Preparing for the Fall - The Week Ahead

Ian Lyngen:

This is Macro Horizons, Episode 238, Preparing for the Fall presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of September 5th. As the first day of school excitement builds and the weather shifts from very hot to hot, we cannot help but recall our own misspent youth filled with Atari, BMX, model trains, and of course, hours spent listening to NPR. Each week, we offer an updated view on the U.S. 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 payrolls report defined trading in the Treasury market, not only in the wake of the event itself, but also in the setup to the August NFP print. The headline jobs growth number came in at 187k versus 170k expected. However, it was accompanied by downward revisions of 110,000 to the prior two months. That brought July to 157k from 187k. In addition, there was a spike in the unemployment rate to 3.8%, which is now four tenths of a percent off of the 12-month trailing average, a pivotal level insofar as it implies a spike higher from here. The labor force participation rate increased two-tenths a percent to 62.8%, all of which suggests that the Fed will have no urgency to hike rates in September, which was largely a foregone conclusion, and it brings into question whether or not the Fed will actually need to move again this cycle.

We could very well be sitting at terminal policy rates at the moment, 5.5% as the upper bound. That being said, when the Fed publishes the SEP or the updated projections on the 20th of September, we see very little incentive for them to lower the 2023 dot. Even if they don't believe that they need to ultimately execute that final quarter point of the cycle, they still want to maintain the flexibility to do so, and perhaps more importantly, they want to make sure that investors don't bring forward the process of pricing in inevitable rate cuts at one point. It's certainly worth mentioning that the Fed via the June SEP has indicated that they are anticipating cutting rates by 100 basis points next year. There's a difference between cutting 100 basis points when you're at 550 versus when you're at 250. Said differently, Powell can certainly justify recalibrating rates lower from very restrictive to restrictive while maintaining an overall hawkish tone.

This is precisely what we are anticipating will transpire in 2024 unless, of course, there's more convincing evidence that the Fed needs to act more dramatically and decisively in cutting rates. With the update of the SEP later this month, we'll be watching the spread between the 2023 and 2024 dots. The prevailing expectation is that the path of least resistance is a slight increase to 2024, which would narrow the spread from 100 basis points to just 75 basis points. This is certainly consistent with a higher for longer mantra from the Fed, and we certainly wouldn't be surprised if this was the method in which the Fed chose to communicate to the market that it is committed to reestablishing price stability at all costs. The costs have not been especially high so far during the cycle, even if we're increasingly concerned that during the balance of this year the pendulum of economic performance will swing decidedly into the hard landing camp.

Ben Jeffery:

Well, payrolls seems the logical place to start. It's obviously been a very closely-watched and highly-anticipated employment situation report that we got for the month of August. While the headline payrolls figures of 187,000 jobs added last month doesn't fit into the traditional definition of bad, the details underlying Friday's employment data showed 110,000 of downward revisions to jobs gains over the last two months, a slower than expected increase in average hourly earnings up just two tenths of a percent, and perhaps most interestingly and/or troublingly, a 0.3 percentage point increase in the unemployment rate from 3.5% to 3.8% in what we'll argue was the most important data point to end a week of data that shows increasing evidence of the lagged impact of the Fed's already executed monetary policy-tightening efforts.

Ian Lyngen:

Ben, I think it's worth briefly exploring the observation that you made about the increase in the unemployment rate. Historically, anytime we see the unemployment rate more than three tenths of a percent off the cycle low or in practical terms, the 12-month trailing low, the unemployment rate re-bases to a significantly higher level. As it currently stands, an unemployment rate of 3.8% is four tenths of a percent off of the April low of 3.4%. This implies that over the course of the next several months, the upward trajectory on the unemployment rate will accelerate.

And, as you point out, the evidence of the lagged impact of monetary policy will continue to mount. As a caveat, within the details of the increase in the unemployment rate, the 16 to 19 year old cohort saw a notable spike, which is consistent with end-of-summer labor redistribution as opposed to a more troubling sign. Nonetheless, we're comfortable erring on the side of history, which suggests that there's going to be more upside potential in the unemployment rate than the Fed seems to be signaling at this stage.

Ben Jeffery:

Away from just the NFP data, we also got two more important looks at some labor market dynamics, first via the JOLTS numbers for July, and then within the wage series that we got along with the disappointing look at ADP hiring for August. First on the JOLTS numbers, the decline in overall job openings to their lowest level since early 2021 came along with a drop in the quits rate, and both of those declines suggest that not only do firms have less demand for sidelined workers, but current workers are becoming increasingly reluctant to resign and pursue presumably higher compensation opportunities elsewhere.

This all is very much in keeping with the idea that we saw laid out in the FOMC minutes that there are signs within the labor market data that the imbalance between labor demand and labor supply is coming back closer to equilibrium, and that should in turn, continue to help moderate wage growth, which brings me to the ADP numbers and especially within the job changer wage series within ADP, the decline in the annualized wage gains that those who changed jobs over the past year received has continued its slide. Along with the same dynamic that's apparent within job stayers, all of this reinforces the argument that not only does the Fed not need to hike in September, but there's increasingly the case to not need to hike in November or December as well, which means that shifting to a fight to stay on hold at terminal is closer at hand.

Ian Lyngen:

To be fair, the numbers were not inconsistent with a no landing or soft landing narrative however. The reality is, that NFP printing at 187,000 combined with an unemployment rate below 4% is still very consistent with a tight labor market even as wages begin to return to more traditional monthly gains with that two tenths of a percent number in August. All that being said, we have a great deal of confidence in the Fed's ability to get the unemployment rate off of the 3.4% cycle low. We have decreasing confidence in their ability to stop the unemployment rate from spiking well above 4%, and that will ultimately define the market's agenda for the balance of this year.

The September 13th release of CPI is expected to show that inflation has continued to moderate in the month of August, and that brings us to one of the biggest risks for monetary policy makers during the balance of 2023. What happens if the unemployment rate moves well above 4% by November and those anticipating a late year spike in realized inflation end up being correct? This would be a version of stagflation that creates what is arguably one of the most difficult challenges for monetary policymakers. Ultimately, the question then becomes whether or not the Fed is willing to either hike another quarter point or simply stay on hold well into 2024 or if they're compelled to respond to a spike in the unemployment rate.

All else being equal, the signaling coming out of the Fed suggests that there will be further pain in the jobs market, and we're operating under the impression that Powell is willing to endure a higher unemployment rate than the market currently anticipates. It's difficult to take this out of the context of the presidential election, however, and if asked a decade ago whether or not the political pressure from Washington would impact the chair's thinking on the monetary policy front, we would've said emphatically no. However, given the experience of the post-pandemic years, it's difficult to completely dismiss the potential for political influence in the event that the unemployment rate is closer to 5% than it is three as the presidential election nears.

Ben Jeffery:

While the jobs numbers, political pressure and the state of the outlook as a whole don't necessarily justify another tightening move from the Fed, it is worth acknowledging that along with the fight to stay on hold that terminal well into 2024 that Powell is embarking on we've also now received consistent messaging from across the FOMC first at the press conference, then again in the minutes, then again at Jackson Hole, that the Fed is willing and able to continue to run down the balance sheet not only when rates are on hold, but even after the first cut of the cycle is delivered. So continuing QT in the background while delivering what will presumably be framed as fine-tuning rate cuts to diminish the level of restrictiveness of monetary policy, that means that the fed and market participants have likely taken a lot of solace in the fact that thus far, the QT process has rolled on really without a hitch.

RRP balances remain lofty, reserves in the banking system are still high, there's no sign of funding market distortions. That means that unlike in 2019 when we saw the reserve scarcity episode trigger an about face in terms of balance sheet policy, there is more than enough capacity for the Fed to continue running down the balance sheet beyond the first rate cut of the cycle that is presumably going to be delivered at some point in the middle part of next year.

Now, there's a criticism to this take that's absolutely justified, and that is that given the impact of the debt ceiling that we saw in the earlier part of summer, a lot of the tightening influence of QT was masked by the rundown of the TGA. That absolutely resonates, and if anything, the fact we're going to be getting an additional tightening impulse via the balance sheet now that the debt ceiling is out of the way that adds to our bullish take on Treasuries, simply given the fact that running down the balance sheet is not higher rates and all it will serve to do is continue to drain liquidity from the system, which will help extend the start of the encouraging disinflation trend that we've seen over the last two months.

Ian Lyngen:

It's worth reiterating that at Jackson Hole, Powell made it abundantly clear that the Fed is holding their 2% inflation target and that's not up for debate. The implications of this are relatively straightforward as the chair is simply saying that the Fed will do whatever it takes to get inflation back to that 2% target. Now, in practical terms, we're less convinced that that involves another quarter point hike, but are increasingly convinced that the Fed will be willing to ignore some of the downside in the realized data as the struggle to reestablish price stability continues. Even putting this in the context as something as simple as Powell's concern about his legacy as Fed chair, we are reminded that almost every chair has a recession, but not every chair loses the price stability assumption.

We'll argue that that dynamic has been overlooked by many market participants. This is particularly evident in the equity market where there appears to be a prevailing assumption of a Powell put of some type. Sure, a power put exists. If the S&P 500 sold off 50%, the Fed would change its course. But as we saw in 2022, the Fed was comfortable with a 25% decline in stocks as long as it occurs in an orderly fashion and didn't necessarily lead to materially tighter financial conditions. Now presumably, the longer that the Fed is able to comfortably hold terminal in place, the more sensitive they will be to a drop in equities. Bringing it back to our earlier observation, this becomes an especially thorny issue as it will be an election year in 2024.

Ben Jeffery:

In August, we did get some evidence of the feedback loop between higher rates, especially in inflation-adjusted terms and risk asset valuations. 10-year real yields moving above 2% was enough to inspire a modest drawdown in the S&P 500, but as we've seen buying come in to take advantage of real rates that high and the accompanying decline back to the low 180s in 10-year real space, the equity market has responded as one would expect. A bounce in stocks is moderating inflation adjusted borrowing costs has in turn boosted valuations. Within our pre-NFP survey this month, we asked explicitly what level of 10-year real rates would trigger significant bearishness in inequities. The responses ranged from 1.5 to 3%, but the vast majority were centered around 2.2. So we'll call the area between 2 and 2.25 10-year real rates a very important zone to watch simply given what it means for risk asset valuations and the overall tightness of financial conditions.

Ian Lyngen:

Vail, you've been awfully quiet today.

Ben:

Is this that quiet quitting thing I've heard about?

Ian Lyngen:

No, I think it's just vacation.

Ben:

What's vacation?

Ian Lyngen:

You don't need to know.

In the holiday-shortened week ahead, the Treasury market will continue to digest the implications from the August employment report. The increase in the unemployment rate combined with a slightly better than expected headline print has given both the bulls and the bears something to work with. There's little question at this stage that the Fed won't feel compelled to hike in September, although November will remain an open question. The economic data on offer is limited. We do have ISM services and a couple of Fed speakers that will hit the tape and help the market make sense of any monetary policy implications from the NFP. Looking toward the end of 2023, while we do remain constructive on Treasuries and we are holding our 3% target on 10-year yields, we've pushed that back into 2024. We'll concede that at this stage, the most reasonable bond bullish target for 10-year yields by year-end will be 3.75%.

We're certainly cognizant that the 4% level in tens will provide a selling opportunity for those more bearishly minded. Ultimately, however, once the data continues to indicate that the Fed has not only been successful in taking the upward bias out of the inflation figures, but also managed to successfully cool the jobs market that the path of least resistance will be for 10-year yields to return to that 3 to 4% trading range. Now, eventually, we do expect that the yield curve will return to positive territory; however, that's unlikely to occur during this calendar year. In the latter half of 2024, once rate cuts become a reality, a steeper curve will follow intuitively. We'll be the first to concede that this year's big macro trade was always supposed to be the curve steepener, that trade did see some satisfaction, but by no means back into positive territory, for 2s/10s.

Fives/bonds, however, did manage to move back above zero in the wake of the non-farm payrolls print, and we continue to target positive 10 basis points before booking any profits on steepeners in fives/bonds. The recent auction performance suggests very little supply indigestion, even despite the increased auction sizes and the potential for more at the November refunding announcement. All of that being said, we're content with a consolidation period for the Treasury market with 10-year yields staying in or around 4% ahead of both the September 13th CPI print, as well as the FOMC meeting the following week. Any attempts to push rates materially higher from here will presumably be met with some significant dip buying interest now that we have enough confirmation of the effectiveness of monetary policy, the fact it continues to work with the lag and the Fed's commitment to the 2% inflation target.

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. As we continue to lament SIFMA's lack of a recommended early close but refuse to let it taint our Labor Day celebration, we take solace in the knowledge that there are only 38 days left until the next long weekend. 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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