Paying for Lower Yields - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 269: Paying for Lower Yields, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring your thoughts on the trading desk for the upcoming week of April 15th. Monday is tax day and we'd like to encourage everyone to do their part. After all, declining revenues will only lead the Treasury Department to issue more bonds, therefore paying one's taxes is bond bullish, and bonds could really use the help.

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 Treasury market sold off sharply. We came into the week already under pressure, given the start of the quarter was a bearish period for the Treasury market. We then had higher than expected core-CPI. Core-CPI for the month of March printed at 0.4%, albeit a very low 0.4 as on an unrounded basis it came in at 0.359%. Now the process of translating this through to the direction of monetary policy has been pretty straightforward. The pace of inflation during the first quarter has effectively taken a June rate cut off the table. Now the Fed's calculus becomes a lot more interesting during the second half of the year, especially if they have any chance of delivering more than one rate cut this year.

At a minimum, we expect that the current inflation profile will lead the June SEP to indicate 50 basis points of rate cuts this year, if not 25 basis points. Now, the logic is relatively straightforward. The Fed had been signaling that it would take roughly three months’ worth of more benign inflation figures to get beyond what we saw in January and February. In light of the fact that the upside on the inflation front has now been extended to March, not only does that timeframe to be convinced move forward, but we'll argue rather than three months, it might take four or even five months. So at a minimum, until we hear otherwise from the Fed, we'll pencil in a rate cut in December with better than even odds that we see a move either at the July or September meeting.

Now, as we've discussed in the past, September is a very difficult meeting at which to start a rate cutting campaign because it would clearly be interpreted as the Fed lacking independence as it would presumably trigger a rally in risk assets, which has historically benefited the incumbent. Now we're unwilling to completely write off a September 1st rate cut simply because of the complexities facing Powell and the Fed. At the moment. The FOMC is clearly attempting to orchestrate a soft or no landing outcome for the real economy. And while at the end of 2023 that appeared very doable, the reality is that inflation came in stickier in the first quarter. And therefore, unless the Fed is willing to move the goalposts of the 2% inflation target, the Fed now has very little leeway to start the normalization process before not only the committee but the market is convinced that inflation is trending back towards the Fed's 2% target.

We're certainly cognizant that the combination of the strong payrolls report and the higher than expected core inflation data has rekindled conversations about a no landing outcome in which inflation settles in at a higher structural rate than was in place prior to the pandemic. The most important wild card in this context is the degree to which Powell is willing to let inflation run hot simply to start the process of normalizing yields lower. Nothing that we've heard from monetary policy makers thus far suggest that that is the case. So we're erring on the side of assuming that the recent economic updates have simply extended the Fed's time at terminal.

Vail Hartman:

Core-CPI surprised on the upside for the third consecutive month in March at four tenths of a percent month over month. And while it was a low 0.4 with the unrounded figure at 0.359%, the move was certainly a shock to a market that was priced to a consensus of 0.3% and the unofficial consensus for a low 0.3%. And there was a rather dramatic sell off in the treasury market in the wake of the data with two year yields breaching 5% and 10s definitively breaching 4.50%. And it was just a few weeks ago when the futures market was priced in line with the SEP's 75 basis point rate cut projection for this year as the market is now pricing in less than 50 basis points of rate cuts in 2024.

Ian Lyngen:

I do think it's notable how sentiment has shifted so dramatically from January when we were pricing in 150 plus basis points of rate cuts to now where we're pricing in one cut, maybe two. I'll note that there was a moment in which the market appeared to be priced to "perfection" in so far as it was 75 basis points, and that's precisely what the market was saying and the market certainly did trade as though that moment was not sustainable.

Now the question then quickly becomes, are we on the other side of the arc of the pendulum or will this be the new norm? If nothing else, March's CPI took a June rate cut off the table. Whether the Fed chooses to signal via the June SEP 50 basis points or 25 is the new wild card, if they do signal 50, it'll be very interesting to see if they choose to deliver that in July, wait till September or do a November-December combination. We think that the November-December combination, two rate cuts at each of those meetings, is the least likely outcome if for no other reason that investors will interpret that as the rate cutting pace is 25 basis points of meeting. And that's the last thing that Powell wants unless we see a material spike in the unemployment rate.

Ben Jeffery:

And the rethink of what we might ultimately see from the Fed this year is more than simply a reaction to just March's inflation data in and of itself. But rather in keeping with the theme that the Fed is not going to be reactive to just one month's worth of new information, it is more the entirety of what we've seen over the start of 2024 and what is now a full quarter of still solid jobs growth, robust wage gains and ultimately core inflation that's proving increasingly sticky in an area that's far closer to 4% than 2%. And given that it's been eight months since we saw the final rate hike of this cycle, the conviction that we're going to see the lagged impact of monetary policy tightening is diminishing with each passing month that we don't see a material weakening in the labor market or a re-ignition of the disinflationary trend.

Now it's worth noting that in the context of economic cycles, eight or nine months really isn't all that long, and so it's not unreasonable to assume there's still more economic damage to come. But for the time being, with the labor market not reacting in a way that necessitates any rush to cut and inflation staying a bit too high for the Fed's comfort, there's not a great deal of incentive for the Fed to do anything other than sound committed to rates at these levels. And while we've seen and heard rate cut projections pushed out into the later part of this year, what hasn't happened yet, is anyone looking for another rate hike. And that I would argue has to do with that lagged influence and the fact that the Fed doesn't want to do that, at least not yet.

Ian Lyngen:

And I think that this brings us back to one of our primary concerns for 2024, and that's the risk that the Fed actually needs to engineer a more material slowdown or a modest recession to get inflation back to the 2% target. Now we are operating under the assumption that the way the Fed would engineer such an outcome would simply be to delay rate cuts even longer, perhaps beyond 2024 and well into 2025 in the event that inflation continues to perform in the way that it did in the first quarter. Now, this isn't our base case scenario of course. That being said, the rate hiking appetite is very low with the committee at the moment and to some extent, one has to acknowledge that the fact that it is a Presidential election year has to be factoring in at least on the margin to the Fed's unwillingness to imply that there is some degree of symmetry at terminal, Which recall, was the conversation during the second half of 2023.

Ben Jeffery:

Ian, it's great you bring that point up around what the messaging was from the Fed after we got July's hike of last year. Remember, the Fed hiked in July and then still signaled a willingness to hike again, data-dependent of course, and stuck with the bias of a hike is more likely than a hold or a cut for at least several months into the start of the fourth quarter. And that helped push rates higher across the curve, got 10-year yields above 5% for that brief period we saw until later in the year when there was a more concerted effort to lay the groundwork for a cut. Remember, Governor Waller's speech is frequently cited as marking that departure point along with the press conference of the December FOMC that was nothing if not dovish.

Fast-forward to today with two-year yields back at effectively 5% and we're nearly back to the levels we reached last year in the very front end of the curve when policy rates were at the same level they are now, but the Fed was suggesting there was a willingness to hike again. And so assuming as we are that the Fed is not going to put rate back on the table in the near term, that means that a downward sloping forward path of policy puts some implicit value in the two-year sector now that we're back at effectively 5%. And we also got the minutes of the March FOMC meeting this week, which while a bit stale given the Fed didn't have CPI at that time, still showed that the overwhelming consensus on the committee is that the bias is still to cut and no one is really entertaining the idea of hikes.

Ian Lyngen:

So Ben, it sounds like what you're saying is that two-year yields at 5% are a screaming buy.

Ben Jeffery:

If you liked them at 4.70%, you'll love them at 5%.

Ian Lyngen:

On the topic of screaming buys, we learned from the Minutes that there's other changes afoot beyond just the steady policy rate.

Vail Hartman:

So the details about the balance sheet unwind within the FOMC minutes to us suggested that a May announcement of QT tapering is firmly on the table, although the March trajectory of inflation certainly complicates such a move. Specifically, the Minutes said the vast majority of members on the committee judged it would be prudent to begin slowing the pace of the runoff fairly soon. And it was particularly notable that the minutes said policymakers favored reducing the monthly pace of the runoff by roughly half from the recent overall pace. So with the Fed currently allowing up to $60 billion in Treasuries to roll off without reinvestment each month, it appears the Fed is laying the groundwork for an adjustment to a $30 billion cap per month. And it was also notable that the Fed provided some color on the pace of the rolloff in mortgages with the Minutes saying that policymakers generally prefer to maintain the existing cap on mortgage-backed securities, suggesting that the current cap of $30 billion per month would remain in place for the time being.

Ian Lyngen:

And in that eventuality, it certainly doesn't do much for the mortgage basis. The mortgage basis has been pegged at very high levels over the course of the last 18 months. One of the interesting aspects of that dynamic is that while it has kept mortgage rates higher, higher mortgage rates haven't really had the anticipated impact on the residential housing market. In fact, as we watch some of the housing inflation data in the form of Rents and OER, we see that that's still providing a pillar of inflationary support in the US economy. Now, from the Fed's perspective, they would probably like to see some downward pressure on valuations, but not too much given the importance of the housing sector to the wealth effect.

Ben Jeffery:

And we can't really discuss the wealth effect without also mentioning the reaction or relatively modest response, one should say, in the equity market and risk assets more broadly to the developments we've seen in terms of the inflation data, but also the rates market this week. Obviously, some weakness in stocks is going to be expected in response to the data and accompanying rate move, but frankly, through a longer-term lens, credit spreads remain very tight, equity prices remain very high. And generally speaking, even as real rates have climbed, financial conditions broadly have not really tightened all that much.

And so while the housing sector is certainly a risk as one of the more rate-sensitive pockets of the economy to keep in mind, with equities and credit still performing relatively well, there haven't been any flashing signals that would suggest a sharp plunges in the offing with what that means for the wealth effect as you touched on Ian and consumer confidence more broadly. And I would argue a big reason for why we've still seen relatively solid risk appetite even after the hotter-than-expected inflation data, is that the economy remains very strong and still it's clear that the Fed's bias is to cut maybe not in June, but at some point this year anyway.

Ian Lyngen:

On the topic of delay in suspense...

Ben Jeffery:

What are we waiting for?

Ian Lyngen:

Ask Powell.

In the week ahead, the Treasury market receives a few data points of relevance to help define trading direction. Although ultimately the market will continue to digest the monetary policy implications from the stronger-than-expected core inflation data. And as the price action settles into a new range, it will be very interesting to see if and when dip buying interest emerges particularly further out the curve.

On the data front, Monday's retail sales print for the month of March is expected to show a four tenths of a percent increase in spending. Now, this is relevant when we put it in the context of some of the anecdotes, which suggest that consumers might soon be facing some more material headwinds. Now, as we know, there's a clear divergence between the pace of consumption in lower quartile versus the upper quartile of US households, and that isn't a particularly new development. However, the increase in credit card utilization at a moment where interest expense is so high does open the possibility that we will start to see a degree of apprehension to continue spending. Of course, a version of that dynamic has been at play over the course of the last several quarters, and we have yet to see personal spending or GDP take a material hit.

The week ahead also sees the Empire data for April as well as Philly Fed. This is relevant given that the March National ISM Manufacturing figures surprised on the upside, printing above 50 for the first time in quite a while, and that was associated with the first leg of the selloff in treasuries. So in the event that the regional manufacturing surveys show a reversal of the strength seen in March, that could readily start the conversation about March's manufacturing ISM being the anomaly and not a sign that sentiment in the manufacturing sector has durably shifted into positive territory.

We also see two auctions of note, the $13 billion 20-year on Wednesday afternoon, as well as the $23 billion 5-year TIPS on Thursday afternoon. The 20-year will be a notable litmus test for investors' willingness to go further out the curve in an environment where there's so much uncertainty about whether or not inflation has structurally changed and is now on a higher plateau. The 5-year TIPS auction, on the other hand, will presumably go reasonably well given the higher-than-expected core-CPI data.

Nonetheless, clearly the tone has been set by the combination of payrolls and CPI and we expect that the prevailing range will continue to hold in Treasuries. And although we continue to view October's 5-handle print in 10s as the cycle's peak, we are also open to a further backup in 10-year rates from current levels with the 4.65% to 4.75% range being the most readily identifiable technical target from here.

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 inflation remains sticky, we reminded that the best things in life are free like this podcast, although one often gets what they pay for.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive as possible, we'd love to hear what you thought of today's episode, so please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

Speaker 4:

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