Quarter End? - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 213, Quarter End, 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 March 13th. And as we fret about stresses in the banking system, we're somewhat comforted by the tone of the contagion conversations not referring to an actual pathogen.

Each week we offer an updated view on the US rates market and a bad joke or two, but more importantly, this 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, there were a few unifying themes across financial markets that ultimately led to defining the US rates landscape. First, we heard from Chair Powell in his semi-annual congressional testimony in which he left on the table, the prospects for a 50 basis point rate hike when the FOMC meets on the 22nd of March.

And while we find ourselves sympathetic to Powell's inclination to retain a degree of flexibility in the context of monetary policy, we remain skeptical that the committee will ultimately choose once again to increase the cadence of rate hikes from a quarter point to a half point. To be fair, that bias is much easier to have in the wake of evidence of regional banking stress that has become evident as the first quarter of the year has unfolded. Now, in this context, we continue to point to the lagged impact of prior rate hikes and notably tighter financial conditions than we had at this time last year. To be fair, financial conditions are or at least were easier than they had been in October when 10 year yields peaked at 4.34.

For context, we continue to look at those yield levels as the peak for the cycle, particularly in tens and thirties. As monetary policy expectations continue to be further refined, we're open to upward pressure on two year yields. Although given the demonstrated vulnerability in certain areas of the financial sector, we anticipate that it will become increasingly difficult to see a path forward to monetary policy rates with a six handle.

All that being said, we still have the March 14th release of Core CPI and the ramifications for near term policy expectations. As a departure point, we are anticipating that the bar is much lower for the Fed to add a quarter point hike in July to terminal as opposed to increasing the pace to 50 basis points in March. Perhaps more importantly as the Fed meets in the coming weeks is the market's perception that given the proximity to terminal when the Fed publishes its updated dot plot, that there will be an implied degree of confidence that that ultimately will be the level at which Powell chooses to pause.

Now the Fed has gone out of its way to communicate that once they pause, that will be for all intents and purposes, the terminal rate for the cycle. Now, there is a solid argument that there should be some degree of symmetry around the pause i.e. if in fact inflation continues to prove sticky, another rate hike at some point should be on the table.

That being said, the news of the week in the banking sector does decrease the probability that once terminal is achieved that we'll see anything other than a rate cut. That transitions the conversation and we believe appropriately so to if and when the Fed will need to revise policy rates lower. Our baseline scenario remains that the Fed reaches terminal this year and demonstrates an atypical amount of conviction in keeping policy rates deep into restrictive territory well into 2024.

Now, to some extent, that is going to be a surprise for a market that continues to expect that the reaction function on the part of monetary policy makers is the same now as it has been in the prior cycles. All of that being said, given the depths of the curve inversion, there does appear to be some degree of capitulation on this front already priced into the market.

Ben Jeffery:

Well, Ian, there is no shortage of topics to discuss this week. It's been obviously an extremely consequential past several sessions for the Treasury market, both in terms of the price action, but also what we learned from Chair Powell at his Humphrey Hawkins testimony. What we've seen in the financial sector in terms of some contagion risks rearing their head as the realities of the post pandemic economy take hold. And then of course there was February's payrolls report that, yes, showed an impressive beat in terms of headline hiring at 311,000 jobs, but the increase in the unemployment rate, the uptick in the participation rate and slowing of wage growth really left the jobs report containing something for everyone.

Ian Lyngen:

I think that's a fair characterization, Ben. The reality is that we have now seen two very strong headline non-farm payrolls prints, but it's the details that have really driven the price action in the Treasury market, specifically that relatively benign print on average hourly earnings at just up two tenths of a percent on a month-over-month basis reminds the market that it's less about the actual amount of payroll's growth in the real economy and more about the trajectory of inflation. And recall that Powell and company have spent a great deal of time recrafting the broader macro narrative on the inflation front to focus on service inflation excluding shelter and the correlation between that series and nominal wage gains.

So the fact that nominal wages printed at a relatively subdued level really leaves open the debate about whether or not the Fed moves 25 basis points on March 22nd or increases the Hawkishness to 50 basis points. And as you pointed out, Powell did open the discussion regarding whether or not 50 basis points should actually be on the table this month, and from my perspective at least, it ultimately all comes down to Tuesday's CPI print and whether or not Core surprises on the upside outpacing the four tenths of a percent consensus that is currently in the market.

Ben Jeffery:

Completely greed, Ian. And going into the payrolls report, we were of the opinion that if we saw another universally strong update on the labor market in February, then the bar for CPI to be strong enough to inspire a 50 basis point hike would've been comparatively lower. The fact that NFP showed enough pockets of softness via that higher unemployment rate and softer wage growth data means that in order for the Fed to go 50 basis points in March, we're going to need to see an even larger increase in core consumer prices in February. As it stands, the current consensus is four tenths of a percent month over month on that Core CPI measure, so it will need to be a five tenths or six tenths of a percent read to really introduce a meaningful probability that the Fed will go 50 in March.

It's also worth acknowledging that Powell's comments did take place before we saw the latest developments in the regional banking sector and the associated solvency risk that dragged the entire financial sector lower, and that's another dynamic that's going to advocate for the Fed being a bit more cautious now that we've got another piece of evidence that their hiking campaign is beginning to flow through to the real economy.

Ian Lyngen:

And let us not forget that one of the aspects of the employment market that we've been on guard for this year is less related to headline on-farm payrolls and more a function of the unemployment rate. Specifically when we look back historically at the relationship between the unemployment rate and the unemployment rate on a 12-month trailing basis, what we see is that anytime the unemployment rate is more than three tenths of a percent off of the low of the prior 12 months, that there tends to be a spike and that spike in the unemployment rate is not 50, 75 basis points, it's 2, 300, 400 basis points. So in practical terms now that we're two tenths of a percent off of the lows, if we find ourselves in the middle of this year with a 3.8 or 3.9% unemployment rate, one needs to become increasingly cautious that that momentum will build upon itself and the real economy could be faced with a five or six handle on the unemployment rate.

Ben Jeffery:

And aside from simply the size of March's hike, we also get an updated dot plot and the proximity to what we're expecting is going to be the Fed's terminal rate has put a great deal of emphasis on the revisions to the 2023 median forecast. In our pre NFP survey this month, the vast majority of responses expected that the Fed was going to raise their forecast from a 5.25 terminal upper bound to a 5.50 or 5.75 one. The distribution skewed slightly in favor of 5.50, which suggests that the true Hawkish surprise would be a 5.75 upper bound.

But nonetheless, at this point it's become clear that the strength of the data to start this year is going to translate to the Fed formally acknowledging that rates are going to need to move higher than previously assumed. At this point, 25 basis point steps to get there seems to make sense with of course the caveat of the inflation data on Tuesday, but regardless along with the actual size of the hike, Powell's ultimate finish line and then the amount of policy easing that's going to be reflected between 2023 and 2024 will probably be one of the most tradable events of the March 22nd meeting.

Ian Lyngen:

And when we ponder the difference between the 2023, 2024 and 2025 dots, it does warrant acknowledging that there's a material difference between moving from 5.50 or 5.75 to 4.50 or 4.25 versus moving below neutral, which let's call it 2.50 for argument's sake. So said differently, even if the Fed signals that they will be cutting rates in 2024, that doesn't mean that they're expecting a hard landing or a more significant economic slowdown. In fact, a soft landing or even a no landing scenario will involve the Fed pulling back from a comparatively very Hawkish stance that we are anticipating will characterize policy by the end of this year.

It's in that context that we continue to see the potential for two year yields to end with a three handle in 2023 as the market looks forward to the path of monetary policy over 2024 and 2025. Admittedly, it sounds like more of a distinction than a difference to ponder how two year yields will continue to trade versus effective fed funds in this context, but the reality is that the further we get through the cycle, the more eager investors will be to contemplate what comes next.

Ben Jeffery:

And as has been exemplified by the equity market this week, there's no shortage of risk in terms of what comes next. Earlier this year we already saw trouble in crypto space and now it appears that the Fed's tightening is moving further in on the risk curve to the realm of venture capital and what that ultimately suggests about overall risk appetite and the willingness of investors to deploy capital into riskier areas of the economy.

Unlike during a cutting cycle and a QE program, when the Fed's goal is to push market participants out the yield curve out the credit curve, out the risk curve, the inverse logic holds true during a tightening campaign like the one we're currently in as the Fed is continuing to raise rates and continuing to run down the balance sheet. What we saw even before this week and became highly topical at the end of this week was that the market is showing a greater collective preference for safer assets, aka Treasuries as it's becoming clear that there are certain more rate sensitive areas of the economy that are responding negatively to policy rates that are as high as they've been in over a decade.

Ian Lyngen:

And let's face it, the Fed knew that there was going to be stresses and strains in the real economy as they went through the process of attempting to reestablish price stability on a forward going basis in the US economy. Now, whether or not this is the particular type of strain that they're comfortable absorbing remains to be seen. I do think that all else being equal, the regional banking stress makes a very compelling argument for 25 basis points rather than 50 at the March meeting.

More importantly, I'll note that the logic is very consistent with a notion that as the Fed gets closer to terminal and further above the neutral rate and truly into restrictive territory, that each move becomes increasingly difficult to justify. That doesn't mean that there's no justification for another three or four quarter point rate hikes, rather that the transition in the messaging on the part of monetary policy makers will intuitively move to a conviction of holding policy in restrictive territory for a prolonged period of time.

Now, we've heard that as a background narrative, but as we know, the market remains very fixated on the near horizon for monetary policy and is less willing to look forward into the second half of this year or even 2024 when refining the broader policy skew at this point in the cycle.

Ben Jeffery:

On the topic of short term, it's also worth mentioning what we learned from the price action itself this past week, namely the relevance of 4% and 10 year yields and the consistent buying interests that appeared each time tens backed up beyond 3.95. And obviously the developments in the financial sector exacerbated that rally on Thursday and Friday. But nonetheless, as we think about what we're still expecting is going to be a broader range trade in duration centered around that 3.50 level and 10 year yields. It was encouraging to see some demand step in to take advantage of the backup in rates we got beyond 4%. Now, depending on how the week ahead plays out, it's going to be telling to see the degree we can get back either to or even slightly through 3.50. And what we are anticipating will eventually be a revisit to the bullish extremes of the range after tens traded at 3.33 just about a month ago.

Ian Lyngen:

And in the context of potential price action, it's difficult not to have a conversation about the Treasury market and not focus on the shape of the yield curve. We achieved that -100 basis point 2s/10s spread, and in fact, the price action extended beyond our target. That being said, we're very much on board with the notion that between now and the point where it becomes inevitable that the Fed will need to stop hiking rates, that there will be a range that holds in 2s/10s of -75 to, let's call it, -108 or -110 basis points. Now, our expectation isn't that the range is centered on -100. In fact, we would expect that the bar to challenge -100 basis points from here is relatively high all things considered, particularly in the context of the banking stress that has become evident as of late.

Ben Jeffery:

And we did get some additional evidence on this front this week via the auction sponsorship in what was a mixed result in terms of the 10 and 30 year auctions. But overall, the takeaway from the start of March's auction process has been... Even if we're not seeing the strength that materialized in January in the primary market for Treasuries, there still clearly exists a bid that's willing to add exposure in the longer dated part of the curve. There are no auctions for this upcoming week, but even if there were, I think it's fair to say that between CPI and everything else that's going on in financial markets, the outright level of 10 and 30 year yields are presently not being set by the supply landscape and Treasuries.

That's a different story in the very front end of the market where the debt ceiling continues to offer distortions in terms of bill valuations, but given most estimates for the drop dead dates still remain at some point in July uncertainty, there's a lot of economic data and a lot more macro developments that will need to be traded before the debt ceiling really becomes a top tier issue that investors are concerned about, even if it's going to continue to linger in the background for the next several months.

Ian Lyngen:

And you make a good point, Ben, it is a background factor and because there's no immediate urgency to it, the financial media has downplayed the risks at this point. But that's not to say that as we get closer to the eventual drop dead date that we won't see a resurgence of concerns regarding the potential for a downgrade, the potential for a missed payment, etc.

At the end of the day, however, we expect that the proverbial show must go on from Yellen's perspective and more importantly, the biggest takeaway from the debt ceiling debate this cycle will be that the rundown of the TGA and the impact on bill issuance will be quickly and rather dramatically reversed once there is some decision on the debt ceiling front. And that will serve as a overall quantitative tightening much more so than what we have seen thus far from the rundown of the Fed's balance sheet. And all it's being equal. I'd expect that that comes at a time when the data is beginning to conform more closely with the fed’s forward expectations of more benign inflation, and we're starting to see increased signs of stress throughout the broader system.

Ben Jeffery:

But other than that, we're fairly optimistic.

Ian Lyngen:

We certainly are optimistic and having been on the road for several weeks, one of the key takeaways from this experience has been... I see bond people.

Ian Lyngen:

In the week ahead. The Treasury market will continue to digest the three key developments over the course of March, the first being Powell's Humphrey Hawkins testimony in which he left open the possibility for a 50 basis point rate hike, the second being, the strong non-farm payrolls print that came in above expectations both on the headline as well as in terms of private NFP. That said, within the details of the employment report, we did see the unemployment rate increase to 3.6%. That was unexpected versus the consensus of 3.4%. Perhaps even more importantly, was the fact that average hourly earnings increased at a slower than anticipated rate printing at 0.2% on a month-over-month basis versus the consensus of 0.3%.

In the context of the Fed's concerns about the potential for a wage inflation spiral. The relatively benign nominal wage gains were undoubtedly a welcome development for monetary policy makers. And then of course, the market saw an unexpected refocusing on the credit quality within the banking sector and the potential for regional bank stress going forward.

Now, of course, it's difficult this early in the process to have a very good skew on whether or not there will be a reasonable amount of contagion resulting from some of the recent developments, but nonetheless, as we get further into the tightening cycle and the cumulative impact of prior rate hikes becomes increasingly evident not only in the real economy but also in the broader financial system it should come as no surprise that there are pockets of stress and pockets of strain that are becoming increasingly obvious.

While there are no nominal coupon auctions on the schedule for the week ahead, we do have the potentially pivotal February inflation report. Tuesday will reveal the Core CPI numbers, and the consensus is looking for a four tenths of a percent month-over-month gain.

Similarly, the forecast for headline CPI is also +0.4% on a month-over-month basis. Given that the CPI release occurs during the fed's moratorium on public comments, we will be looking once again to the financial media for any resulting bias that would push the market one direction or another based on the 25 versus 50 basis point debate. All else being equal, we remain in the 25 basis point camp, but we will concede that a five tenth or a six tenths of a percent core number could sway monetary policy makers back to the 50 basis point cadence.

All that being said, we expect that the price action itself will become increasingly a fundamental story i.e. as we see 10-year yields consolidate closer to that 3.50 as opposed to 4.25 level. The market has intuitively recalibrated its forward expectations for precisely how far rates might ultimately back up given the balance of risks that are facing not only the US but also the global economy as we continue to see evidence of the fallout of the cumulative tightening that occurred in 2022 on a global scale.

We've reached the point 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 the debate between 25 basis points or 50 basis points on March 22nd comes down to the wire, we're left to ponder if it's the end of the quarter quarter or simply a delay of change.

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 Podcast 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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