Red Dot State of Mind - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 197, Red Dot State of Mind, 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 November 14th. Friday is a holiday in the bond market, but not in equities, further reinforcing our career decisions. Although let's face it, we were never going to be optimistic enough to make it in stocks anyway.

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. That being said, let's get started. In the week just passed, the Treasury market rallied significantly on Thursday as a function of the lower than expected core CPI print.

By way of a quick recap, core CPI printed up just 0.272%, which was far under the 0.5% consensus. This conformed broadly with the peak inflation narrative and to some extent has been anticipated by market participants for some time. Frankly, it was the August and September core figures that were the bigger surprise and is what has led the Fed to increase their estimate of the terminal policy rate for this cycle. The post CPI price action was notable insofar as all of the benchmarks rallied. In some cases, the move was over 25 basis points. 10-year yields fell slightly below effective Fed funds, which is 383, a fact that brings into question how the curve will behave between now and the end of the year.

If we see two-year yields dragged higher by the next 50 basis point rate hike in December, it follows intuitively that we'll see a return of the deeper inversion narrative. For the time being, however, the market seems content to bring forward what we anticipate will be the big trade of 2023, and that is the cyclical bull steepening of the curve. Now, all the post CPI incoming Fed speak has reinforced that there is still more work to be done to keep forward inflation expectations well anchored, and that implies several more rate hikes from here. The path of least resistance, the Fed funds futures market at the moment suggests 50 basis points in December, 25 in February, 25 in March, and a reassessment at that stage.

That would bring effective Fed funds to 4.83. The question then returns, should that be the lower bound for two-year rates? Especially given the fact that the Fed will signal their intention of keeping policy rates elevated for an extended period of time. All that being said, there's certainly room for 5s, 10s, and 30s to rally from here, even in an environment where there's potentially another hundred basis points of rate hikes yet to be realized before the Fed chooses to go on hold. As is so often the case in financial markets, investors are attempting to get ahead of the next big move, an inclination for which we certainly have a fair amount of sympathy.

The balance of risks as we see them between now and the end of the year is that the longer end of the market continues to rally despite what we expect to be a decidedly hawkish tone from incoming Fed speakers as officials attempt to push back against the market's pricing in of a policy pivot.

Ben Jeffery:

Well, Ian, it's been a long short week and really it was always going to be a trading environment when the only thing that mattered was Thursday's inflation data. Sure, we got an impressive tail at the 10-year auction on Wednesday, but really the biggest takeaway was that October CPI print came in meaningfully below expectations with details that supported the peak inflation narrative, and that in turn brought 10-year yields decidedly back through 4% and even through 3.90 as buying interest in Treasuries picked up heading into the long weekend.

Ian Lyngen:

The moves were very sharp. We saw most sectors across the curve rallying by 25 basis points or more intraday, and that's meaningful given that this was the first significant miss that we've had on core CPI over the course of the last several months. Core CPI on an unrounded basis printed at 0.272% for the month of October. Consensus was for effectively double that at 0.5%. As a result, the year over year pace declined to 6.3 from 6.6. Now, that's the lowest since July and is very consistent with the notion that the prior Fed rate hikes have begun to have an impact on the real economy and realized consumer price inflation.

Owners equivalent rent also decelerated slightly, still above the norm, but printed at +0.6 versus +0.8 in September. Used car and truck prices declined 2.4%, and that's on top of the -1.1% in the prior month. Overall, the sentiment reflected in the Treasury market was one of renewed confidence that the Fed has made significant progress in its fight to keep forward inflation expectations well anchored.

Ben Jeffery:

Outside of the reaction in the longer end of the curve and 10-year yields, it was also extremely notable what we saw in the Fed Funds futures curve, specifically terminal pricing, and what was a very well entrenched expectation that terminal this cycle will be a 525 upper bound. That was before the CPI numbers hit. And after the data was in hand, we got a full 25 basis point rate hike pulled out of those valuations. Now the futures market shows an upper bound at 5%, but more immediately relevant is what this means for December's Fed meeting, specifically the debate between a 50 or 75 basis point rate hike.

And while yes, October's data is just a single month, the disappointment we saw Thursday morning all but takes another 75 basis point hike in December off the table. As we heard from The Wall Street Journal immediately following CPI, 50 basis points should be the operating assumption going into the last Fed meeting of this year.

Ian Lyngen:

Also keep in mind that we will get another CPI print before the Fed decision in December. It is certainly conceivable that if we see another lower than expected print in core terms, that the debate could shift to 50 versus 25. That certainly at this stage should be on the radar as a potential outcome.

Ben Jeffery:

And beyond December, the next phase of trading the Fed is likely going to be not how many additional 50 basis point moves we get, but how many quarter point hikes will be realized in the early part of 2023. At this point, a reasonable base case is at least one in February. If not necessarily, an additional quarter point move in March. But given we have four additional inflation prints between now and the March meeting, that is going to be, to quote Powell, data dependent. As for what this means for the level of rates in the front end of the curve, the argument can now be more compellingly made that the yield peaks and benchmark Treasuries are in.

We're transitioning to the point where investors are going to be less willing to sell rallies and more willing to buy dips. Now obviously a major theme of 2022 has been real money accounts decidedly underweight duration. And now that we've seen that bias move back toward neutral, the next step in that logical path is moving to overweight duration in an environment where the economy is beginning to slow and the lagged impact of the Fed's hikes are beginning to show up more materially.

Ian Lyngen:

Another important milestone that we've seen in the Treasury market in the wake of the October CPI data was the rally in 10-year yields brought the benchmark through the effective Fed Funds rate. Now, this is a dynamic that we had on our radar for this period between the November and December meetings. The fact that this occurred based solely on a single inflation print is somewhat surprising. However, with effective Fed Funds currently at 3.83, the fact that 10s got as low as 3.825 does set up for a meaningful challenge of the narrative that effective Fed Funds should function as a floor for Treasury yields up until the point the Fed is done hiking.

Now, clearly the next 50 basis point rate hike in December will push rates well through effective at least further out in the curve. What remains to be seen is whether the two-year sector will use effective Fed Funds as a floor. All else being equal, we do think that that will hold as a floor into the end of the year. It's not until the market can see the final hike, which will presumably be in March, if not May, that we would expect the two-year sector to begin to outperform versus funds.

Ben Jeffery:

While we've talked a lot about the ongoing flattening potential of 2s/10s, we've reached the point in the cycle when flattening in 5s/30s is becoming less clear cut. One way to think about this uncertainty is really the degree of clarity we're going to have on the path of interest rates over the next five years, which in the post-pandemic world gets back to the question whether the shock brought on by COVID really ushered in a more structural change to the economy. Is inflation durably higher?

Do policy rates need to be more sustainably elevated? Ian, as you touched on, now that we are approaching the end of the hiking cycle, what version of policy easing needs to be incorporated into rate assumptions on the other side of 2023 and into 2024 and beyond? What does that mean for the steepening potential of 5s/30s as the economic data begins to roll over more significantly?

Ian Lyngen:

Our take has always been that the dislocations created by the pandemic were going to take much longer to work through the system, but ultimately, the post pandemic world won't be all that much different from before 2020. The notion that a push for fringe shoring and onshoring the manufacturing sector was going to ultimately lead to a sustainably higher wage inflation environment as inflation expectations become embedded in the economy only resonated on a temporary basis.

One of the reasons for this has been the Fed's commitment to the 2% inflation target. As long as the Fed is committed to returning inflation to 2%, even if the strength of the jobs market might otherwise have led workers to anticipate further wage gains on a forward basis, the reality is that the Fed's willing to endure enough demand destruction to make 2% happen.

Ben Jeffery:

And despite our and the market's latest focus on the disappointing CPI print, let's not forget what we saw last week in the jobs numbers. Another unquestionably strong read on hiring in October. And despite headlines to the contrary, even the jobless claims figures continue to show that the labor market overall remains in a very strong place. The participation rate still has room to increase. And while this strength will likely not keep the Fed hiking through the entirety of next year, it will provide Powell the excuse to not deliver rate cuts as soon as would otherwise be expected.

Given that even in an environment when inflation starts to decelerate more materially, we're still going to be a great distance from that 2% inflation target and the labor market still has ample room to give before the job side of the dual mandate will start to become a more important input than inflation into the Fed's calculus.

Ian Lyngen:

Recall, Ben, that we did see an increase in the unemployment rate, however, a two-tenths of a percent gain to 3.7% from 3.5%. That occurred with a decline in the number of jobs reported by the household survey. We made the observation at that point, and I still think that it's relevant, and that is we only tend to see a divergence between the headline nonfarm payrolls from the establishment survey and the change in jobs reported on the household level when there's an inflection. In this case, we're anticipating that the inflection is going to be toward a weaker labor market in 2023.

Now, to a large extent, that is by design because the Fed is actively attempting to put the brakes on the real economy to regain some of its lost credibility as an inflation fighter, but this is the area that we've identified as having the highest potential to indicate the Fed has overshot on the tightening side. We have a lot of confidence in the Fed's ability to move the unemployment rate from 3.5% to 4.5%, but much less confidence in their ability to stop the unemployment rate from going to 5.5% or 6%.

Ben Jeffery:

Ian, to put that risk you emphasized in a different terminology, central banks have a poor track record of engineering soft landings. It's this narrative that's going to be the defining trend of 2023, a worsening labor market, a lower growth environment, moderating wages, all with the global backdrop of the issues facing Europe as a result of the war in Ukraine and inflation, simmering geopolitical tensions in East Asia, and all of that will reinforce this safe haven dip buying bias that we'll argue has started to materialize over the past few weeks.

Ian Lyngen:

Well, at least it's materializing somewhere. Sorry, crypto.

In the week ahead, financial markets will continue to digest the downshift in core inflation and the implications for monetary policy makers not only in the US, but also globally. The economic data highlight will be Wednesday's retail sales numbers. We're anticipating a 1.1% increase in sales during the month of October, but we'll also get housing starts and permits data, as well as existing home sales on Friday. All of this with the backdrop of a variety of Fed speakers, including Williams, Harker, Jefferson, and Kashkari.

As we've heard so far, the Fed will not be dissuaded from a 50 basis point hike in December simply based on one weaker than expected core number, particularly as the downshift is consistent with the Fed's objective and we continue to see relative strength in the employment market. Now, as we've lamented, once momentum begins to shift in the employment landscape, we're concerned that the move might run too far. We also get the PPI data for October. But given that it follows CPI, it will be far less impactful for policy expectations we suspect.

Similarly, Wednesday's release of import prices for October will be more of a background factor reinforcing some of the moderation that we saw on the consumer price side. From a supply perspective, $15 billion, 20 years on Wednesday should require something of a concession if not outright, then at least on the curve. We also have Wednesday's $15 billion 10-year TIPS auction. Underwriting inflation protected securities in the current environment hasn't been a particular issue given the emphasis on the outperformance of inflation. At some point, there might be a wane in demand. But with year over year headline inflation still running at 7.7%, we're doubtful that it will be this year.

As we enter the latter half of November, we're reminded of the liquidity strains that are already evident in the Treasury market and the potential for those to exaggerate as the year end turn comes to fruition. If we are going to see any pre year end shift in the SLR, it will need to be announced sooner rather than later so the market can incorporate any changes. 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. Note that we do see the University of Michigan's Consumer Sentiment Report on Friday despite the bond market's closure.

Equity traders will be in to respond to the release, implying better sentiment in bonds than in stocks by definition. 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. 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.

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