hike in Tokyo continues to linger, that's likely going to mean that, after the yen has spent the better part of the last two years underperforming, what we'll likely start to see is a stronger yen, a weaker dollar, more broadly, and that should make us rates more attractive to the overseas investment crowd that has been the case in quite some time, especially if global growth is going to be taking a step lower, as we expect it will be.

Ian Lyngen:

This is also consistent with the price action that we saw in December, specifically, as flows emerged, other investors wanted to make sure that they simply weren't left out in the bullish performance of Treasuries. So to some extent, that is what has pushed rates to extremes, and why we expect to enter 2024 with the 2s/10s yield curve anchored at negative 50 basis points. That's one of the aspects that's been the most counterintuitive about this move, specifically, Powell signaling that rate cuts will be a reality next year should have been the trigger for a bull steepener. The fact that the shift in rates on net ended up being effectively parallel speaks to the earlier observation we made about the market simply waiting for an opportunity, or for a signal to add duration exposure.

Ben Jeffery:

And it hasn't just been the price action and nominal treasuries that's been impressive, but real rates as well have dropped back to multi-month lows, and a textbook dovish re-pricing has left breakevens well-contained, real rates lower, and especially interesting has been the fact that stocks are higher. We saw the Dow reach a record high, the S&P 500 continue to close back in on that same milestone, and the Nasdaq do what the Nasdaq has done all year, in an impressive rally that has implications for the wealth effect, but also financial conditions that are now back to the easiest they've been since the summer. And while the Fed was pleased with how tight conditions were at the November meeting, clearly the easing that has accompanied the pulling forward of rate cuts, the move toward lower rates, and the rally in risk assets, has not pushed the FCI easy enough to really spark concern around a reflationary surge for monetary policymakers. But nonetheless, this week's Fed's speak did try to push back against Q1 cuts, even if with limited success.

Vail Hartman:

And this week, we heard a couple of Fed speakers speculate on why they think the market is so aggressively pricing in rate cuts in 2024. Chicago Fed President Goolsbee said it seemed like the market was just pricing in what they wanted the Fed to be saying, and it seemed like there was some confusion about how the FOMC works, and that the committee does not debate specific policies speculatively about the future. And we also heard from Cleveland Fed President Mester, who said the next phase is not when to reduce rates, even though that's where the markets are at, it's about how long does monetary policy need to remain restrictive in order to be assured that inflation is on a sustainable path to 2%. And she said the markets were a little bit ahead, and they jumped to the end part, which was, we're going to normalize quickly, and she doesn't see that happening.

Ian Lyngen:

To Goolsbee's point, and I think he's spot on in this regard, the Fed doesn't make next year's rate decisions today, and I'll argue that's precisely the message that he was attempting to communicate. When the FOMC meets, they decide whether to cut rates, leave them unchanged, or hike rates at a specific meeting. Now, the Fed speak might have been a little bit disingenuous to imply that the market shouldn't be looking at the forward projections in the SEP, because, after all, even the FOMC knows that the market is going to respond to the 2024 DOT. So while we're certainly sympathetic to the challenge that Fed speakers faced in the week just passed, the reality is that the market is comfortable discounting the Fed's stance, and assuming that rate cuts are going to be more significant next year.

Ben Jeffery:

And aside from the market moves and what we heard on the monetary policy front, it was also an important week as it relates to geopolitics. Obviously, the war in Israel and Palestine continues, and while the immediate risk of a broader contagion and a wider spread conflict has waned since the early days, what we have seen is that disruptions in some major shipping channels, most notably the Red Sea, and several large shipping companies making the decision to reroute cargo ships away from the Suez Canal and the Red Sea, and instead take the long way around Africa, brings to mind the supply chain issues that have continued to pop up in the post-pandemic period, as a source of higher prices, as a source of consumer angst, and as a source of general uncertainty, that frankly, central banks are not going to be able to do a lot about.

Now, obviously, given that this is taking place in the Middle East, it matters for the oil market, of course, but it's not just oil that gets shipped through the Red Sea, and this means that the longer commerce needs to be detoured away from the region, the more likely it is that shipping delays, higher costs, and a repeat of something similar, if not necessarily as severe, as what we saw coming out of the pandemic, offers a supply side inflationary impulse that complicates the Fed's plans to deliver that first-rate cut. Because if we see progress toward 2% inflation stall, or even begin to reverse slightly, even if it is a supply chain issue, that's going to make the FOMC and other central banks' communication around the less restrictive monetary policy all the more complicated.

Now, as with anything as it relates to geopolitics, it's probably still too soon to have a high conviction opinion around just how long this lasts, but the longer it does, the greater the economic impact will be, and probably the greater influence on the market it will have.

Ian Lyngen:

Ben, as you point out, ultimately, if anything, this will simply delay the timing of the first-rate cut of the cycle. One question that has repeatedly come up regarding the Fed's pivot is the degree to which it was politically motivated. Now, setting aside Powell's politics, per se, it is reasonable to assume that, for the sake of central banking independence, if nothing else, the chair would want to start the conversation with the market about rate cuts long before the presidential election next year in an effort to at least distance the two, even if the reality is that they are coincident and not correlated.

Ben Jeffery:

And in any case, as we watch 10-year yields get increasingly comfortable below 4%, there's also a flows in positioning dynamic that's worth discussing, given the point in the calendar, and the fact that liquidity is probably not as robust as it otherwise would be, and how the evolution of positioning may set January up for either an extension of the buying or a rationalization of valuations, given that almost by definition there was a lot of buying that took place first since the November FOMC, and then even more buying that took place since the December FOMC. And so, while there was a case to be made that maybe January 2024 was going to look a lot like January 2023, in that the year of the bond was going to bring in a lot of demand for yield as the calendar turned, maybe after a lot of the markets spent the better part of the second half of 2023 sidelined, a lot of that demand was pulled forward into this year.

So, to put it a different way, maybe some New Year's buyer's fatigue, that means we're going to need to see a stronger bullish impulse to see an extension of the rally if in fact a lot of the buying has already been executed between 4.25% and 4%. Particularly if we get a strong December payrolls report, or as attention turns to the February refunding announcement, and the risk that another round of increased coupon auction sizes reignites the term premium conversation. After we've rallied so much, there might be some potential for higher yields to materialize in the early part of 2024.

Ian Lyngen:

So out like a bull and in like a bear, is what you're saying?

Ben Jeffery:

It's more like yields will go up, yields will go down, but not necessarily in that order.

Vail Hartman:

I think I'm starting to get this strategy thing.

Ian Lyngen:

In the two weeks ahead, there'll be a lot and a little happening in the US rates market of relevance. The market's closed on Monday, December 25th, for Christmas, and then there's a recommended early close on Friday, December 29th, which will make the final trading week of the year largely a non-event. We do see $57 billion two-years on Tuesday, followed by $58 billion five-years on Wednesday, and in the years coupon auctions are capped with a $40 billion seven-year issue on Thursday.

Underwriting US Treasury auctions in December has always presented a bit of a wild card for the market, although we expect that there'll continue to be solid demand, and don't anticipate that the supply events will be distortive of the broader market. The first week of January is really all about the payrolls report. Current expectations are for a December NFP print of +165,000, with the unemployment rate increasing slightly to 3.8% versus the 3.7% number in November. Average hourly earnings are also seen increasing three-tenths of a percent to end the year, and that's consistent with the idea that while wage gains are still higher than we saw prior to the pandemic, they are beginning to moderate, very consistent with the broader theme of moderating consumer price inflation as well.

Let us not forget that on the 3rd of January, we see the FOMC meeting minutes from the December 13th decision. Investors will be scrutinizing this release for any indication of the Fed's thinking about the timing of the first rate-cut of the cycle. Now, we expect that the minutes will be used to emphasize the difference between cutting and easing, which is a topic that Powell began the press conference with, i.e. going from 5.50 to 4.75, or even 4.50, is taking policy from very restrictive to less restrictive, but still comfortably above neutral. That's a nuance that the market doesn't seem to be trading at the moment, so we're open to some potentially bearish implications for at least the two-year sector as a result.

In contemplating the beginning of 2024, we're coming in with a bear flattening bias, upward pressure on two-year rates as the market continues to push out the timing of the first-rate cut, and a bounce of 10-year yields off of the 3.85 low, simply as a function of some of the seasonality in the inflation data, as well as the broad-based seasonality in US rates, which has a tendency to see the first quarter of the year with a decidedly bond bearish skew. Market participants will also be watching the performance of risk assets, as well as commodities. The relevance of risk assets to easier financial conditions is difficult to overstate, especially in light of the record, or near record, equity valuations, and how that has eased financial conditions at a moment when the Fed is attempting to err on the side of tighter financial conditions, at least for a few more months.

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 we look forward to ringing in the New Year, our list of resolutions is growing, and we're reminded that it's important to get behind early, because that gives you more time to get caught up.

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:

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
Vail Hartman Analyst, U.S. Rates Strategy

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