Sliding Into Summer - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 275, Sliding into Summer, 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 27th, and with Memorial Day weekend marking the unofficial start of summer, we're looking forward to barbecues, fireworks road trips, and yes, working from the office on Fridays. Thanks again, unnamed regulator.

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 most relevant developments came in the form of the price action itself. We saw a decided flattening trend emerge, and to be fair, the trend toward a flatter curve has been in place over the course of the last several weeks. What was notable was the fact that 2s/10s traded below the 200-day moving average and started to move back toward that negative 50 basis point target. While it's difficult to envision 2s/10s will retest the cycle lows of negative -111 basis points, the current move also has the support of the fundamentals, insofar as the Fed has made it abundantly clear that they're not cutting rates next month, probably not in July, although ultimately monetary policymakers will start the process of normalizing policy rates lower by the end of the year. The tone of recent Fed-speak has been very consistent with the notion that the Fed was happy to see the April CPI print show a resumption of the cooler trend in inflation, but has yet to be convinced that inflation is moving back towards target.

The comments from Waller as well as the FOMC meeting minutes both struck a hawkish tone, although it is notable that the FOMC meeting minutes were from May 1st, before officials had the non-farm payrolls print for April, as well as retail sales and obviously CPI. So to say that the official communication was a bit dated, is an understatement, although some of the sentiment was consistent with the idea that regardless of how April's data plays out, there's not much appetite at the moment for lowering rates. Now we're reminded that a lot can happen between now and the July or the September meeting, and we expect that the evolution of the macro narrative will ultimately be what dictates whether or not the Fed can cut in the third quarter.

One of our key assumptions coming into 2024 was that we would see rate cut expectations rolled later and later into the year, as the economic data came in and demonstrated resilience in the labor market, even as the inflation profile started to improve. The one major wrinkle, at least from our perspective, was the stickiness in the core inflation numbers seen in the first quarter.

Now assuming that the second quarter marks the resumption of the trend toward cooler inflation and moderating jobs growth that was in place during the second half of last year, then it's safe to anticipate rate cuts during the second half of the year. One key wild card for estimating the timing of rate cuts comes in the form of the events of June 12th. We have the FOMC rate decision, no cut expected. We have the core-CPI numbers for the month of May, moderation still anticipated at this point. And then perhaps most importantly, we have the updated SEP, which contains the beloved dotplot.

Within the details of the DOT plot, the market will be looking for whether or not the Fed signals 25 basis points or 50 basis points worth of rate cuts. To some extent, this all comes down to how core-CPI performs in the month of May, certainly at this stage, given April's data. If the DOT plot indicates 25 basis points, the market will simply roll forward, rate cut assumptions to the December meeting. That will alleviate some of the concerns or the calculus around cutting immediately before the presidential election. On the flip side, if the Fed signals 50 basis points, that's a strong indication that they're willing to go in September, which at the moment at least, is an active debate.

Vail Hartman:

It was a week that saw a decided flattening of the Treasury curve as the year-to-date flats in 2s/10s and 5s/30s came back onto the radar, and contributing to the flattening was an array of hawkish Fed-speak, including some hawkish anecdotes from the FOMC minutes, and we also had another solid initial jobless claims print, and better than expected PMIs.

Ian Lyngen:

In part what drove the flattening was a positioning story as well. It goes without saying at this point that a flatter curve was almost by definition the pain trade, given where we are in the cycle and expectations for the Fed to eventually begin cutting rates. The fact that we saw a reasonable amount of pushback from monetary policymakers via the more hawkish skew to the minutes, as well as some of the Fed speak, suggests that as the Fed has been saying, the path towards rate cuts has been delayed but not derailed.

Ben Jeffery:

And from a bit of a higher level, it was also interesting to see the discussion within the minutes surrounding the actual level of restrictiveness that is currently playing out in the real economy. There were various members of the FOMC that we're not quite so sure that policy is as restrictive as was initially anticipated and while had Fed funds not already been well above 5%, that might imply further rate hikes. At this stage, given the FOMC is debating the degree of restrictiveness and not whether monetary policy is restrictive at all. This along with the realized data is another point of emphasis on the idea that the Fed is in no rush to begin the process of bringing rates lower. And implicitly embedded within the skepticism around the level of restrictiveness is also the bigger question of whether or not r-star has moved higher, thereby narrowing the spread between effective fed funds and r-star and making monetary policy less restrictive.

Now, as we always discuss with an FOMC minutes release, the fact that this conversation was had before we got NFP, CPI, and Retail Sales, means it's already somewhat stale and there's a case to be made that the data we've gotten since the May Fed meeting does demonstrate the effectiveness of monetary policy. But the fact that Wednesday's Fed communication once again gave some airtime to this broader monetary policy debate around where it is exactly our star might be, means that as summer unofficially kicks off this weekend and another few Fed meetings before Jackson Hole quickly become the most important events of the summer season, at least for us, that means both sides of the higher or lower r-star debate are going to continue to be had in summer 2024.

Ian Lyngen:

One of the things that I find a bit perplexing about the question of where is r-star, is we know where our star is, Vail is right here.

Vail Hartman:

Thanks man.

Ian Lyngen:

But anyway, the reality is that as you point out, Ben, as long as monetary policy is restrictive, it's not as though the Fed needs to reach some specific level of tighter financial conditions to be content with their overall policy stance. But rather, the Fed has shifted the narrative from one about level to one about duration at terminal. And to the Fed's credit, the Fed has done a good job in preparing the market for this transition. It also follows intuitively that investors have been eager to bring forward the next logical shift in monetary policy, which comes in the form of a rate cut. That being said, those rate cut expectations have now convincingly been pushed to September, if not beyond. And as we continue to view the June 12th session as defining for the near and medium term policy expectations on a number of levels, it's worth reiterating that that day sees not only the May-CPI numbers and the Fed decision, but also the updated SEP and dotplot, adding further focus on the 25 versus 50 basis points worth of rate cut argument.

Vail Hartman:

And on the topic of the timing of the cycle's first-rate cut, this week we heard from Fed Governor Waller who said that in the absence of a significant weakening in the labor market, he needs to see several more months of good inflation data before he would be comfortable supporting and easing of the Fed's monetary policy stance. He also said that we're not seeing anything right now that looks like staying here for three or four months is going to cause the economy to go off a cliff. Although Waller's comments aren't necessarily consistent with a rate cut in June or July, it does leave the door open for a rate cut in September given that investors will have four additional CPI prints before the September meeting.

Ian Lyngen:

And the issue with the September meeting, as we know, is the last meeting ahead of the presidential election, and there's obviously speculation on either side of whether or not that will or should prevent the Fed from beginning a rate-cutting campaign. Optics aside, Powell did do a good job of starting the conversation with the market about rate cuts in December of 2023, and therefore the Chair could arguably, in being intellectually honest, claim Central Bank independence even in the event that the FOMC decides to go in September.

Ben Jeffery:

And away from simply the evolution of the domestic economic data and how the political pressure the Fed is feeling is impacting their decision-making, let's not forget that 10-year yields at 4.50% is not solely a function of what's going on in the US, but also what's taking place overseas. We got a generally as expected inflation read out of Canada this past week, along with an upside surprise in the UK, that is now again pushed back Bank of England cut pricing to later this year.

But in a conversation with an especially astute client recently, he made the observation that for global fixed-income investors, if one is seeking yield of any type, really, the only game in town for the time being remains the US. Part of this is obviously a function of the fact that the Fed is probably not going to be the first Central Bank to cut, and this means that holding all else equal in terms of the economy's performance and also domestic investor behavior in terms of the Treasury market, we don't necessarily need to see a material dovish pivot from the FOMC, in order for stronger buying interest in treasuries to begin to materialize.

This is obviously a meaningful divergence from what we've seen over the past 18 to 24 months, where generally speaking, overseas appetite for US duration took a step back as now declining yields as a function of local central bank dovishness in Canada, England, and Europe, all add to the case for shifting some exposure into US rates, given the comparatively elevated level of yields that will keep a stronger dip buying bias intact in Treasuries, than would otherwise be the case as the global outlook in terms of growth and inflation, continues to face downward pressure.

Ian Lyngen:

And picking up on this theme, it's been very interesting to hear the market's response to Biden's recent round of tariffs and what that might mean for A) the inflation complex, but perhaps more importantly for the Fed's chances of achieving the 2% inflation target. All else being equal, higher tariffs should translate through to higher imported prices. However, we're at a very specific point in the cycle where the upcoming divergences in monetary policy are going to continue to result in a stronger or at least a not weaker, US dollar versus the rest of the world. And we could find ourselves in a scenario without increased tariffs in which the stronger dollar leads the US to import disinflation. Layering tariffs on top of that might be a short-term offset, but it could over time, increase the probability that the Fed ends up importing deflation as the global growth outlook dims. Perhaps equally as importantly is the underlying question of whether or not at this point in the cycle, higher costs can be passed on to the end user or if those costs need to be absorbed by the producers or the importers.

Ben Jeffery:

And based off what we've seen in terms of Retail Sales, but also the JOLTS data and NFP, I'll suggest that it's probably going to need to be the latter. After all, wage growth continues to slow and we've seen the quits rate and job openings continue to decline, which generally points to a consumer that is feeling less confident about where they are and probably less willing to pay up and consume in the event that more price increases get passed along. And troublingly, what this means in terms of a feedback loop is ultimately profit compression on the firm level and profit compression ultimately necessitates cost-cutting with the easiest place to cut costs either workers' hours or the number of workers themselves. And it's this logical path that ultimately leads to a conclusion of a softer labor market and a more benign growth outlook, that will be what it is that triggers that first Fed rate cut, although clearly open to debate, whether that's September, December, or maybe next year.

Ian Lyngen:

And adding to the complexity of the outlook the stickier inflation is and the more resilient the labor market appears to be, obviously increases the time at terminal, but I'll argue at least, it increases the probability that the Fed is forced to stay at terminal too long, thereby creating more demand destruction than otherwise would be needed and increasing the odds of a recession.

A long time to a recession, a long time to a rate cut, at least we have a long weekend ahead, Vail. Got any plans?

Vail Hartman:

Just brushing up on my podcast jokes.

Ian Lyngen:

Good thing we got that extra day.

In the week ahead, not only is the trading week condensed into four days, but the auction schedule is also compressed with both the two- and the five-year auctions scheduled for Tuesday, May 28. We see $69 billion twos, and $70 billion fives that day. This should contribute to the curve inversion bias that we have seen as the front end heavy supply pushes twos, tens and fives thirties flatter. On the data front, perhaps the most significant update comes in the form of Friday's core PCE number. This information is for the month of April, and to some extent, the combination of PPI and CPI has made it easier to estimate what we expect on Friday, which the consensus is 0.3%, but forecasters are largely split between 0.2% and 0.3%, so it'll be interesting to see where that prints. Ultimately, however, we don't anticipate that the tone of training in duration, i.e., tens and thirties will be materially impacted by the core-PCE number.

It could be price section that is limited to the two-year sector, if there's a significant price response at all. Now, our logic here is relatively straightforward. We know roughly what the inflation profile looked like in April, and that suggests that the first quarter was the anomaly and the Fed's objective of cooling inflationary pressure is back on track. So regardless of the PCE numbers, the focus has appropriately shifted towards the employment profile, which suggests that the non-farm payrolls print the following Friday, which is June 7th, will be the major tone-setting event, at least until the June 12th CPI release. We do have a fair amount of incoming Fed speak. Mester, Williams, and Bostic are all currently expected to chime in terms of their thoughts on monetary policy at the moment, and it's important to keep in mind that this will be the last week before the Fed's pre-meeting period of radio silence.

So if policymakers do want to provide any specific guidance in terms of what to expect, i.e., no rate cuts, this would be their last and primary opportunity to do so. From a trading perspective, while we ultimately anticipate that yields will grind lower over the course of the summer, certainly by the end of the year, we are in a trading range, and it's a trading range that we suspect will struggle to see ten-year yields drift materially below the 200-day moving average, which is roughly 4.33%. With tens caught between 4.30% and 4.50%, the more notable price action will occur in the shape of the yield curve. We remain biased to see a continued flattening, particularly in 2s/10s and 5/30s between now and the June FOMC meeting, with an acknowledgement to the fact that there will be periods of in-range consolidation or knee-jerk steepening, depending on the evolution and the specifics of some of the incoming data.

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 the mercury rises and the days get longer, at least in terms of sunlight, we are reminded that the longest days are the ones right before a holiday weekend, even if there is an early close.

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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