Summer's Last Stand - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 237: Summer's Last Stand, 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 28th. After what's been a decidedly undoldrummy second half of summer, the week ahead of Labor Day would usually present an opportunity to make the most of what used to be one of the quieter periods in financial markets. Alas, the BLS and SIFMA have once again conspired against the good people of the bond market to deliver, not only a jobs report, but also a conspicuously absent early close ahead of the long weekend. One could trade payrolls from the second tee box, right?

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, without question, the most important event was Powell's speech at Jackson Hole. The market was looking for any indication that the Fed was willing to revisit or revise their 2% inflation target. What investors received was precisely the opposite. Powell made it abundantly clear that 2% as the inflation target is here to stay, and won't be revised.

Now this is key for our broader constructive outlook on the Treasury market. Because the one way in which we could envision 10-year yields sustainably above 4%, is in a world where inflation was allowed to run closer to 2.5% or 3%. Now eventually we do have confidence that the Fed will be increasingly successful in their ability to contain realized consumer price inflation. And as a result, breakevens will be biased back toward, if not ultimately achieving, the pre-pandemic norm of roughly 185 in 10 year breakeven space. Now we're certainly cognizant that part of the underlying bearish pressure in the Treasury market is associated with the idea that term premium should return to positive territory, given the amount of supply, the large deficits being run on the federal level. And of course the fact that the employment market and real economy have demonstrated a remarkable amount of result despite the amount of policy tightening that has already occurred in this cycle.

Now to some extent, the lower trajectory for payroll's growth combined with moderating realized inflation does indicate that policy continues to work with a lag of six to eight months. And given the fact that we didn't see a shift into truly restrictive policy territory until Q4 of last year, it follows intuitively that the next several months’ worth of economic data will define whether or not the Fed has overshot the mark, or if they've been able to create a soft or no landing scenario. The emphasis on September being a skipped meeting certainly resonates, and we expect that that will come to fruition. The conversation now, however, has turned to whether or not the market should expect a November hike. Powell's comments on, ‘there's more work to be done in fight against inflation’ has certainly kept the possibility of another hike between now and the end of this year in play.

We'll also note that even if September is a skipped meeting, we will have the SEP in which the Fed is more likely than not to retain the 575 upper bound, which implies yet another hike by the end of the year. Now even in the event that the economic data begins to moderate even further, we would expect that for the sake of retaining flexibility, if nothing else, the Fed would be reluctant to eliminate that extra hike in the SEP. While the initial jobless claims numbers were constructive for the economic outlook and the potential for consumption to continue driving the real economy, we did see weakness in durables. We also saw weakness in the PMI series, both domestically and abroad. Which suggests that the overall global growth momentum continues to slow. And eventually the dip buying interest that was evident in the weak just past, will provide yet another incentive for otherwise sidelined investors as the end of the Fed's hiking cycle comes into greater focus.

Vail Hartman:

It was a week that saw longer dated Treasuries find a solid bid as 2/10s move further into inverted territory. And the market's preoccupation was Treasury supply and Powell's speech in Jackson Hole, where specifically the market was looking for any insight on the committee's thinking about the 2% inflation target, and the neutral real rate of interest. Ultimately, Powell said the FOMC cannot identify R-Star with certainty and there is always uncertainty about the precise level of monetary policy restraint. He also said 2% is, and will remain, the Fed's inflation target.

Ian Lyngen:

What struck me about the price action that followed was the fact that we didn't get a more significant rally in US rates. All else being equal if the market was in fact anticipating some softening of the language around the 2% inflation target, that's precisely not what Powell was willing to deliver. In fact, we've maintained throughout this cycle that the Fed's credibility is linked to that 2% inflation target. And so that means that there's a reasonable probability that Powell chooses to err on the side of excess demand destruction in order to get inflation back to 2% in the event that some of the components end up being stickier than the Fed would like to see. Ultimately, the Fed does have the ability to get inflation back to 2% via triggering a recession. At the moment, that thinking has fallen to the back burner as it appears that there is ample momentum in the real economy, as evidenced by the drop in unemployment claims this week, as well as the Atlanta Fed's GDP now tracking above 5%.

Now, it's important to keep in mind when we talk about the GDP trackers that there are a variety of them out there. The St Louis Fed has one, the Atlanta Fed has one. And they can send decidedly different signals. Now part of that has to do with the inputs that they use to estimate, and part of it has to do with a willingness to use forward forecast incorporated in a current estimate. So, not that the Atlanta Fed's GDP now is to be taken lightly per se, but rather given the evolution of its forecast over the course of a quarter's data cycle, we are cautious against assuming that we'll have a five handle on GDP in the third quarter.

Ben Jeffery:

And it wasn't universally a week that showed that the economy was re-accelerating. Yes, the broader market narrative is very much in keeping with the points you touched on, Ian. That thus far, despite monetary policy being well into restrictive territory, growth and employment are holding up remarkably well. And the trend in inflation is encouraging, but the outright level is still too high. However, to begin the week, remember the impact that we saw from both the disappointing series in terms of European PMIs and also the lower than expected read in terms of US PMIs, as an indication that business sentiment is beginning to come under pressure at this point in the cycle. Those PMI prints dovetailed well with some of the comments we got from Philadelphia Fed President Harker on Thursday. Firstly that he doesn't see the need for another rate raise this year. And instead given that, in his district there's ample signs of tighter credit conditions and certainly indications that the economy is slowing.

Which means that rather than continuing to hike, it's more important to wait and evaluate how the data performs to rates this high over the balance of this year and into next year. It was also noteworthy to hear a relatively centrist member of the FOMC in Harker, talk explicitly about rate cuts next year. And he acknowledged that given the labor market is moving closer to equilibrium, if we start to see inflation fall more quickly, then that will mean rate cuts can happen sooner. Not earth-shattering new information by any means, but the fact that the idea of rate cuts made it into part of the official communication from Jackson Hole was telling insofar that it shows the committee is acknowledging that terminal might not be quite at hand, but it's certainly close by.

Ian Lyngen:

It's also important to keep in mind that a lot of the conversation around rate hikes at this point from the Fed is really focused on the September meeting. It's far too soon to commit to anything in November or December, so the Fed is signaling a willingness to skip the September meeting, which is very consensus at this point. Certainly it is our expectation as well. What will be interesting to see is whether or not the Fed is willing to signal that we've already achieved terminal. And they would simply do that via the updated SEP, specifically the 2023 dot. Now, the spread between the 2023 and the 2024 dot will be very much in focus. Recall that in the June SEP there was 100 basis points worth of rate cuts projected. Now it follows intuitively that given the neutral rate of policy is a moving target, that the Fed is assuming that they will need to normalize rates lower from terminal, whether that ends up being 550 or 575.

More importantly, as we think about the next big leg in the Treasury market, one tends to see the market willing to price in a more significant turn in the cycle once it has become abundantly clear that terminal has been achieved. Now, this particular cycle, as evidenced by the inversion of the 2s/10s curve, has been complicated by the Fed's introduction of symmetry at terminal, i.e, once we're at 550 or 575, there's still a chance that the Fed might need to hike in the event that the economic data dictates. Now, we ultimately think that 550 will represent terminal and while there is a non-zero chance that we get another move in November, there is a lot of economic data between now and the point when the FOMC will need to make that November decision.

Yes, we have seen some moderation in core inflation, which is certainly welcome from the perspective of monetary policymakers as well as those who have a more constructive outlook on the Treasury market, but we've also seen the evolution of the employment landscape suggests that the Fed not only is in restrictive territory, but the lagged impact of monetary policy generally, as well as the data collection cycle, has created more uncertainties for the balance of 2023 and the beginning of 2024, than it has reinforced the no or soft landing narrative.

Ben Jeffery:

And there was another aspect of monetary policy that was discussed this week aside from simply another hike or not and the outright level of terminal, and that was the role that the balance sheet is going to play in the Fed's endeavors to keep this higher for longer regime intact. Specifically, after we heard both from Powell in the press conference and then again at the FOMC minutes, we also heard from other Fed speakers around the idea that QT can continue even after the Fed begins lowering policy rates. This is an important detail to consider, because ostensibly cutting rates AKA removing restriction runs directly opposite, running down the balance sheet, which is introducing restriction. However, it's worth mentioning that given Powell told us R-Star is difficult to measure, that the overall level of restrictiveness, especially around a cycle turn, is important to take into consideration.

What I mean by this is that, unlike in 2019, when policy rates were just at 250 and maybe not even at neutral, now we have policy rates at 550 and a balance sheet that continues to shrink at $60 billion worth of Treasuries a month. So that means the FOMC has afforded themselves the flexibility to cut rates. And in acknowledgement of the influence that higher yields have on the banking sector, the shifts we're starting to see in the labor market, the influence on business sentiment, might not necessarily require such restrictive policy. Even though with inflation still very far from 2%, some restriction is warranted. So that means even after cutting 200 basis points, a Fed fund's target band above 3% will still be restrictive and then add on top of that the fact that the balance sheet can continue to run down.

It wouldn't be difficult for the Fed to craft the narrative of, "We're still fighting inflation, just not quite as aggressively." And I don't think that necessarily needs to come along with a discussion around an even faster pace of QT or even the idea of outright Treasury sales from SOMA, but rather this cycle's version of fine-tuning a monetary policy stance in response to how the economy develops over the balance of this year and into 2024.

Ian Lyngen:

Another aspect of this that has been fascinating is the degree to which the market has been content to price in a no landing narrative. We have two-year yields at effectively 5%. We have 10-year yields trading in and around 425, 420. And there does seem to be a collective degree of confidence in the Fed's ability and commitment to fight inflation, as evidenced by the fact that we haven't seen 10-year breakevens break substantially higher. In fact, the trend over the last year and a half has been a grind lower. That being said, breakevens have yet to return to pre-pandemic levels, which implies that the market is expecting that over the course of the next 10 years, inflation is going to err on the side of being above the Fed's target as opposed to below it, which had been the case prior to the pandemic.

Now, we're reluctant to suggest that this is any clear confirmation of the market's perception that structural inflation has changed, i.e., it will be higher post-pandemic. But we are certainly cognizant that embedded within that pricing is the non-zero risk that in fact it has become higher and the Fed will eventually need to revise its inflation target. Again, not our expectation. And as Powell said at Jackson Hole, the 2% inflation target is here to stay. Nonetheless, it is a background factor that investors have been trading off of.

Ben Jeffery:

And in terms of the valuations we reached this week, cycle high yields almost across the curve and particularly in real yield space, was enough to bring in meaningful duration demand into this past week's Treasury supply in both the 20 year refunding and the 30-year tips reopening. Vail, we got tails, but that doesn't necessarily mean those were weak auctions.

Vail Hartman:

That's right, Ben. This week's pair of tails did mean we have now seen four of the five auctions since the refunding announcement tail, but I'll note that across the board, every auction has seen above average bid-to-cover ratios and good non-dealer demand. And taken together, this leaves our constructive take on the primary market for Treasuries intact. And heading into front-end supply in the week ahead where each auction holds the potential to clear at the cycle high levels, we'll be curious to see what the results imply about how accurately front end pricing reflects the most probable outlook for policy in the wake of Jackson Hole.

Ben Jeffery:

And along with in the wake of Jackson Hole. It's also important to remember that even though Friday is September 1st, we do get August's payrolls report where the current consensus is for a headline jobs gain of just 160,000. That would be the lowest NFP read since December 2020, which remember was below zero. And I'll argue the coming week, unlike the previous one, is going to be more defined by the trajectory of the labor market data. We obviously have JOLTS ADP and NFP, and less about the theoretical considerations around R-Star or the monetary policy framework associated with the 2% inflation target.

If the trend in terms of the labor market recently is any indication, even an as expected or slightly better than consensus payroll's read, would be keeping with this idea that yes, the labor market is still in good shape, but it is unquestionably slowing. And as a lagging indicator that will serve as an important detail to keep the Fed a bit more cautious in raising terminal estimates and delivering even more rate hikes. Now, Ian, you touched on it at the beginning of the conversation. That doesn't mean that the 2024 dot within the September SEP won't be moving higher to reflect the expectation for less rate cuts next year, but when early signs of softening start to materialize, August NFP is going to be very tone setting as the market prepares to return for the unofficial beginning of autumn.

Ian Lyngen:

And as a lagging indicator myself, I will say I do appreciate the sentiment Ben.

Ben Jeffery:

Takes one to no one.

Vail Hartman:

Wait, what? Sorry, I'm a little behind.

Ian Lyngen:

In the week ahead, while we'll spend a great deal of time lamenting the absence of an early close on Friday ahead of Labor Day weekend, the market does have a great deal of fundamental information with which to guide the overall direction of US rates. The week just passed was spent contemplating whether or not Powell would be willing to revise the 2% inflation target, and what the near-term trajectory for policy rates will be. We came away from the process with clear confirmation that 2% is intact and will remain that way. And that the Fed could ultimately deliver yet another 25 basis point hike by the end of the year. In the week ahead, the variety of jobs proxies culminating in the official non-farm payrolls print on Friday, will shift the broader conversation away from policy, and back squarely on the performance of the real economy. In particular, the labor market.

The consensus for headline NFP is 160,000 jobs and an unemployment rate at 3.6%. It's also notable that average hourly earnings are seen increasing four tenths of a percent month over month in August. Now, given the high correlation between nominal wages and core services ex-shelter that the Fed has emphasized time and time again, we'll be watching average hourly earnings for any lingering indication that the Fed should be worried about a wage inflation spiral. For the time being, given the progress that the Fed has made on containing realized inflation, we expect that a wage inflation spiral will be a secondary concern for the market. And instead the market will focus on the slowing trajectory of jobs growth with a nod to the fact that the labor market is still expanding. We are in positive territory for payrolls. And a cooling of the labor market is precisely what the Fed has been attempting to achieve.

We'll also see the JOLTS data for the month of July. And given the market's propensity to trade off of this series, one would be remiss not to put it at the top of the list as a potential event risk. Let us not forget that given the nuances of the calendar, the nominal auction schedule will be brought forward with the 45 billion 2-year coming on Monday morning, followed by the 46 billion 5-year on Monday afternoon. Nominal coupon supply will be capped with the 36 billion 7-year on Tuesday afternoon. This will allow for relatively clean dynamic in the setup for payrolls on Friday. Keep in mind that we also do see ISM manufacturing on Friday in the wake of non-farm payrolls. And expectations there are for a modest below 50, 46.7 print. Taking a step back, while we remain constructive on the Treasury market in the medium and longer term, we do respect the technicals and the evolving macro narrative that is now deeply rooted in the no landing scenario.

We ultimately do expect that we will see greater demand destruction. The real economy will slow, breakevens will decline further, and nominal rates will anchor lower. That being said, the path to 3% 10-year yields this year has gotten a lot narrower, and we now see such levels as more achievable mid 2024 once the Fed begins the process of normalizing rates lower.

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. Whether September by Earth, Wind & Fire, September Song by Frank Sinatra, or the time-tested classic Wake Me Up when September ends by Green Day, we're looking forward to the flip of the calendar.

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.

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