Rebooting the Rally - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 274: Rebooting the Rally, 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 May 20th. And as we continue to ponder the accidental early release of April's CPI report, we look forward to the results of the investigation. However, we ultimately expect it comes down to an intern, AI, or a long overdue reboot. It's always the reboot.

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, all eyes were appropriately on the April CPI release. Core inflation came in as expected, increasing three tenths of a percent month over month. That brought the year over year figures down slightly. And when we look at this on an unrounded basis, it was a relatively clean 0.3%. Unrounded, the core move was 0.292%. What we didn't see is we didn't see it erring on the high side, which is good for the Fed. We also saw rents and owner's equivalent rents come back in line with pre-pandemic norms. While we're not seeing prints as low as we saw in 2018 and 2019, we're certainly off of the recent troubling highs. The same can be said for the supercore measure as well, not where the Fed would like it to be, but at least trending in the right direction.

Our takeaway from the CPI release was not only does the data conform with a 0.2% on core-PCE, but it's also the type of progress that the Fed was hoping to see as the second quarter gets underway. Recall that part of the Fed's narrative has been Q1 was the anomaly on the inflation front with a lot of the upside surprises weighted towards the early part of the quarter i.e. January. And as the proverbial inflationary dust settles, we expect that what will emerge is a resumption of the trend toward moderating inflation pressures that was well established during the second half of last year.

For the time being, however, there was really nothing within the CPI release that would imply any urgency on the part of the Fed to start cutting rates. The market's response followed somewhat intuitively with the odds of two rate cuts in 2024 increasing in terms of pricing in the futures market. The wildcard in the week just passed ended up being the retail sales print. It was expected to show growth of four tenths of a percent in the month of April, but it was flat. And the control group, which is the subcomponent most highly correlated with consumption in real GDP, actually declined. And as a barometer for consumption as the second quarter gets underway, it was certainly a troubling release.

In light of Powell's recent reiteration of the dual mandate i.e. jobs as well as inflation, investors have been particularly sensitive to any jobs proxies of relevance. The early May spike in initial jobless claims gave way to a bit more moderation, albeit still off of the lows. Now the discussion around the recent spike in jobless claims has to do with some seasonal adjustment issues. And as the week ahead contains initial jobless claims for nonfarm payroll survey week, we expect that it will be more closely followed for any implications for the May payrolls data.

On net, the recent price action the Treasury market has conformed with our assumption that the yield peaks for the year are in, in large part because Powell completely took the possibility of a rate hike off the table and because Q2's inflation profile is expected to show further moderation. 10-year yields managed to decline through the 200-day moving average of 4.32%. The associated price action in the yield curve was a bull flattener with 2s/10s inverting even further. Now in part, the stickiness of yields in the 2-year sector reflects the Fed's commitment to avoiding rate cuts as long as they deem necessary. So we weren't too surprised to see the flattening nature of the move. Eventually however, once the Fed either acknowledges that a rate cut is near or begins the process of normalization, we would expect the bull steepening to ultimately emerge as this year's theme.

Vail Hartman:

The data calendar ahead is light. We get the FOMC Minutes and a few housing sector updates leaving investors to focus on the risks ahead over the next several months as summer becomes a reality.

Ian Lyngen:

And with summer becoming a reality, we're reminded of the seasonality that tends to be very strong in the U.S rates market. Historically, or at least within the last 10 years, yields have tended to peak sometime in either late May or the beginning of June and subsequently drifted lower during the summer months. Now, this is obviously not prescriptive to every environment, but as we ponder the months ahead, it's important to keep this dynamic in mind, especially in the event that it becomes obvious that the Fed will be delivering something in terms of rate cuts because our expectation is that once the Fed finally starts the process, that the market will be eager to price in, even more than the Fed is willing to signal. Now, the degree to which that translates through to lower rates further out the curve is a significant uncertainty. If nothing else, once the Fed starts cutting, it should be a bull steepening, at least bullish for the 2-year sector.

Now, as we continue this period of relative stability in terms of fed funds at least, we'd be remiss not to at least acknowledge that as we get closer and closer to the presidential election, that there will be at least some probability that if Trump retakes the White House, he'll take a hard look at Powell as chair. Now, one could argue that perhaps that's an incentive for the Fed to start cutting sooner rather than later, but at the end of the day, it ultimately comes down to the data. Moreover, Powell's term doesn't expire until early 2026, although there have been some rumblings about whether or not the administration could find a way to marginalize Powell before his time as it were.

Ben Jeffery:

And as was always going to be the case in 2024, the start of summer is also going to usher in a heightened focus on the election itself and what the political outcomes of November are going to mean for the economy and for the market. Yes, on the one hand, the pressure that Powell feels or doesn't feel from the White House is an important variable to consider in pondering this dynamic, but also there's the direct legislative and executive action that can be taken either by Congress, whatever form it ultimately takes, or the White House in what that means for support for the economy, potential tax rates, higher deficit spending, and all of these factors that have become far more prominent in a discussion around where 10-year yields are going since covid and the massive amount of fiscal stimulus that was pumped into the economy and contributed to 2021 and 2020’s inflationary surges.

And to talk about a change in the political landscape more broadly that's taken place over the last several years, is the fact that whether it comes via the potential for higher taxes or via more governmental borrowing, generally speaking, the government's role in supporting the economy has become more pronounced. We saw that with the Inflation Reduction Act. We saw that with the CHIPS Act. And what this means is that as the Fed is doing its best to curtail demand without crushing the labor market and ultimately bring inflation lower, is that on the side of the equation, Congress and the White House are doing their best to keep jobs strong, keep consumption elevated, and keep the economy churning. It's not a new dynamic that politicians want a strong economy, while the Fed is more concerned about fighting inflation, but especially as policy platforms take clearer shape over the summer as we get closer to November, there's certainly the potential for a shifting consensus around who will win the presidency and the composition of Congress to drive a price response in terms of the longer end of the Treasury curve.

Ian Lyngen:

To your point, Ben, a sweep in either direction, either all GOP or all Democrats would be far more bond bearish than a split Congress or any implied checks and balances on the spending front. Ultimately, I suspect that that will be what truly drives the market's reaction to the results of the November election. I'll also make the observation that a Trump victory will be nowhere near as surprising in 2024 as it was in 2016. Therefore, the price action, at least in comparison to 2016, will likely be more muted regardless of who ends up in the White House.

Ben Jeffery:

And shifting away from politics and back to the monetary policy landscape, even though it's not an especially exciting data calendar this upcoming week, we do get the FOMC minutes from the May meeting where Powell's tone was not nearly as hawkish as the market was prepared for. Within the minutes, there will be a couple details worth looking out for. Most importantly will be any greater clarity on how the FOMC's relative weighting of labor versus inflation continues to evolve now that the actual language of the statement shifted the characterization of inflation progress as continuing to more of a past tense progress. And so the level of concern among several, few, or many participants on the committee about a reinflationary acceleration is going to be critical as the market continues to grapple with the uncertainty around the timing of the Fed's first cut and the likelihood that maybe, but probably not, another hike could be required.

Away from policy rates, we'll also be looking for a greater explanation behind the committee's decision to follow through with the announcement of tapering QT that's going to start in June and shrinking SOMA's runoff cap from $60 billion a month in Treasuries to $25 billion a month. Given the fact that all else equal, a slower runoff of the balance sheet is ostensibly a dovish impulse. Our interpretation is that this is just an extension of the logic that's become increasingly evident in Fed rhetoric that as it relates to the tightening side of a monetary policy cycle, the balance sheet and policy rates are driven by two distinctive factors. Policy rates are obviously more a function of the performance of the labor market and inflation, while it's the banking sector and the overall state of money markets and the financial system that is far more impactful for how aggressively the Fed was willing or not to continue conducting QT given reserve concerns and the risk of another move too close to reserve scarcity for comfort.

Now, the $25 billion a month cap that's going to take effect next month was very much in keeping with the guidance that was offered at the previous FOMC minutes. And so looking forward, we're going to be eager to see if there's any more information offered around how long the $25 billion monthly cap will continue, whether that's for a few months, a quarter, a few quarters, or if the Fed wants to return SOMA to full reinvestment of its Treasury holdings a bit more quickly.

Ian Lyngen:

One potential underlying motivation behind the Fed's decision to announce QT tapering is the fact that the Treasury department is expected to heavily utilize the bill market in order to fund any increase in deficit spending. So in practical terms, it's worth noting that the run-up in bill issuance that we have seen thus far has been credited for the very sharp decline in the utilization of RRP. Once RRP gets down close to zero, the baseline assumption is that bill funding will, for all intents and purposes, come out of bank reserves. Now, it's safe to say that while that might not have been the overarching motivation behind the Fed's decision, it certainly did play a factor.

One aspect of the Fed's QT tapering decision that doesn't have a dovish interpretation is the fact that they didn't change the cap for the mortgage runoff. It was left at $35 billion. Now, because of the slow pace of prepayments, the mortgage cap hasn't been reached in some time. Nonetheless, the Fed did make the point that any maturities in excess of the cap will be reinvested into Treasuries. So indirectly, the Fed is attempting to lean into higher mortgage rates. Now, when we think about this in the context of the performance of the real estate market, it's notable that prices have rebounded. And a key underlying driver of this dynamic is the fact that so many borrowers refinanced during the low-rate environment of the pandemic, effectively locking themselves into both a thirty-year mortgage and the property associated with it. So there has been very little supply brought to market. And when we think about the updates from the housing sector on the horizon, the market will be eagerly awaiting any evidence that there has been at least some incremental thawing and perhaps more activity as the typical selling season is fully underway.

Ben Jeffery:

And one of the drivers of our more constructive take on Treasuries over the balance of the year and frankly over the longer term is the fact that we have seen and expect we'll continue to see stronger foreign demand for US rates as the ECB, the BOE, the BOC all begin the of removing policy restriction a bit earlier than the Fed. This cycle has demonstrated that the U.S is something of an outlier in terms of the economy's resilience to higher rates. Even as recession risks become far more pronounced in other geographies or recessions have already been experienced in other places, the fact that housing's contribution to the overall economic landscape in the US is much more meaningful and contributes to inflation calculations in a more material way than in places like Europe, means that that supply shortage that you touched on, Ian, is much more influential for the domestic economy and ultimately the timing of the Feds first cut.

Clearly, the ECB is not going to delay cuts because US housing is remaining strong and the Fed is not going to rush to bring rates lower because growth in Europe or Canada starts to look a little bit shaky, but that won't prevent investors in either of those places from looking to the U.S for comparatively higher rates. And that in turn will limit the extent of any greater treasury selloff in a way that was dissimilar from 2022 and 2023 when every Central Bank was hiking.

Ian Lyngen:

So Ben, effectively what you're saying is that yields will go up and yields will go down, but not necessarily in that order.

Ben Jeffery:

Glad someone's paying attention.

Ian Lyngen:

In the week ahead, the Fed is once again in focus, not because we have an FOMC decision, but because we have a full slate of official Fed commentary including the New York Fed's Williams, as well as the release of the Minutes from the most recent FOMC meeting. Within the minutes, we're expecting that the Fed will err on the side of being hawkish, particularly because the last time the committee met, they didn't have the benefit of the April CPI print. So to some extent, the release will be stale in so far as it’s old information. But at the end of the day, we do think that it will be informative for market participants to have a sense of the conversations that were occurring when the Fed last met.

The week ahead also contains an early close on Friday for the long Memorial Day weekend, and the auction schedule is erring on the side of benign if nothing else. We have a $16 billion 20-year issue on Wednesday and a $16 billion 10-year tips offering on Thursday. The rally in the treasury market has reached the point that we would expect that any further downward progress in yields will run up against an increasing amount of resistance. Now, this isn't to suggest that 4.25 shouldn't be on the radar, but rather when we look at the technical profile, what we see is daily stochastics are well into overbought territory. Weekly stochastics and momentum measures suggest that there's still room to rally. However, the dailies imply that we need a period of in-range consolidation before investors will be comfortable staging a push towards lower rates.

We came into this year expecting 10-year yields to end below 4% at 3.95%. And given the recent developments on the macro side, we are increasingly comfortable with that forecast, and we will see how the combination of data and the price action play out over the course of the summer months with an acknowledgement of the fact that this tends to be a particularly bond bullish period of the year from a seasonal perspective and it's not difficult to envision our 3.95% target in 10-year yields being realized in June, shortly after June 12th.

Recall that June 12th is a marquee day for our macro traders because we have not only the FOMC rate decision, but we'll also have the Fed's updated projections for GDP, PCE, core-PCE, and unemployment, and then the beloved dot plot, which will signal either 25 or 50 basis points worth of rate cuts for the balance of 2024.

Combined with the Fed events, we will also have the release of the May CPI report. So it would be an understatement to suggest that the tone of summer trading will be struck on the 12th of June. In terms of curve shape, while we are on board with a deeper inversion in the near term, we ultimately think that 2s/10s will slip back into positive territory by the end of the year, but that's clearly contingent on the looming shift from the Fed favoring normalization towards lower policy rates.

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 we continue to marvel at the fact the stock market rally appears to be on rails, we are reminded that sometimes a light at the end of the tunnel is an oncoming train.

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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