Sahm's Gauntlet - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 285, Sahm’s Gauntlet, 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 August 5th. And as we watch our 401K become a 301K with eyes on a 201K, we're reminded of how much we love working, retirement's for quitters.

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 had a wide variety of influences from which to derive trading direction, and it ultimately resolved in lower rates and a steeper yield curve. 2s/10s got as steep as roughly negative five basis points. Marking the extremes for this point in the cycle, and it's very consistent with the cyclical re-steepening of the curve that many market participants had been anticipating. We also saw the refunding statement in which the Treasury Department announced an increase in the size of their liquidity providing buybacks to $30 billion from $15 billion. There was also renewed geopolitical risks in light of the tensions in the Middle East. And the week was capped with a disappointing employment report, one that saw the unemployment rate reach 4.3%. This is nine tenths of a percent off of the cycle low, and it triggered the Sahm rule, which suggests that the market should be on recession watch over the course of the next 12 months.

Now, obviously weakening in the employment market doesn't necessarily trigger a recession per se, and the Sahm rule is just one of many potential indicators that the market will be following. Nonetheless, ten year yields managed to drift below 3.80%, and as the market continues to consolidate, we anticipate that the takeaway from the July employment report will be that there's plenty of justification for the Fed to move 25 basis points in September. Although the report in and of itself isn't enough justification for a 50 basis point cut. We're reminded however that between now and the September 18th meeting, we'll see two CPI prints and another payrolls figure. The combination of these three additional updates could put 50 basis points solidly on the table, although all else being equal, the Fed would probably rather cut 25 in September, November and December as opposed to starting the process of normalization with 50.

Even cutting 25 basis points at each meeting will incentivize the market to price in rate cuts at every meeting in 2025, thereby re-steepening the curve even more dramatically. As it currently stands, the market is more than fully priced for 25 basis point rate cuts at each of the next three meetings, with the risk that we could see more. And let us not forget that there was a cautious tone set at the FOMC meeting as the Fed included the word somewhat in their characterization of inflation to now read “remained somewhat elevated". The introduction of the dual mandate language into the statement also served to refocus investors on the notion that the trajectory of employment matters, and that was at a minimum serendipitous timing given the July non-farm payroll sprint.

Speaker 2:

The July FOMC displayed a clear shift in rhetoric that solidified the market's expectations that Powell is on the precipice of a normalization campaign. That said, Friday's disappointing payrolls figures have led the market to greater speculation around whether the FOMC will deliver a 50 basis point rate cut in September, as opposed to the market's prior operating assumption for a fine tuning 25 basis point rate cut. Several comments from Powell at the post FOMC press conference suggest policymakers would be open to 50 basis points as opposed to 25. First, we heard Powell say he could imagine anywhere from zero to several cuts over the balance of the year. Second, Powell said there was a real discussion back and forth of what the case would be for moving at the July meeting. And third, the chair said that the committee is well positioned to respond to weakness with the policy rate at 5.3%, and there is a lot of room to respond in the event of more material weakness in employment and growth.

Ian Lyngen:

And this is certainly consistent with the way that the market has been trading. The front end of the market rallied, the 2s/10s curve re-steepened, and we're now fully priced in for 25 basis points at each of the next three meetings with the possibility of more. The question becomes whether or not the Fed would actually be comfortable doing 50 as opposed to simply adding another 25 into November, to signal a more measured pace going forward.

When all is said and done, we are reminded that the reintroduction of balance into the employment market was to a large extent by design from the perspective of monetary policymakers. And even though the unemployment rate at 4.3% is nine tenths of a percent off of the cycle low, the reality is that in outright terms, a 4.3% unemployment rate is consistent with a strong labor market. Also, keep in mind that we saw a one tenth of a percent increase in the labor force participation rate to 62.7%. So, to some extent it was a "good” increase in the unemployment rate. All of that being said, the Treasury market liked it, and most of the major benchmarks are now trading with the three-handle.

Speaker 3:

And even before the soft look at headline hiring, the increase in the unemployment rate, and the slowing of average hourly earnings growth, the universal line of questioning we got from clients this week coming out of the FOMC was, okay, sure the market should rally, but should the market rally by this much? And I would argue a lot of that dynamic has to do with the asymmetry around the forward path of the economy and the path forward for the FOMC.

Said differently, and to your observation on the unemployment rate Ian, if history is any guide, the increase in the unemployment rate does not typically precede a lengthy period of moving sideways comfortably around a level close to NAIRU, and instead it's a much more elevator up, escalator down type of situation, that in terms of the price action in treasuries, leaves a lot more asymmetry to the yield downside than upside. After all, over the course of the next several meetings, it's relatively straightforward for the Fed to cut by 50 basis points once or even multiple times. It's much more challenging for the Fed to walk the market back for the more than a hundred basis points that is now priced in over the balance of 2024.

Ian Lyngen:

Although keep in mind that's precisely what happened at the beginning of the year, and that did result in a fair amount of pain in the Treasury market, for lack of a better phrase. And we saw choppy price action with the outlook for a march cut being effectively taken off the table by the real economic data. We remain on board with a 25 basis point rate cut in September, with a chance in November, but at this stage we'll argue it's probably overpriced and we would need to see the deceleration pick up in the employment landscape and far more benign inflation figures to get the Fed going at every meeting.

Recalling January of this year, it's certainly not atypical for the market to want to get ahead of what the Fed will ultimately deliver. And so we are anticipating that over the course of the next week and a half, i.e. between now and the July core-CPI number on the 14th of August, that the market will consolidate in the prevailing range with a curve steepening bias. If for no other reason than we do have supply on the horizon. And while the employment report might have brought investors to the precipice of jobs related anxiety, it's unlikely to have so for the Fed. Again, the logic here being that the Fed wanted to cool the jobs market and they have been successful in that endeavor. There was little in July's jobs report that will convince the Fed that they've overshot. That, if it occurs, won't be until we have the August and potentially September data in hand.

Speaker 3:

And it's that, remain calm, things are going according to plan narrative that we'll be on the lookout for as fed rhetoric returns on the other side of the July meeting and the market prepares for the Jackson Hole Symposium at the end of August. Given that one of the main takeaways from Powell's press conference was a renewed emphasis on the dual mandate and an acknowledgement that the risks facing the labor market are now more or less on par with the risks around the inflation complex, that means that two more months’ worth of data and a full six months’ worth of data before the end of this year are going to need to show on the one hand unemployment rate that does not accelerate materially higher to five or five and a half percent, and also crucially, disinflation that continues to show up in the realized data.

Now obviously, Friday's average hourly earnings report was a vote of confidence in consumer prices continuing to trend lower, but now with the market pricing fed funds to nearly 3% by the end of 2025 and well below the last dot plot in terms of the last update from the Fed's official projections, the risk of sticky or even accelerating inflation over the next six to 12 months has been heavily discounted by investors. And that could certainly end up being the case, but as we heard from Powell on Wednesday, the Fed's going to want to see that data first.

Ian Lyngen:

And let us not forget that the Fed isn't the only major central bank in motion. In the week just passed, we saw a rate cut from the Bank of England, and that is the first of their cycle, bringing the bank rate to 5.0% from 5.25% where they spent roughly a year. On the flip side, the Bank of Japan delivered an arguably unexpected increase in policy rates to 25 basis points from the prior level of 10 basis points. Now, when we put this in the context of the Treasury market, the Bank of Japan's decision was followed by an extension of the rally in the yen.

Japanese investors have long been a key component of the treasury market, although the prior weakness of the yen, to a large extent, had kept buying at bay from one of the key regions of sponsorship for Treasuries. As we watch the policy divergence between the US and the Bank of Japan start to extend, one would assume that that's accompanied by continued strength in the yen. That will also translate into less onerous hedging costs and presumably the return of Japanese investors in more significant size to Treasuries. On net, this is also consistent with our broader constructive outlook on the treasury market, and we'll remind that there is a strong seasonal tendency in treasuries that favors lower yields between now and the middle of September. Which during this particular cycle happens to correspond with when the market is expecting the first rate cut.

Speaker 3:

And it wasn't as if there was any lack of bullish drivers for Treasuries over this past week, but geopolitics also re-entered the macro conversation as what appears to be a renewed escalation in the Middle East and a re-flareup of tensions with everything that means on the one hand for a flight to quality impulse into safe haven assets, and on the other hand, the inflationary implications in commodity markets. Now, as we've talked about several times throughout the course of this cycle, the role that oil plays in driving higher costs has now taken on a less prominent role than it initially did when inflation was in the process of peaking a couple years ago. And it really didn't matter whether that was oil driven, wage driven, or driven by anything else, because the Fed was simply going to continue hiking regardless of the nuances between headline and core consumer prices.

Fast forward to today and the progress that the Fed has already made in bringing core inflation lower allows them a little bit greater leeway in drawing the distinction between higher prices that are simply a function of energy costs and higher prices that are a result of truly demand-driven factors like we saw on the other side of the pandemic. So in an environment where jobs, monetary policy, and global central bank's actions have definitely been in the driver's seat in terms of getting 10-year yields back below 4%, there's now a renewed area of focus as to what might happen next in the Middle East. That's another thing for investors to consider as we head into next week, which is relatively sparse from a data perspective, but important as it relates to Treasury supply and the August refunding auctions of tens and thirties.

Speaker 2:

The refunding announcement confirmed unchanged coupon auction sizes for the upcoming quarter, and the statement retained the phrase that said the Treasury department does not anticipate needing to increase nominal coupon auction sizes for at least the next several quarters. And this effectively pushes out the focal point of the debate regarding the earliest we could see the next round of coupon auction size increases to the second half of 2025. i.e. August versus November. Now, it's difficult to have a high degree of conviction around when we could see another round of increases that far in the future, given that the outlook will be very heavily dependent on the November election results and whether or not we see a sweep in either direction from the GOP or the Democrats.

Ian Lyngen:

It's also important to keep in mind that there are two parts of the deficit spending equation. One is spending, but the other is revenues. And so if we find ourselves slipping into an economic slowdown, presumably tax revenues will be lower. And that is an environment in which typically we tend to see an increase in deficit spending and associated with that would be more borrowing by the Treasury department. But given the fact that 10- and 30-year yields are a function of global macro expectations, we could find ourselves in the second half of 2025 with an outright lower rate environment, just given what's going on with the real economy, even as the Treasury department needs to increase coupon auction sizes. So, to simply conclude that it is a supply and demand dynamic unfolding in the Treasury market, overlooks the fact that 10-year yields below 4% at the moment have nothing to do with what's going on at the Treasury department.

Speaker 2:

What's going on at the Treasury department?

Ian Lyngen:

Sounds like nothing.

In the week ahead, we're expecting a bit more drama in the Treasury market than the relatively uneventful calendar would imply. We've seen a material shift in the broader trajectory of the Treasury market and US rates, and we have also seen this accompanied by a pivot in forward monetary policy expectations. The market came into last week assuming that the Fed would start a well-telegraphed, measured campaign to normalize policy rates. The disappointing payrolls print however, suggested that the Fed might need to be a bit more aggressive in bringing rates back to neutral if they're going to preserve the notion of a soft or no landing. As a result, the 2s/10s curve re-steepened to negative five basis points, not quite in positive territory, but we anticipate that over the course of the next two weeks, we will see a continued grind of 2s/10s back into positive territory.

Now, this will be assisted at least in part by the upcoming refunding auctions. Recall that on Tuesday, we have $58 bn 3-years and then $42 bn 10-years on Wednesday, capped with $25 bn 30s on Thursday. On the data front, we do have the ISM Services print on Monday, which will in all likelihood set the tone for the first part of the week. The market also gets the quarterly update from the Fed's Senior Loan Officer opinion survey, and while this survey has yet to show any material tightening of credit standards, we are getting to the point in the cycle where the outright level of real policy rates suggest that we might finally see some indication that this is flowing through to credit standards and the willingness to lend. We'll also see Thursday's update of initial jobless claims, and given the renewed focus on the labor market and the trajectory of jobs growth, it could ultimately be that Thursday's 8am weekly release of jobless claims ends up being the most tradable event on the macro horizon.

It's with this backdrop that we are watching 10-year yields comfortably below 4%, and expect that even in the context of a modest concession for the $42 billion worth of supply, that we've transitioned to an environment in which three handles have become the new four handles, and this will likely persist at least through the summer months. With the backdrop of geopolitical uncertainty leading to flight to quality moves, and the fact that the market has pulled back from aggressively trading any potential election outcome, we're on board with the notion that the market might be in for something of a sideways grind as we redefine the trading parameters and the trading ranges in place. Although we're not anticipating a slow summer week as the calendar might imply.

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 the post-NFP dust settles and the market refocuses on the upcoming 10 and 30 year auctions, we have to thank the Treasury department for putting the fun back in refunding.

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 FIC Macro Strategy Group and BMO's Marketing team. This show has been produced and edited by Puddle Creative.

Speaker 4:

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