Raise the Ceiling or Hit the Roof - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 219, Raise the Ceiling or Hit the Roof, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey and Vail Hartman to bring you our thoughts from the trading desk for the upcoming week of April 24th. As Congress begins the process of debating how to handle the federal debt ceiling, we are sincerely looking forward to submitting design ideas for the trillion dollar coin. The Shiba Inu has to be top of the list. Bushwood dog to its friends, Elon surely won't mind.

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 put in a mixed performance, spending a reasonable amount of the time with upward pressure on rates only to see that reverse as the week played out with the 3.5% level in 10-year yields remaining an important focal point on both a technical and tactical level. We saw the 20-year auction tail a slight 0.3 bp, which came almost immediately ahead of the Beige Book release. Now, the Beige Book release has historically not been a very meaningful market event, nor has it traditionally been associated with sharp price action. Within the Beige Book, however, there was an acknowledgement that credit standards had began to tighten as a result of the regional banking crisis and we were at least expecting some type of follow through in the Treasury market.

Alas, what we saw was a muted response. The biggest price action on the week was associated with developments overseas, specifically the higher than expected UK inflation data pushed rates higher earlier in the week only to be countered by weaker than expected PPI data out of Germany, as well as a disappointing consumer inflation print from New Zealand. The comparatively light liquidity conditions during the overnight market arguably contributed to exaggerated moves in US rates during these periods, but nonetheless, this contributed to decidedly range trading conditions within the US rates market. The shape of the yield curve remains very topical with 2s/10s pushing through the 40-day moving average. We are continuing to target the opening gap at negative 82 to negative 89 basis points as a target between now and the end of May. The logic is relatively straightforward. What we are suggesting is that there will be upward pressure on front end yields as the Fed delivers the final rate hike and attempts to retain at least some degree of flexibility at terminal.

Clearly, the biggest debate from a macro perspective will be how long can the Fed keep terminal in place and rate policy decidedly restrictive. The Fed fund's futures market suggests that it won't make it into the end of the year, whereas everything that monetary policy makers have suggested thus far implies the first-rate cut won't be until 2024. Our interpretation of the 50 to 75 basis points of rate cuts priced in by the end of 2023 is that this reflects the binary nature of the potential outcomes. Either the real economy performs close enough to a soft landing that the Fed isn't compelled to cut rates or financial conditions tighten so dramatically that monetary policy makers are required to respond with a downward adjustment on policy rates. It goes without saying that it's much too early in the process to have a firm opinion about which of those two scenarios is more likely to play out, but all else being equal, we tend to err on the side of pessimism.

Vail Hartman:

While it's been a relatively uneventful week in US rates that I think would be best characterized by the VIX reaching its lowest level since November 2021 and the move index also pulling decidedly off its mid-March peaks, what do you guys think… is vol gone?

Ian Lyngen:

Well, given the headlines that have come out of the banking sector, specifically that earnings did not show any significant evidence of strain as a result from the developments in the middle of March, the market has been content with a period of consolidation for US rates and something of adrift higher in risk assets. Now, this isn't to suggest that the regional banking turmoil won't eventually have some ramifications for the real economy, but rather that the acute risk has passed. When we think about the fallout, it will most likely come in the form of tighter financial conditions that will have a slow and steady impact on consumption as opposed to the flight to quality or systemic risks presented by a bank run. Perhaps more importantly, a bigger takeaway from the last six weeks is the fact that the Fed's macro prudential tools appear to be adequate to address the type of banking crisis that we might have found ourselves in at the moment without the FOMC needing to resort to rate policy.

Now, the implications for the May 3rd meeting are relatively straightforward. We anticipate a 25 basis point rate hike, which will be the final for the Fed's tightening campaign, reaching terminal of 5.1% in effective terms or an upper bound of 525. This is very consistent with the signaling that we've received from the Fed over the course of this year, including the March SEP. All that being said, the bigger question quickly becomes whether or not the 25 basis point hike will be accompanied by more cautious language, i.e., a dovish hike, or if there'll be an emphasis on flexibility going forward, i.e., a hawkish hike.

Ben Jeffery:

It's exactly that dynamic that I would say is the main driver of that drop in volatility that you highlighted, Vail, both in equities and rate space. The fact that the price action has become far more tame versus the excitement of March is the market's vote of confidence that the combination of the discount window and the BTFP are functioning as designed and containing any broader contagion and that in turn has translated to increased conviction on the near term trajectory of monetary policy for what I would argue is the first time since the pandemic when the Fed was extremely committed to maintaining an accommodative policy stance. So now that we know or at least have higher conviction in the fact that one more 25 basis point hike and then an extended period on hold is at hand, that in turn has translated to something of a period of equilibrium in terms of Treasury yields with 10-year rates right around that 350 level.

The 2s/10s curve also similarly consolidating around negative 60 basis points more or less, and this points to a market that is waiting for the next fundamental input to inform that debate that you touch on, Ian, which is the next big macro one in the timing of the Fed's first-rate cut. More tactically and technically speaking, we also heard the observation offered several times this week that the reason we've seen this period of bearish consolidation and 10-year yields back up to as high as 365, 370 earlier this week is that for the first time in a long time, collectively the market is long duration and that means that the selloff that's required to bring in the incremental buyer from the sidelines is going to require marginally higher yields given the fact that a lot of bonds have already been bought.

Ian Lyngen:

Said differently, the market is increasingly all on the same side of the trade, which in this environment implies that the pain trade will be higher rates as the Fed comes into focus. Let us not forget that we do see the first look at Q1 GDP on Thursday. Expectations are for a 2% increase in real growth and our take is that there's very little shy of a negative GDP number that will materially contribute to the Fed's outcome the following week. Nonetheless, it will be a tradable event and given that the Fed will be in its pre-FOMC period of radio silence, the initial knee-jerk in the US rates market could ultimately develop a momentum of its own.

Vail Hartman:

We also had tax day this week, unfortunately, and we got an early indication of what tax receipts will look like. What do you guys think this means for the debt ceiling?

Ben Jeffery:

It's a great point, Vail, and this is something that is also unfortunately occupying an increasing share of the conversation that we're having with clients on just how likely it is that the US technically defaults and misses a bill payment at some point in the upcoming months. Yes, it was tax day over this past week, and so we've gotten an early indication of the state of individual tax returns and just how much money is going to be flowing to the Treasury Department. Now, it will still take a couple of weeks for us to have true clarity on this issue just given the fact that it will take time to process the incoming payments, but the early indications seems to be that tax receipts are not as strong as initially hoped. What this means for the debt ceiling and the potential drop dead date is that while there was some discussion that the drop dead date could be as far out as late August or even early September.

Now, that conversation has shifted decidedly earlier, so early July, June, and we've even heard some expecting that the Treasury Department could run out of money as soon as the end of May. In terms of the market's reaction, bill rates have responded in textbook fashion and that maturity's ahead of the perceived drop dead date, so that's May's paper into early June are outperforming dramatically as there is a share of investors who are unwilling to take the risk posed by a delayed payment and that in turn is translating to a fair amount of risk premium baked into the yields that are offered on bills maturing in June.

Now, to be clear, we view the risk of a delayed payment as effectively zero, although we'll acknowledge Congress is more divided that it's been in recent memory, which marginally increases the odds of a delayed payment. But remember, the unique aspect of Treasuries is that even if a bill payment is one or two days late, that does not then mean that every Treasury outstanding is then in default. So in terms of the broader ramifications for say a 10-year note, somewhat counterintuitively, we actually expect the debt ceiling risk will resolve in favor of lower long end Treasury yields, not higher.

Ian Lyngen:

And if nothing else, the demonstration of this function in Washington will remain topical in the coming weeks. The process of negotiation has already begun. We do anticipate, as been alluded to, that it will come down to the 11th hour and as a rolling target without greater clarity from the Treasury Department as to precisely when the government runs out of money. Congress finds itself in a position of it being most politically expedient to delay a deal until we can actually see what the 11th hour is and then cobbling together some type of agreement that avoids a technical default.

Ben Jeffery:

And while it's very unlikely that any of the early proposals are going to make it all the way through the legislative process, we have seen two alternative plans floated, one by the GOP and one from a bipartisan group of lawmakers. The former advocated for raising the debt ceiling by one and a half trillion dollars, which is estimated to give the government a run rate to sometime toward the end of Q1 2024, and the bipartisan suggestion was simply a suspension of the debt limit until the end of the calendar year 2023 in order to buy more time for the negotiating process to play out. And while the Fed meeting is probably going to dominate the discourse over the next week, once we get into the later parts of May and toward June, it's a very reasonable assumption that the angst on the debt limit is only going to pick up from here.

Vail Hartman:

The fact that we didn't see a significant price response following some evidence of tightening credit conditions in Wednesday's Beige Book leaves the market eagerly awaiting any insight on the issue, but the Fed's senior loan officer survey isn't released until after the May FOMC meeting.

Ian Lyngen:

You make a good point, Vail, and I do think that the muted price action speaks to the notion that the market would like to move beyond the potential for a banking crisis, but the reality is that changes in the lending landscape don't have immediately tradable ramifications because at the end of the day, we won't have a good sense for the degree to which tighter lending standards impact the real economy until we're well beyond the point in which the transition commenced. That implies that it won't be until perhaps the third quarter before we have more concrete evidence for what the regional banking crisis did to the US economy.

Ben Jeffery:

And in terms of a potential area of focus on what might come next, a prominent feature of a lot of the questions we've received this past week has been commercial real estate. Obviously, that's a sector of the economy that's heavily reliant on relatively easy access to credit, and when taken with the well discussed story about increased office vacancies, some noteworthy defaults in the commercial real estate space, there's definitely an increasing focus on what it means for commercial real estate. If vacancies continue to drop and firms are not as easily able to access capital. Now as it presently stands, I think that's best categorized as something to be mindful of, not necessarily an imminent crisis, but if the regional banking crisis in March was one of the early cracks that have started to appear in the economy as a result of the Fed's tightening, I would say the commercial real estate sector is another one to look out for as we get towards summer.

Ian Lyngen:

This brings up an interesting point, Ben, and I'll ask you this question. If the commercial real estate market found itself in a dearth of liquidity, do you think that the Treasury Department would step up and do buybacks?

Ben Jeffery:

Well, maybe not of office buildings per se, but we did talk a lot about buybacks this week, and that was in the context of off the run bonds. What Ian has so eloquently segued to is the fact that within the May refunding questionnaire, the Treasury Department continues to ask about the issue of liquidity support for the Treasury market via conducting buybacks, both for cash management purchases in the shortest part of the market with maturities less than one year, but also for liquidity support and secondary trading further out the curve. Anything beyond a year to maturity. And the way such a program would work is that auction sizes would begin growing, aka increased on the runs in order to fund the purchase of comparatively less liquid off the run securities across the curve, likely distributed in such a way that wouldn't distort the overall maturity profile of the market.

While such a program would likely accomplish the Treasury Department's goal in terms of concentrating trading activity and on the runs, it would likely come at the expense of liquidity in off the run space and diminish some of the relative value trading opportunities that we tend to see in that part of the market. After all, the Fed holds a lot of these securities and many of these bonds are also tucked away in hold to maturity portfolios, and so a diminished trading float runs the risk of less active market participation and off the run space, which would drive more trading into on the runs and presumably lower the Treasury department's cost of funding.

Ian Lyngen:

We're certainly sympathetic to the timing of the conversation from the Treasury Department. Because of the debt ceiling, there has been liquidity put into the market, for all intents and purposes, the Treasury Department has been providing QE while the Fed has been attempting QT. It's not until the TGA gets replenished after the debt ceiling issue has been resolved that we'll see the full extent of the Fed's balance sheet rundown and the implications for reserves and liquidity in the system. So in light of the timing of Yellen's conversation around buybacks, if nothing else, the Treasury Secretary is attempting to put in place a stop gap in the event that things go terribly awry with Treasury liquidity during the summer months.

Ben Jeffery:

Speaking of summer, Vail, any plans?

Vail Hartman:

I'm thinking about starting a podcast.

Ian Lyngen:

Really? What would you call it?

Vail Hartman:

Beyond the Veil, obviously.

Ian Lyngen:

Well, I'm looking forward to the unveiling.

In the week ahead. The Fed will be in its pre-FOMC meeting moratorium on public comments, which in effect is radio silence until we get to the May 3rd meeting. The biggest data point of any relevance will be Q1 real GDP. Expectations are for a two-tenths of a percent increase and, within the details, the market will be interested to see how inflation performed and if there's been any material impact on personal consumption in Q1. Now, these numbers will be followed on Friday by March's spending and inflation numbers, and while all of March's data will be contained in the Q1 combined figures, the trajectory of consumption and inflation will be the biggest takeaway from the March series. We also do have a variety of auctions that will be hitting the market, specifically $42 billion in two-year notes on Tuesday, followed by Wednesday's five-year offering of 43 billion and capped by Thursday's seven-year at 35 billion.

We remain relatively constructive on the auction process and expect that there'll be more than sufficient demand to take down Treasury supply. It's also notable that as the debt ceiling approaches, bill auction sizes will be skewed lower and that could ultimately drive incremental demand for the two-year sector. Speculation and expectations as far as how the Fed will characterize the final rate hike of the cycle, whether it ends up being a hawkish hike or a dovish hike, has clear implications for the shape of the yield curve. In the event that Powell delivers a quarter point and quickly transitions the conversation to an emphasis on how long terminal will be retained, that will at least initially be read as more dovish than expected and resteepen the curve. In the event that Powell focuses on flexibility and symmetry following the pause, this would imply that another rate hike might actually be on the table this year, and that would be a more hawkish outcome and serve to invert the 2s/10s curve even further.

As is so often the case, departure point matters. If we go into the Fed with 2s/10s at negative 50 basis points, there'll be a much higher probability that a flattener ends up being the takeaway. If the market finds itself with 2s/10s at negative 75 or negative 80 basis points, then the path of least resistance will be a steepening presumably led by the front end of the curve as investors focus on any dovish elements that the chair has to offer.

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 watch Tesla prices drop by nearly a third in three months and the recent headlines highlighting Twitter office closures, we cannot help but ponder how long it will be before the BLS publishes a CPIX Elon Index. Not super core by any means.

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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