Talking Turkey - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 199, Talking Turkey, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of November 28th. The holidays are at hand, and we look forward to a more fundamental, non-market based usage of the phrase ample liquidity.

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. That being said, let's get started.

In the week ahead, the Treasury market will return from the long holiday weekend to an array of fundamentals that will help contribute to the broader macro narrative. First and foremost will be the payrolls report on Friday. As it currently stands, the consensus is for the addition of 200,000 jobs in the month of November, and that is expected to be accompanied by an increase of one tenth of a percent in the unemployment rate to 3.8%. Recall that 4.4% is the Fed's year end target for 2023 and, with that in mind, we'll be watching the trajectory not only of the unemployment rate, but also of labor force participation.

In November, average hourly earnings were seen increasing three tenths of a percent, and a gain of this magnitude will be sufficient to keep the wage inflation discussion alive for the time being. We also see the job proxies in the run-up to NFP. ADP for November is currently forecast to increase 188,000. We'll also see jobless claims as well as the JOLTS data from October.

In addition, the investors will have the revisions to Q3 GDP. Recall that in this year, as we saw a disappointing 0.5% quarterly annualized increase in final sales to domestic purchasers while the hedge fund GDP growth was a solid 2.8%, the influence of inventories in trade masked the slowing of domestic demand. We'll be eager to see how the revisions play out in this context.

Let us also not forget the influence of month end. As November comes to a close, we would expect duration to perform reasonably well. In addition, we hear from Powell on Wednesday. His comments will be essential in setting the tone ahead of the December meeting, if for no other reason than Friday, December 2nd, is the last day for any Fed commentary ahead of the official moratorium on public comments before the December 14th FOMC rate decision.

As the week gets underway, we'll have anecdotes from the beginning of the holiday shopping season, with discounts expected to be the theme, but ultimately sufficient enough to bring out shoppers. The ultimate uncertainty in the current environment is whether consumers will drive the retail sector between now and the end of the year in a typical fashion, or if higher prices, inflation, and budding economic uncertainty will result in more subdued holiday spending. If nothing else, the first couple days of the week ahead will give us context for the initial trajectory.

Ben Jeffery:

Well, it was an effectively three-day trading week. Sure, Friday's session is technically open, but with an early close, the bulk of the price action took place before Thursday's market holiday, and frankly, attention is already turning toward the holidays, thinner staffing levels, lower liquidity, and overall diminished trading conviction in the Treasury market. What we did see this week, however, is a milestone we've been waiting for in the 2s/10s curve, as that benchmark dropped below -75 basis points for the first time since the 1980s, as the theme of very deep, very persistent curve inversion continues into December, which begs the question from here. How does the end of the year shake out? And more broadly, what does 2023 look like in the Treasury market?

Ian Lyngen:

In the context of the curve inversion, I think it's notable that, while the curve reached extremes not seen since the '80s, in outright terms, the inversion is much more meaningful simply because yields were notably higher in the '80s. The last time the curve was this inverted, 10-year yields were at 12% and 2-year yields were at 14%. That's an entirely different context than 2-year yields at 4.5% and 10-year yields at 3.75%. What remains to be seen is how deep the inversion will ultimately extend.

Our base case scenario is that we get to -100 basis points in 2s/10s, all else being equal, probably by the end of the year. If not by the end of this year, then some point during the first quarter as the Fed continues with what we anticipate to be at least another three rate hikes before achieving terminal; 50 basis points in December, 25 basis points in February, and 25 basis points in March is not only consensus, but also resonates with the messaging that we've heard from most of the FOMC members, with the notable exception of Bullard, who does err on the side of being more hawkish historically.

As we've been contemplating the year ahead, there are two operative questions that come to mind. First is what will the market be focused on for any indication that the Fed has overtightened, pushed the restrictive policy narrative too far, and will ultimately be risking a deeper recession? The other question is if the Fed does find it in the situation where it has overshot the mark, how much excess demand destruction will Powell be willing to tolerate?

Ben Jeffery:

As we think about next year and timing this ultimate inflection point, which will probably be the "big trade" in Treasuries in 2023, it's really going to come down to, firstly, the shift in the Fed's focus from containing inflation at all costs toward the other side of the dual mandate, and an increased discussion on what will almost certainly be the softening in the labor market. As we've discussed frequently throughout the course of the last year, at this point, the dual mandate is really just a single mandate. Inflation is far too high for the Fed to be anything other than resolutely committed to removing policy accommodation and pushing Fed funds even further into restrictive territory. That's not going to persist indefinitely, and 2023 will almost certainly be the year that we see the pendulum swing from explicit concern on inflation back toward increasing angst on the labor market.

Now, if that's a Q1/Q2 story, presumably as the Fed arrives at terminal, that means staying on hold for a longer period this cycle than previous cycles is going to be far more challenging. But if we arrive at terminal at the February or March meeting, and then Powell is able to stay on hold for eight, nine, ten months before we really start to see the unemployment rate tick up, that will allow, A, the curve inversion to persist for longer, but B, the FOMC a longer time horizon before they need to start acknowledging that maybe policy doesn't need to be quite so restrictive. In the early days of this inflection, we're going to be looking out for any rhetoric suggesting that fine-tuning might be appropriate, and it's not unreasonable to assume that 2019's playbook of those fine-tuning 25 basis point rate cuts is going to be how the other side of the monetary policy cycle is going to play out, at least initially.

Ian Lyngen:

One of the things that we didn't see in 2019 and into 2020 is how those fine-tuning rate cuts might have eventually evolved had it not been for the pandemic. What we suspect the forward path will be is several fine-tuning rate cuts, a period on hold followed by a more concerted effort to return policy back to at least neutral, if not slightly accommodative. Another key uncertainty in such a context will be how the Fed chooses to deal with the balance sheet runoff. Does the Fed need to pause the balance sheet runoff to deliver fine-tuning rate cuts, if they're communicated as such? We don't think so. Returning to neutral, or some version of an accommodative policy stance would, however, require the balance sheet runoff to be put on hold.

One of the many things we don't know is whether this is a 2023 issue, '24 issue, or if, in fact, the Fed has been able to engineer the ever elusive soft landing. For context, returning to the notion that the first half of the year will be spent trying to determine whether or not the Fed has overtightened and the economy is cooling too quickly, the first thing that we'll be watching is the unemployment rate. The Fed's forecast for 2023 and 2024 is an unemployment rate that ends at 4.4%. We're currently at 3.7. To get to 4.4%, that would require the reduction of roughly 1.2 million jobs. Our primary concern isn't the Fed's ability to get the unemployment rate up to 4.4%, but the ability to stop the erosion of the labor market once their unemployment target is achieved without shifting to an easier monetary policy stance. In this context, a version of overshooting would be too quickly getting unemployment to 4.4% and subsequently slipping into the 4.5 to 5% zone. If that were to occur in the first half of next year, I think that would be problematic for the Fed.

Ben Jeffery:

The main reason that would be problematic for the Fed is that, by that time, almost by definition, inflation is still going to be far too high versus the Fed's 2% inflation target, for Powell to signal anything other than an ongoing commitment to policy in a restrictive stance. Yes, October's CPI data was encouraging, in that it showed some moderation in the key areas of core inflation, but still with core inflation at effectively 6% on a year over year basis, the consumer prices backdrop still is going to require a longer period of time to allow supply side issues to continue to work themselves out, but also increasingly relevant, given the fact that services are now accounting for an increasing share of overall consumer prices, is the lagged impact that monetary policy is going to have on the demand side of the equation.

The hallmark of this economic cycle has been just how fast everything has played out. Unlike the last time around, when the Fed was tightening at a 25 basis point per quarter cadence, now we've had four back to back to back to back 75 basis point hikes and, given the first of those was in June, we've not even yet really reached the point when the vast majority of this cycle's rate hikes have flown through to the real economy. In early March of 2022, the Fed was still actively buying bonds and only delivered a single 25 basis point rate hike. This is why we're optimistic that inflation will come down in 2023. The tricky part is going to be keeping the unemployment rate low enough for long enough to allow that to play out.

Ian Lyngen:

The higher for longer approach has clear ramifications for the real economy. We'll be watching the GDP numbers as they develop over the course of 2023. The market is anticipating a recession and, to some extent, the Fed has already conceded that that might come to fruition. With that backdrop, the biggest question is one of magnitude.

If we have a pedestrian contraction in consumption of 1% to 2% two back-to-back quarters, that wouldn't be sufficient to be characterized as overshooting. If we look historically, or at least back to the 1980s and excluding the pandemic, what we see is that when the U.S. economy is in a recession, the average quarterly annualized rate of contraction is 3%. Envisioning a situation where the unemployment rate increases more quickly than expected and real GDP is declining at a rate greater than the average -3%, that would create a scenario in which the market would be comfortable looking to the Fed's actions and characterizing them as overtightening.

Ben Jeffery:

Where it gets challenging for the FOMC is that, in such an environment, the market's going to pull forward the pricing of rate cuts, whether those be fine-tuning or otherwise, in a similar fashion to what we're seeing currently. Call it 50 basis points of cuts priced in at some point in 2023, and where the true test of the Fed's resolve is going to come is going to be how willing and how aggressive monetary policymakers are going to be in pushing back against a market that's going to try to pull forward rate cuts.

Ultimately, what this means for financial conditions is that, in the event we see policy stubbornly on hold, even without hiking, the Fed is still going to be tightening financial conditions by not giving in to what the market wants. This means that, in market terms, real yields are going to remain high and risk assets are going to remain under pressure, at least until enough progress has been made on inflation that the Fed doesn't need to push back against rate cuts being priced in.

Ian Lyngen:

We've spent the bulk of this conversation talking primarily about the performance of the U.S. economy and labor market. The impact on overall financial conditions from developments overseas is also worth putting on the radar as a potential risk. Now, as we've seen, the post-pandemic performance of different economies has varied rather dramatically. Given the fact that China continues to struggle with the zero COVID policy and Europe is facing a long winter with a potential energy crisis, it's well within the sphere of potential outcomes to see risk assets overseas underperform. In that environment, a global tightening of financial conditions would flow through to U.S. financial conditions and provide something of a buffer for the Fed to be incrementally less aggressive on the hawkish side than they might otherwise have been.

Our biggest concern is that, as global investors look to the major central banks in anticipation of a pivot, that equities rally. If equity volatility declines, then that flows through as an offset to the tightening already done by the Fed, thereby prompting the Fed to go even further. A scenario in which bad news is good for equities means that good news is bad for the Fed.

Ben Jeffery:

There's another aspect of the current state of the world overseas that is an additional risk the Fed has to be thinking about, and that is what the strength of the dollar might ultimately do to emerging markets, and the risk of some credit event or sovereign default triggering contagion in an environment without the cushion of accommodative policy. Unlike the last 10 years, inflation is now high, and so are interest rates. That means that any extraneous shock, perhaps resulting from the strength of the dollar, in EM space, will not be able to be smoothed over by easy access to cheap capital. This all points to a very precarious situation for the Fed and, frankly, central bankers globally, that continue to try to bring the global economy to a soft landing.

Ian Lyngen:

One place where the strength of the dollar certainly hasn't been obvious is this holiday shopping season.

Ben Jeffery:

There's your inflation.

Ian Lyngen:

Keeping it real.

In the holiday shortened week just past, the Treasury market was engaged in a round of consolidation, certainly in outright yield terms, but the curve itself managed to push to new cycle extremes; 2s/10s dipping below our -75 basis point initial target certainly reflected a broader flattening trend that occurred across the curve. Now, the market is running up against the logical extremes of how far one should expect the curve to invert. This is particularly the case further out the curve with a nod to the price action in 5s/30s.

Eventually, we'll see a cyclical re-steepening begin to occur. The initial move will start in 5s/30s, eventually followed by 2s/10s. But, for the time being, the curve flattening trend is difficult to ignore, nor would we attempt to fade it, aside from a tactical move. Now, in this context, a tactical move is consistent with a 7 to 10 basis point incremental re-steepening, as positions are squared, particularly at this time of the year where liquidity is low and conviction is light, ahead of the new year.

Year end liquidity strains are not new territory for the Treasury market. What makes this cycle so unique, however, is the fact that the Fed's balance sheet runoff is contributing to the situation and, given the outright level of Fed funds, the FOMC's tightening endeavors are beginning to take hold. Now, that being said, we're not anticipating any dramatic dislocations between now and the end of the year. However, we're certainly cognizant that increments flows will have a bigger influence on the outright level of rates. Therefore, what might have otherwise triggered a moderate response could create price action that takes on a life of its own. Let us not forget we're also up against the backdrop of a potential monetary policy inflection point, both in the U.S. as well as overseas, and that carries with it a great deal of uncertainty, as well.

We know that the big macro trade for 2023 is expected to be the bull re-steepening of the curve. However, it remains far too early in the process to scale into that trade, so we continue to anticipate the 2s/10s curve will probe new depths of the inversion with -100 basis points, our ultimate target, and that in an environment where we see 2-year yields at 4.50 and 10-year yields at 3.50, as investors begin to use any backup in 10-year yields as an opportunity to engage in dip buying, as investors continue to look forward into 2023 with mounting concerns that the Fed will need to keep policy deep into restrictive territory for longer than the real economy can handle and still be in a soft landing scenario.

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 you'll be spending Thanksgiving watching football or watching football, enjoy the holiday, and have fun watching football.

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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