Price of Summer - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 230, Price of Summer 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 July 10th, and with the Institutional Investor Survey underway, we'd like to ask for your support and please reach out if you need any assistance in the process, if for no other reason than to keep Macro Horizons ad free. Vail, what was it that you wanted to say about my vehicle's extended warranty?

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 US rates market received a lot of fundamental information despite Monday's early close and Tuesday's market holiday. First, and by far the most relevant was June's nonfarm payrolls print, which came in at 209,000 jobs. Now that was modestly below the consensus and the lowest since December 2020. Similarly, we saw a miss on private nonfarm payrolls, which gained just 149,000.

All of that being said, the unemployment rate did tick lower as expected to 3.6% from 3.7%, and this occurred with an unchanged labor force participation rate at 62.6%, which implies that the improved household survey data, i.e. lower unemployment rate occurred with relatively little noise. Further, within the details were the average hourly earnings figures for June. Here we saw a monthly increase of four tenths of a percent versus the three-tenths of a percent anticipated. In addition, May was revised higher from three tenths of a percent to four-tenths, and as a result, the year-over-year pace in nominal wages printed at 4.4% compared to the 4.2% estimate. Overall, while the headline was somewhat disappointing, particularly versus elevated expectations given the ADP figure, the release nonetheless did nothing to deter the Fed from hiking on July 26th. It did, however, create a bit more uncertainty related to the potential for the Fed to move in September, but there's still a lot of data between now and then.

The market also got a disappointing ISM manufacturing print as well as a stronger than expected ISM services number. It's interesting that on Monday the market was content to ignore the disappointing manufacturing figures and selloff. And as a theme, in fact, throughout the bulk of the first week of the third quarter, upward pressure on rates has emerged, 10-year yields moved above 4%, which is a level that's been flagged as a reasonable buying opportunity. And as the summer unfolds, we remain biased for rates to drift lower back into the prior range with an ultimate target of 350 by the point that the market returns from the Labor Day weekend in September. The market also benefited from the FOMC meeting minutes from June in which it was highlighted that some members wanted to hike 25 basis points at the last meeting. So the fact that the more hawkish voters were swayed to the Dovish camp was interpreted as assigning a higher probability to a July hike simply because June was in fact a skipped meeting as opposed to a true pause.

In addition, Thursday's release of the Ministry of Finance data from Japan showed the eighth consecutive week of the net purchasing of overseas notes and bonds for a running total of more than $43 billion. Now, this data fails to break down whether it's all in treasuries, but historically the vast majority of the flows have been into US treasuries. Once the monthly MOF data is revealed, we'll have better context for precisely how much of that flowed into US rates. But as an answer to who is the potential dip buyer, it's difficult not to look at Tokyo in this environment.

Vail Hartman:

It was a week that was always going to be defined by June's NFP and the slowest month-over-month hiring pace since December 2020, 0.1 percentage point drop in the unemployment rate, and slight uptick in average hourly earnings did effectively nothing to derail the Fed from delivering a hike on July 26th with the odds of a move at over 90%.

Ian Lyngen:

Vail, I think you're spot on. It was a report that had the potential to add to the broader macro discourse, but the fact of the matter is we did have a somewhat disappointing headline and private nonfarm payrolls number, but the unemployment rate did tick lower and we saw upward revisions to average hourly earnings in addition to the figures that you've already highlighted. What our takeaway, and frankly this was our thinking in the run-up to the event, was that this report does nothing for the probability of a July hike still at roughly 90% given what's priced in the fed funds futures market. Instead, it will be incorporated into the probability that we see a follow on move in September. Obviously, given the data cycle, it's far too soon for us to have a strong skew on September, but the trajectory of jobs growth does imply that the Fed will have optionality come the end of the third quarter, if nothing else.

Ben Jeffery:

And this gets at an aspect of the calendar and the timing of the September meeting along with when we're going to get subsequent NFP prints and also CPI reads. Unlike the window between the June and July FOMC meeting, the space between July and September allows Powell to see two more full months worth of data before ultimately deciding whether or not another 25 basis point hike at the end of the third quarter is going to be appropriate. And just to highlight one of the takeaways from our pre NFP survey this month, in contemplating what the second half of the year is going to look like in terms of Fed tightening, the most likely outcome for Powell was seen as just one more 25 basis point hike this year in contrast to what we saw in the dot plot in that 50 basis points of tightening that was forecasted before 2024 gets underway.

It's also worth mentioning that the second most likely scenario was seen as two 25 basis point hikes at alternating meetings and after the committee opted to take June off an alternating meeting schedule. Given the fact that now we've seen the pace of hiring drop to its slowest level in almost three years, a more measured tightening pace from here will emphasize, Ian, exactly as you point out, flexibility to continue to evaluate the incoming information both on the hiring and inflation fronts. Which is coming in an especially relevant time, given what is broadly expected to be the start of a more significant moderation in the trend of consumer prices that is likely to kick off with Wednesday's data.

Ian Lyngen:

There's an argument to be made that a July rate hike is at least ostensibly contingent on how the June core-CPI figures come in. The reality is any reasonable outcome on Wednesday, i.e. a 0.2 or a 0.3 on the month-over-month change of core CPI would be consistent with what the market is anticipating as well as reinforce the argument for the Fed to deliver a quarter point move. Now, obviously as we move into the proverbial summer doldrums, the market's response to what is widely anticipated to be a July 26th rate hike will be notable. First off, it will represent yet another data cycle in which the Fed has retained a restrictive monetary policy stance and up the proverbial ante buy another quarter point. As we've noted in the past, the Fed's primary objective in 2023 isn't necessarily achieving a higher terminal rate, but rather avoiding a scenario in which investors expect that the Fed will have to deliver rate cuts by the end of the year or, frankly, anytime sooner than they currently envision.

And that's a bit of the nuance that I think will make the July FOMC press conference so interesting. First off, there will need to be some type of rationale from Powell for hiking despite the lowest nonfarm payroll print since December 2020. In addition, assuming core inflation moderates as anticipated, that will put the year-over-year pace at 5.0%, well off the 6.6% peak from September. Cooling inflation, eroding trajectory of the jobs market isn't typically an environment in which one would expect the Fed to move. However, in this case, it comes down to the departure point i.e. inflation was running very high and the jobs market is very strong. They might be off the peaks, but still in absolute terms, the US economy is on strong footing at least by these measures.

Vail Hartman:

And on the topic of Fed speak, Thursday morning we heard from Dallas Fed President Logan who said that while some people say a lot of further cooling is in store from the lag consequences of the rate increases the FOMC delivered over the past year and a half, she is skeptical about the potential for large additional effects from this channel. What do you guys think about the possibility that a material economic fallout never comes to fruition?

Ian Lyngen:

I think that the market is pricing that to a large extent, and if the Fed is ultimately able to orchestrate a no landing scenario, it will be one for the history books to be sure. All that being said, the reality is there have clearly been fundamental shifts in the way that workers interact with the employment market and how the population views work post-pandemic. The most relevant question in this context is: are these changes permanent? On some level, they are. The people who left the labor force, took early retirement are not coming back. People who have opted out of the labor force for other reasons are less likely to return than we might have seen in prior cycles. All of this implies that nominal wage growth is going to remain elevated, and that's a scenario in which the Fed's hawkishness is justified because we need to see a higher unemployment rate and some of the tightness come out of the labor market to ensure the reestablishment of price stability.

Now, what is less obvious is what happens to new entrants into the labor force in a post-pandemic environment. To a large extent, a lot of incoming workers have not, in their working life at least, lived through some of the dynamics that we have seen over the course of the last two years and taking a step back, that creates a pretty significant uncertainty. It's also the fact that with the exception of the once in a generation, one-off massive drop in GDP that was quickly reversed in 2020, many workers who remain in the labor force haven't seen an actual recession comparable to what we saw in 2008 and 2009. That was more than 15 years ago and therefore, a lot of workers don't have a go-to response function themselves in how to handle a significant deterioration of the labor market.

Ben Jeffery:

Ian, that's a very good point about the labor market's departure point for the next leg of the cycle and what it might ultimately mean for the path of wages. Additionally, on the wage growth front, it was also worth mentioning what we saw within the ADP series this past week, which showed an impressive 497,000 jobs added according to the alternative private payrolls measure. But within the details, despite almost half a million workers being added, we actually saw an ongoing cooling in the annualized wage gains. Both from a higher departure point in terms of job changers, but also job stayers, which when taken with the Jolts data and job openings that have moderated from their peaks, suggest that the labor demand side of the equation is at least marginally helping take the upward pressure off of wages. Now, that doesn't mean we're in a negative wage growth environment, but nor are we accelerating at the rate that we saw in 2021 and 2022. To zoom out a bit and refocus the conversation on that potential for a no landing question that you asked, Vail.

It's also worth mentioning what we saw in terms of market moves this week and specifically in the two-year sector where yields reached a fresh cycle high. And that in turn pushed the 2s/10s curve back to its inverted extreme at negative 111 basis points. And so in thinking about the Fed's ability to firstly deliver another rate hike or more rate hikes as we expect they're going to, but then keep policy higher for longer, two year yields at their current levels seem to imply a degree of optimism, especially after the regional banking crisis, that rates at these levels are not going to have any significant impact on the real economy. And actually are probably fitting in quite well with Logan's argument that she doesn't anticipate a slowing economic environment is going to result from policy at current levels.

Now, as a bit of a counterpoint, I would simply point to the real yield environment and in a five-year space, the fact that inflation adjusted borrowing costs are now back to the cycle highs and the highest they've been in well over a decade, that that is going to have a real influence on firms, ultimately profitability, wage gains, and the size of the workforce. And so given these risks, looking at a two-year yield that's right near 5% doesn't seem like such a bad buying opportunity, at least over a medium term time horizon.

Ian Lyngen:

And in keeping with your theme, Ben, of real rates, we had an astute client ask the question about what we're thinking about 10 year TIPS yields or 10 year real yields at this moment. When we look at what has occurred over the course of the last two or three weeks, we've seen a very sharp spike in 10 year real rates back to roughly 1.8%. That's the cycle high, and if the logic that has brought the shape of the yield curve off of the cycle lows in terms of the depths of the inversion can also be applied to the demand for inflation protection, i.e. creating a bid for 10 year tips, one should expect if nothing more than a near term phenomenon that we will see a drop in 10 year real rates over the course of the next week or two.

Now, this to some extent is a technical story of a double top versus the double bottom that was represented in the curve. But it's also consistent with the broader notion that we're reaching an inflection point for the monetary policy cycle, i.e we get another hike or two, and then we're on hold for a significant period, and that should have ramifications for investor behavior. Said differently, we're getting very close to the point where dip buying becomes a norm as opposed to selling strength.

Ben Jeffery:

Ian, was that your attempt to keep it real?

Ian Lyngen:

Ben, was that your attempt at a joke?

Vail Hartman:

I'm just attempting to figure out where terminal is.

Ian Lyngen:

It's a day closer today than it was yesterday.

In the week ahead, the primary event of any relevance will be the June release of the Consumer Price Index. Expectations are for a three-tenths of a percent increase in both the headline and the core measures. The latter, bringing the year-over-year pace to 5.0%. Off the peaks to be sure, but nonetheless far from being consistent with the FOMCs target of 2% inflation. In contemplating the risks surrounding the numbers, the near term monetary policy implications are relatively straightforward. As long as we get a two or three tens of percent monthly gain, it won't derail the Fed. In the event that we see a negative print on the core side, which is highly unlikely, we would then find the market contemplating the prudence of a July hike. The scenario in which core-CPI is above the three-tenths of a percent consensus would imply a higher probability of a September or November hike, but not incentivize the Fed to go from 25 basis points this month to 50.

So ultimately, while yes, there might be an argument that the Fed's actions are contingent on the trajectory of inflation in June, it won't be July's actions, but rather what we should expect in the balance of the year. Let us also not forget that this is the final week in which Fed speak will help refine market expectations. So in the wake of the inflation numbers, we anticipate that there will be a unified message of some sort, i.e. clearly going to hike 25 basis points or an open discussion as a function of the data itself. At the end of the day, our interpretation is that Wednesday's CPI will give us a skew of whether or not we should expect a hawkish hike on the 26th that focuses on flexibility to move higher later in the year or a Dovish hike, which begins to lay the groundwork for no future moves.

It's with this backdrop that the Treasury auctions hit the market Tuesdays $40 billion 3-year followed by $32 billion 10-years on Wednesday and capped with $18 billion long bonds on Thursday. We also see July's first read of the University of Michigan sentiment data. Recall that the most recent print showed a sharp decline in the one-year inflation expectations component to 3.3%. Now, while this was associated with some price action in treasuries at the moment, that move has ultimately faded. Anything that comes out of Friday's number that reinforces the downward trajectory on forward inflation expectations could ultimately prove more of a tradable event, again with an emphasis on the September, November probability as opposed to whether or not the Fed moves on the 26th.

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 once again, a friendly reminder. It is the season for the Institutional Investors Fixed Income Survey. Whether you vote early or vote often, we hope you vote for BMO.

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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