Skewed Steeper - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 118, skewed steeper, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffrey and Vail Hartman to bring your thoughts from the trading desk for the upcoming week of April 17th. And for anyone wondering why Vail missed last week's episode, let's just say he wasn't skiing.

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.

The week just passed was one of heightened relevance from a macroeconomic perspective. We saw the March CPI print come in at just one tenth of a percent. Core CPI matched expectations at 0.4%, but it was low on an unrounded basis, which has served to incrementally restore market participants confidence that the Fed has not only the will, but also the correct tools to use monetary policy to re-anchor inflation expectations.

Recall that much of 2022 was spent debating whether the Fed would ultimately be able to get inflation back in line with its objective given the tools at its disposal. Fast forward to today and there's more of an emphasis on the lagged impact of cumulative policy action as opposed to whether or not higher rates will eventually translate through to contained realized inflation. Now, obviously a broader question remains insofar as will we see this translate into downward pressure on forward inflation expectations. If we use the tips break even market as a barometer, it is encouraging that breakevens are well below the highs for the cycle, although certainly not back into the pre-pandemic range. A reality that we anticipate will remain a focal point in the coming months. The week just passed also contained the retail sales report for the month of March, which disappointed on the headline declining one full percentage point.

Now, it's relevant to keep in mind that the retail sales report is not in inflation adjusted terms, so as their nominal numbers, if we back out even the benign one tenth of a percent headline CPI print, that implies that real retail sales were even weaker. Now when we drilled down into the retail sales numbers, what we see is that the control group, which is most closely correlated with GDP estimates outperformed expectations. Although it did still decrease three tenths of a percent. On net, this was less of a negative for Q1 real GDP estimates. It was however interesting to see the price action which followed. We saw a Treasury selloff rather dramatically with the two-year sector driving the down trade, even as import prices came in weaker than anticipated.

Overall, the price action had more of a feel of the end of the week recalibration as the market settles into what we anticipate will be an extended period of consolidation that persists at least until we get to the May 3rd FOMC meeting. Now in the interim, there's very little meaningful economic data of relevance with perhaps the exception of the April 27th release of real GDP. Patterns of consumption combined with overall real growth will be instrumental in helping investors calibrate expectations for the balance of the year in the wake of the FOMC minutes, which acknowledged that the Fed staff is expecting a mild recession in the US economy by year-end.

Vail Hartman:

Well, Ian and Ben, it's been an informative week in US financial markets with most notably marches CPI release in hand. Though I would note that trading in US rates has become notably less volatile in recent weeks with the average intraday trading range for two year yields down to 17 basis points over the last two weeks versus an average trading range of 43 basis points during the two weeks following the regional banking crisis.

Ian Lyngen:

Well, Vail, you make a very good point and I think that part of what is going on at the moment is as we get closer to the Fed’s terminal rate investors have a better idea of what the risks around retaining terminal into the end of the year actually are. And as a result, we have seen clarity inspire a narrowing of the realized trading range, and that's something that we expect will continue at least until we get to the May 3rd FOMC meeting.

Ben Jeffrey:

And looking out over the next few weeks, frankly, there's very little on the economic calendar that is really going to call into question whether or not the Fed is going to be comfortable delivering that 25 basis point hike that we think and based on the Fed rhetoric seems that the FOMC thinks is going to be the final of this cycle before transitioning to that hold, Ian. Now that we have March's NFP print, which was solid and the CPI report that yes showed progress in terms of bringing core inflation lower, but at 5.6% core CPI on a year-over-year basis is still far too high for the Fed's comfort. This means that there's still more tightening work to be done, but that tightening is going to increasingly take the form of not cutting rates as soon as July as the Fed fund's futures market has priced, and instead holding a restrictive bias and evaluating the incoming data that I would argue is widely expected to continue to soften.

Vail Hartman:

So what do you guys think the likelihood is the Fed is able to keep rates on hold for a prolonged period?

Ian Lyngen:

Well, the first thing I would say is the likelihood is higher than what the Fed funds market is pricing in at the moment. We've oscillated between 50 and 75 basis points worth of rate cuts being priced in by the end of the year, and Powell certainly believes that the Fed will be able to stay the course for far beyond what the market is indicating. What I will note is that as we make the rounds and talk to clients, there's far less of a consensus around the idea of what an extended period on hold actually means. When we look historically, the Fed tends to spend an average of seven months at terminal. If May is the last rate hike, that means December would be an average stay at terminal. The idea that the Fed could delay the first rate cut into 2024 almost by definition would be required to achieve an extended albeit slightly extended stay at terminal.

Ben Jeffrey:

And we did get some additional information on one of the operative unknowns in terms of the Fed's debate when it will ultimately be to end that time at terminal given what we saw in the minutes of the March FOMC. Unsurprisingly, the biggest point of emphasis within the official communication was that the committee was worried about the credit tightening ramifications from the regional banking crisis that was taking place essentially as the committee was meeting. And while there were some FOMC members that would have otherwise favored a 50 basis point hike, remember Powell laid the groundwork for exactly that at his congressional testimony before we saw those bank failures. Ultimately, the combination of inflation being too high led the committee to deliver the 25 basis point hike, but the risk of a broader financial crisis was clearly sufficient to keep a return to a half point move off the table.

So looking forward in terms of this credit tightening question and what it ultimately means for the Fed, there are a few inputs to consider. The first, and I would probably say most important is going to be the senior loan officer survey that gets released in May after the Fed meeting. But over the next several sessions we're also slated to receive several large financial institutions first quarter earnings and any greater clarity that information offers on how much credit has been pulled back. Finally as something of a third tier release. We did get the NFIB survey this week that showed expectations on credit conditions are back to their tightest since January, 2013. So not a market moving event in its own right, but potentially useful context as an indication of what's to come.

Ian Lyngen:

Part of the conversation about tightening of credit standards throughout the US economy has to do with estimating how much the tightening is worth in terms of Fed hikes. Said differently, how much lower will terminal be as a result of the banking sector turmoil? Clearly what Powell & Company have indicated is that it's roughly 50 basis points as evidenced by the fact terminal is now seen at 525 instead of the earlier signaling, which pointed to 575 or even potentially 6%. Now at this stage, our operating assumption is that credit tightening being worth 50 basis points is a floor, not a ceiling. So that means if the situation worsens over the course of the next several months that the Fed might see undue tightening in financial conditions, which brings them back to the table to contemplate an adjustment lower in policy rates sooner rather than later. Again, this is not our base case scenario, but it is part of the dynamic that is playing out in the market at this point.

The other nuance that I would add here is that we continue to see the 50 or 75 basis points of easing priced in by year end, not as 100% confidence in an adjustment of that magnitude, but rather a probability somewhere between 40 and 50% that the binary outcome i.e no cuts or dramatic cuts will error on the side of more dramatic cuts by year end. From another perspective, if in fact the Fed has overdone it on the tightening side, they will need to recalibrate lower simply to keep overall financial conditions in their targeted range.

Ben Jeffrey:

And looking at the shape of the yield curve, it's become clear that the market is coming around to this narrative as well. We saw 5s/30s steepen fairly significantly in response to the CPI data and reach above 20 basis points back to close proximity of that support level at 22 basis points that we've been watching. But regardless, the flattening response to the retail sales report and some of the choppier trading conditions we saw on Friday still leaves the fives bonds curve in a much steeper trading range than we've seen for quite some time. Remember, it was only a few weeks ago that we were talking about negative 30, negative 40, 5s/30s, and that was in response to those hawkish assumptions, Ian, that you touched on of a 5.75 or 6% upper bound.

So the fact that now we've settled into a higher conviction monetary policy assumption framework that should also usher in a trading regime where taking advantage of flattening to scale into those core steepening positions is going to be increasingly prudent simply given this idea that there's certainly room for lower policy rate expectations further out in 2024, 2025 to begin benefiting the belly of the curve more materially, and that should keep the steepening pressure that we've seen intact.

Ian Lyngen:

It's also notable that the recent price action did get 10-year yields as low as 325. And when we put that in the context of what we've seen positions wise, the most recent data from the Japanese Ministry of Finance showed two consecutive weeks of net selling out of Tokyo, which is an interesting start to their fiscal new year to be sure. In addition, we've also seen the Stone and McCarthy Real Money survey reach as high as 100.9% of the duration weighted target of investors. Now that represents the longest real money has been since October, 2010. So for context, the market came into the second quarter decidedly overweight Treasuries following an episode in which rates had re-priced materially lower. I think that really gives us some interesting context for the recent takedown of the 3, 10, and 30 year auctions. Vail, what did you make of the 2.1 basis point tail at the 10-year reopening auction?

Vail Hartman:

Well, despite the sizeable tail, I would note that the bidding statistics were effectively in line with recent averages, and I would also note that the auction took place 60 minutes before the release of the FOMC minutes and on Thursday bonds stopped effectively on the screws with another set of bidding statistics that were effectively in line with recent averages. And this sets us up for another relevant update on the demand for duration at next week's 20-year auction that will face notably less event risk given the slate of second tier economic data releases in the week ahead. And also amid the period of consolidation we're beginning to see in the US rates market.

Ian Lyngen:

I'm certainly on board with the notion that twenties face decidedly less event risk than the 10-year auction did. However, I will offer one caveat and that is next week's beige book comes an hour after the 20 year. Now one might be tempted to say, well, the beige book doesn't matter for the Treasury market. It hasn't mattered for the Treasury market in decades. And while certainly sympathetic to that interpretation, the market is starved for information regarding any potential tightening resulting from the banking crisis and the anecdotes contained within the beige book could hint at if not confirm that banks are scaling back on aggressive lending and more importantly, that would serve to materially decrease the velocity of money thereby extending Powell's battle against inflation.

Ben Jeffrey:

And it's not only twenties that are going to be auctioned in this new range that we've found ourselves in, but also five year tips on Thursday. And while the beige book will be relevant for the duration setup in the inflation protected space, especially for the five-year sector, the latest repricing we've seen in the oil market is going to be particularly relevant for the shortest dated part of the inflation protected market. Despite the OPEC headlines we got last week and what is appearing to be a higher oil price regime above $80 a barrel in WTI space, five-year breakevens have been relatively well contained. And that suggests while on the one hand, higher commodity prices are not going to be something that the Fed is going to be particularly well equipped to contain, from a market valuation perspective, there does appear to be some collective faith that policy rates quickly closing in on 5% are going to have the desired effect on demand, which is going to continue to bring inflation lower.

And we've made it this far without highlighting that within the CPI report, we did see the core services ex-shelter component decelerate to two-tenths of a percent month over month, and that's a positive indication of the efficacy of monetary policy. Yes, not related to oil, sure, not related to some of the nuances of the real estate market, but in terms of the sub-component of inflation most directly linked with wages, good news for Powell as he continues to try to bring consumer prices lower.

Ian Lyngen:

One of the defining characteristics of the first quarter has been, as you point out, Ben, the renewed faith in what had been concerns about the Fed's toolkit in addressing the type of inflation that had been plaguing the US economy. What do you make of that, Ben?

Ben Jeffrey:

Is that a joke set up?

Ian Lyngen:

Is monetary policy a joke to you, Ben?

Ben Jeffrey:

Of course not. But in all seriousness, I would say the fact that the Fed has made meaningful progress in reestablishing their credibility through both higher rates, but also the balance sheet rundown introduces the idea, especially at this juncture, that monetary policy can continue to be set by the fundamentals of employment and inflation independent of some of the contagion risk that has obviously been very thematic over the past few weeks. This is the long way of saying that the Fed's emergency lending tools to support the financial sector are working.

And within the H.4.1 update we got on the Fed's balance sheet this week, we've continued to see a trend lower in discount window utilization while the bank term funding program uptake has remained lofty. Now right around 130, 140 billion worth of support from the Fed and its position as the lender of last resort is not necessarily encouraging in its own right. But the fact that it's been a couple of weeks since we've seen a bank failure means that the tools are working and means that the Fed can continue to point to the progress made in terms of the real data that monetary policy is working and it can continue to be data dependent.

Ian Lyngen:

You know what they say, sometimes it's H.4.1, sometimes it's H.4 all. Am I right?

Ben Jeffrey:

I would like to think of us as the three Musketeers.

Vail Hartman:

I could use a candy bar.

Ian Lyngen:

In the week ahead, the Treasury market will see a dearth of economic data, certainly not much in terms of market moving potential. Obviously we do have existing home sales as well as building starts in permits, which will give some context for the degree to which the recent tightening has continued to weigh on the housing market. However, given that the broader macro conversation has shifted away from near term inflationary concerns and toward the prospects for the real economy to come under pressure as the Fed endeavors to keep policy well into restrictive territory, any updates on rebounding home prices or real estate activity during the month of March will be largely dismissed. Let us not forget that the broader conversation in real estate has to do with commercial real estate and the prospects for the shifts in utilization to create a bigger dislocation than has already been seen in the wake of the pandemic.

On the supply side, we have a $12 bn 20-year auction on Wednesday afternoon. We also see a $21 bn 5-year TIPS. Given Friday's stronger than expected one year inflation expectations print, one would be safe to assume that a lot of that was driven by higher energy prices. Putting that in the context of tip supply, a premium for inflation protection given that the Fed can now see the end of its tightening cycle follows intuitively and all else being equal, we anticipate that supply in the week ahead will be easily absorbed.

In terms of official Fed commentary, we do have the beige book within the beige book, which has not historically been a market moving release. Nonetheless, we'll be looking for any details related to the banking sector and tightening credit standards following the turmoil scene in the middle of March on the regional banking front. The recent steepening of the curve ran into something of a roadblock on Friday with a market selloff in the two-year sector, which had very little obvious origin outside of position squaring ahead of the weekend.

So in the week ahead, given that the only real supply of relevance on the nominal side will be the 20 year, we see the path of least resistance being a steeper curve. All else being equal 5s/30s, anytime it dips below 10 basis points, we are going to view that as an opportunity to scale into a core steepening position. We expect that a negative fives bonds curve is going to be a thing of the past for this cycle as the market moves on to the reality that the Fed has one final hike to deliver. And then the debate will consist of how many months will Powell remain on hold before needing to recalibrate policy rates lower to address what remains a highly uncertain impact from the cumulative tightening that has already occurred, not only from the FOMC, but also from most other major global central banks.

In terms of outright yield levels, 350 remains an important focal point for the 10-year sector. Any attempt to sell off beyond 360 or 365 we view as a buying opportunity, but wouldn't fade an initial challenge of 350, particularly given the price action in the energy market combined with the steady messaging from FOMC members that there's at least another quarter point to go before claiming mission accomplished on the rate hike front.

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 with the mercury on the rise, temperature not tuna, thoughts will certainly shift to vacation time and summer travels. Don't worry, we'll keep the podcast on for you. 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, 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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