Supplying Volatility - The Week Ahead

Ian Lyngen:

This is Macro Horizons' episode 221, Supplying Volatility, 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 8th. Ahead of the refunding auctions, we are reminded that while there's no such thing as a bad bond, a bad price by any other name causes just as much pain.

Each week we offer an updated view on the U.S. 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 received a variety of meaningful, high-level fundamental and monetary policy inputs to help define the trading direction. The first and perhaps most fundamental was in the form of a 25 basis point rate hike from the Fed, and this was accompanied by changes to the statement that imply that even if this is not the final rate hike of the cycle, there are not that many more opportunities on the horizon for the Fed to move rates higher. Specifically, the removal of the language focused on future rate hikes has opened the door for the Fed not to hike in June.

Now, obviously, this will be a function of how the economic data plays out in the interim and whether or not the committee is actually convinced that policy is in restrictive territory. Now, April's stronger-than-expected payrolls report suggests that if the Fed is restrictive, that the lagged impact of that is taking longer than one might traditionally expect. It's also worth highlighting that in addition to the higher than expected NFP print, the unemployment rate decreased to 3.4%, which is the cycle low, and that occurred in a month where the labor force participation rate was unchanged, which makes the improvement in the unemployment rate all that much stronger. In addition, average hourly earnings, which were seen increasing three tenths of a percent month over month surprised on the upside printing at five tenths of a percent, which led to an increase in the year-over-year pace of average hourly earnings to 4.4%.

This feeds into market participants' concerns about a wage inflation spiral and if anything would serve to push back against any expectations that the regional banking crisis would lead the Fed to cut rates in June. Before Non-Farm Payrolls, there was roughly a 10% probability of a June rate cut priced into the market, and unsurprisingly, since the employment update, that probability has been reduced markedly. We also received the refunding announcement, which showed as expected auction sizes were unchanged with 40 billion 3s, 35 billion 10s, and 21 billion bonds.

Now, perhaps more importantly within the announcement the Treasury Department laid out its plan to follow through with conversations surrounding buybacks, but those buybacks are not slated to begin until 2024. That will give the market more than sufficient time to anticipate and accommodate what the Treasury Department hopes will be a liquidity-enhancing event, at least for on-the-run securities. Now, issuing more on-the-runs to buy off-the-runs, which is in effect what the Treasury Department is doing won't help the off-the-runs. If for no other reason than it will take off-the-runs out of the market completely, then they won't be held by private market participants or by the Fed and be available for repo, which in practical terms creates a disincentive for market makers to sell those securities if they know they're going to struggle to purchase or find them in the secondary market.

Vail Hartman:

From what we thought would be a week of price action driven by the slate of economic data ended up being largely driven by headlines out of the regional banking sector. We saw the VIX spike to its highest level since the end of March, and regional bank stocks came under significant pressure as the financial crisis might not yet be over.

Ian Lyngen:

Well, Vail, you make a very good point. The primary drivers in the U.S. Rates market over the course of the last week shifted back to the regional banking saga. Now, obviously, given the resurgence of this concern, the reality is that it's going to be quite some time before investors are comfortable putting this episode behind us. More importantly, the developments occurred as the Fed delivered what is largely considered to be its final rate hike for the cycle, bringing the upper bound to 5.25. With an effective Fed Funds of 5.1, this creates a much deeper inversion of funds versus 2s and funds versus 10s. The reason I highlight this is because there's an assumption in the market that 2s can't trade deeply below Fed Funds unless the Fed is near a rate cut. That being said, the stronger-than-expected payrolls print takes the risk of a near-term rate cut off the table for the time being and frankly reinforces the notion that the Treasury market is going to remain in a lower rate environment with 10-year yields now comfortably below 3.50 for the bulk of the week.

Ben Jeffery:

And within Powell's press conference, we did hear the chair sound relatively optimistic on the state of the banking system and the effectiveness of the discount window in the Bank Term Funding Program to continue functioning as an emergency source of funding for banks who need it. But the fact that the day after the Fed, the concerns that you highlighted Vail led to the market pricing in nearly 10 basis points of rate cuts at the June meeting clearly suggests that while the Fed may be confident that the crisis will be contained and that policy can now stay at terminal for an extended period of time, the market is not so convinced. And within the language of the policy statement we got on Wednesday, we also saw the committee change their characterization of future tightening moves from maybe being appropriate to now a function of the incoming data. We've got yet another stronger-than-expected employment report, both in terms of headline NFP and the unemployment rate, caveated by downward revisions, and that's going to leave the next pivotal macro point Wednesday's inflation update.

Ian Lyngen:

Let us not forget, however, that there is going to be a tightening impulse for overall financial conditions associated with the spike in equity vol that Vail pointed out earlier. So this suggests that we actually could find ourselves in a situation that despite stronger payrolls data and an as expected or even incrementally firmer inflation report, the Fed chooses to stick with the messaging that it will take several months before Powell is convinced in either direction whether or not the Fed is truly in restrictive territory. This brings us to a question that we received this week from a particularly insightful client, and that was: What's more likely, the FDIC increases the insured maximum deposit to something above $250,000 or the Fed cuts rates both presumably as a result of the banking crisis?

Ben Jeffery:

At a first pass, I would say FDIC increase may be more likely.

Ian Lyngen:

So you clearly haven't been following what's been going on in Congress. We're worried about Congress not dealing with a debt ceiling in a timely of enough manner to avoid a default by the U.S. Government. The notion that Congress could muster the needed support to shift the FDIC's deposit limit higher is really difficult for me at least to get my arms around, particularly at this point when contagion appears to be relatively contained. I'll suggests that to get to the needed stage of urgency on the part of lawmakers to actually push through an FDIC increase in the insured deposit amount, that overall financial conditions would've needed to tighten so far beyond the Fed's comfort level that if nothing else a rate cut might be equally as likely as the FDIC being allowed to increase its limit.

Ben Jeffery:

And along with that line of thinking is an idea that the three of us have discussed, which is the unknowable uncertainty of how many rate hikes is a regional banking crisis worth. And along with CPI and the refunding auctions next week, we also get to see the Senior Loan Officer Survey that is released on Monday.

Ian Lyngen:

To you two, everyone is a senior citizen.

Ben Jeffery:

But in all seriousness, the Senior Loan Officer Survey is one of the benchmark quantitative measures we're going to get in terms of how lenders around the country are pulling back on credit at a time when firms arguably are going to need increased access to capital given the state of the overall economic outlook.

Ian Lyngen:

It's also notable that the recent re-escalation of tensions in the banking sector put Monday's report in a very particular context, i.e., if we don't see credit standards being reflected as tighter, the market will simply look at that information as dated because it doesn't have the most recent leg of the saga. On the flip side, if loan officers indicate a great deal of tightening, the market will similarly say, "Well, that doesn't fully reflect what has happened and presumably what will happen over the course of the next couple of months."

Ben Jeffery:

And we had several discussions around this issue with a variety of types of clients this week, and the very good point was made around the role that regional banks play in terms of the overall lending landscape. Specifically given what might be ongoing consolidation in the financial space, that the variety of loans that regional banks give to presumably smaller local businesses may not carry over on a one-for-one basis to larger financial institutions.

Vail Hartman:

But a serious question, if you have your money at a smaller bank, why not move it to a larger one?

Ian Lyngen:

That's actually a very interesting notion and to some extent, we have seen outflows from small and regional banks into the big money center institutions. However, and as Ben pointed out, access to funding for small and medium-sized firms is a key service that is provided by the regional banks. And for all intents and purposes, it's the relationships between the small banks and the end user that have resulted in at least some of the deposits being comparatively sticky. Certainly, there's more loyalty on the part of depositors at small banks than there might be between large institutions, if that makes sense.

Ben Jeffery:

So this line of thinking should theoretically put a floor under the scale of deposit flight we'll see from smaller banks, but through a longer term and more macro lens, that's not going to prevent credit tightening from flowing through to actual business activity in terms of hiring plans. And it's that delayed flow through to ultimately the lagging indicator of the jobs market that's going to ultimately inspire a more dovish tone shift from the Fed. Although clearly in April with a 3.4% unemployment rate and an unchanged labor force participation rate that didn't happen last month.

Ian Lyngen:

We also haven't addressed the portfolio side of the regional banking sector. We know that even if it is in the held-to-maturity accounts, the sharp spike in interest rates over the course of the last 8 to 12 months has served to undermine some of the key assets. And frankly, that's why the banking sector finds itself in its current situation. Now, this isn't to suggest the global monetary policymakers are to blame, but rather it's simply a side effect of what the Fed has attempted to accomplish over the course of the last year and a half.

Vail Hartman:

So we've talked about the Fed and NFP and we also got the quarterly refunding announcement and what we're expecting will be the final unchanged coupon auction sizes.

Ben Jeffery:

You're exactly right, Vail. Wednesday morning we learned that next week's refunding auctions are going to be 35 billion 10s, 21 billion 30s, and 40 billion 3s to kick off May's coupon supply on Tuesday. But what investors were more focused on going into the release was any additional information that the Treasury Department was willing to give on the issue of Treasury buybacks, both for cash management purposes but also for liquidity support in the longer end of the curve. And what we saw was somewhat surprising on two fronts. First, we did get a fair amount of information on what it is the buyback program is actually going to look like. That was a surprise simply given the fact that the Treasury acknowledged they're going to need to continue to study this topic and get feedback from market participants, and then on the other side was the timing. While there were some that were expecting the program would be implemented as soon as August, what we actually learned is that we're going to need to wait until early next year until the initially relatively modest-size buyback program gets underway.

In terms of mechanics and size, what we saw was that for the Liquidity Support Program, the Treasury is endeavoring to purchase up to between 5 and $10 billion a month in maturities greater than one year, that will be spread in a distribution across the curve reflective of the current maturity profile of debt outstanding, similar to what we saw take place during QE. In terms of the cadence of the buying, somewhere between six and eight operations per quarter was suggested as a way to deliver one or two operations in each maturity bucket with the size and timing of the operations likely announced once a quarter, presumably at subsequent refunding announcements. So February, May, August, and November.

Ian Lyngen:

This actually brings us to a couple of issues as it relates to the Treasury Department's new buyback program. The first being how much will actually be utilized. Will we get to that 10 billion a month number and stay there or as we suspect, utilization will be high in the very beginning and as the program runs its course and continues to be a background factor, participation will slowly decline as the market re-prices to the reality of the Treasury's buyback program being in place for an extended period of time?

The second observation that we'd like to make is that the timing of the implementation of the program was very strategic. The Treasury Department is currently dealing with the debt ceiling issue, which means for all intents and purposes, the rundown of the TGA is creating a QE impulse at the moment where the Fed is actively engaged in QT. Fast-forward to the beginning of 2024, presumably the debt ceiling will be resolved and the QT that had been held at bay will be far more tangible in the real economy. And while the Fed's buybacks are neither QT nor QE, the reality is the net effect of the liquidity-enhancing effort will be a government buyer in the Treasury market. Which brings me to a question for you Vail. What is the difference between a bond and a bond trader?

Vail Hartman:

I don't know.

Ian Lyngen:

Bonds mature.

In the week ahead, U.S. Rates will be influenced by supply, inflation, inflation expectations, and of course any developments in the regional banking saga. Up first will be the 3-year auction of 40 billion on Tuesday, followed by 10s on Wednesday, and capped by 21 billion 30-years on Thursday. On Wednesday morning, the April CPI print is expected to come in at four tenths of a percent month over month with the core numbers at three tenths of a percent month over month. Given the recent volatility and some of the fluctuations within the used auto prices as well as the stickiness of OER and rent, despite the March numbers, there appears to be a modest bias toward an upside surprise within that series. It also warrants a nod to the fact that average hourly earnings in April did increase more than expected, about half a percent. And the correlation between average hourly earnings and core services ex-shelter is very high and represents the most direct pass-through that could lead to a wage inflation spiral of the type that the Fed has tried very hard to push back against over the course of this cycle.

Let us not forget that on Friday we get the University of Michigan's survey and this information is for May and contains the forward-looking inflation expectations number. Recall that the most recent print showed an upside surprise in one-year inflation expectations. Keep in mind that there's a high correlation between gasoline prices and short-term inflation expectations. So given some of the moves that we have seen in the energy sector, that shift was not particularly surprising. More importantly, the 5 to 10-year expectations remain at 2.9%, that's elevated by pre-pandemic standards and as a result, will remain an ongoing concern for monetary policymakers. While we are not expecting a near-term retracement of inflation back to the levels that the Fed would view as consistent with their longer-term objective, eventually the year-over-year base effects combined with a moderation in that monthly gains will lead the Fed to a position in which it chooses to emphasize forward-looking inflation expectations over the realized data in the event that the realized data finally conforms with a 2% inflation target.

The regional banking issues and concerns that the contagion could spread further have and will probably continue to influence the Treasury market and keep rates lower than they might have otherwise been. 3.65 in 2-year yields prove to be a good selling opportunity. And in the event of a retest of that range, we would similarly expect a bounce in front end nominal rates as such pricing implies a near-term Fed cut that we struggle to imagine comes to fruition. Looking further out the curve, we continue to view 3.50 in 10-year yields as an important focal point. And while we might see 10-year rates drift above 3.50 as indicated by the technical profile at the moment, anything above that 3.60 to 3.65 zone would represent a solid buying opportunity given the mounting array of global economic headwinds.

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 we break down the details of the employment report, we'll note that April represented the 13th consecutive upside surprise. Not so unlucky after all, unless you were long Treasuries.

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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