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The 366th Day - Macro Horizons

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FICC Podcasts Podcasts January 26, 2024
FICC Podcasts Podcasts January 26, 2024
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Ian Lyngen, Ben Jeffery, and Vail Hartman bring you their thoughts on the U.S. Rates market for the upcoming week of January 29th, 2024, and respond to questions submitted by listeners and clients.


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About Macro Horizons
BMO Strategists discuss the week ahead in the U.S. rates market delivering relevant and insightful commentary to help investors navigate the ever-changing global market landscape.

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Ian Lyngen:

This is Macro Horizons, episode 258, the 366th day, 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 January 29th. As we look forward to the 29 days of February, we're reminded that 2024 has a 366th day or a 13th month in some circles. Of course, this is done to keep the calendar year synchronized with the astronomical year as the latter technically has 365 and a quarter days. Ah, the quarter day. That was a work from home thing for everyone else too, 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 the Treasury market put in an impressive performance, particularly in the context of the new fundamental information that the market received. Most notably, the market got its first look at the Q4 real GDP numbers, which came in at 3.3% on a quarterly annualized basis. Now, this was versus expectations for roughly 2%. The composition of the upside surprise included stronger than expected consumption, which brings us back to the underlying tension in the market at the moment, and that is how can the Fed choose to begin normalizing rates lower in the event that the real economy continues to outperform expectations and the labor market remains on very strong footing.

From our perspective, we think that the data that we have seen for the month of December only reinforces the expectation we have for the Fed to avoid cutting rates during the first quarter. Now, that's not to suggest that we won't see the process of normalization start sometime in the second quarter, but given the eagerness with which market participants were pricing in a March rate cut, this does represent a meaningful shift in the consensus as we anticipate that the probability of a March cut will diminish the closer that we get to the March 20th meeting. Now, our assumption is predicated on the notion that we don't see a remarkable shift negative in the economic data, but even if we did see a moderation in the pace of consumption or an increase in the unemployment rate of note, the Fed still has enough of a runway to simply characterize a bounce in the unemployment rate or hit to consumption as noise in the economic data as we've come off of a stronger than expected second half of last year.

Now, the recent data also conforms to the no landing Goldilocks narrative and frankly, Powell's decision to pivot in December was for all intents and purposes doubling down on the Fed's potential to orchestrate a soft landing. We'll be the first to concede that we remain apprehensive that the Fed will ultimately be able to deliver a soft landing for the real economy. Although the probability of such an outcome is at its highest at this moment, particularly in light of the performance of the real economy last year. It's with this backdrop that we're focused on the first quarter holding the highest potential of a bond bearish surprise i.e. upside in 10 and 30 year yields as the market is faced with digesting a meaningful amount of supply on the Treasury side at a moment when the monetary policy backdrop appears to be steady for the foreseeable future.

Now, obviously, the definition of the foreseeable future is a work in progress, but each incremental Fed meeting that passes without a nod to the fact that there'll be cutting rates in the near term will push forward rate cut expectations, and that's precisely what we're expecting to be the net takeaway from the January 31st FOMC rate decision and Powell’s press conference. Specifically, the Fed has a long history of being unwilling to commit to future moves in policy rates. And as a result, Powell is more likely than not to simply emphasize flexibility and data dependence over any preset direction for policy rates.

Vail Hartman:

Treasuries bull steepened in the wake of Q4’s real GDP data, albeit rates remain definitively within the prevailing range as the combination of softer jobs data and an encouraging read on inflation ostensibly overshadowed stronger than expected consumption and growth figures. GDP topped all economists’ estimates at 3.3% QoQ versus the median forecast of 2%, and personal consumption added to the overall strength gaining 2.8% compared to the 2.5% consensus. The Treasury market's response to the data was remarkably similar to what we saw back in October when Q3’s softer than expected read on core-PCE and the increase in jobless claims offered a bond bullish surprise for Treasuries despite the blockbuster 4.9% real GDP print and taken together the market's response reinforced our assumption that there isn't much more Goldilocks that can be priced into the market as the trajectory of core inflation remains the primary driver of monetary policy expectations.

Ian Lyngen:

And to be fair, it was a Goldilocks print. The lower-than-expected headline inflation figure at 1.5%, well below the market's anticipated level, and Vail to your point, continue to reinforce this notion that the Fed will in fact be able to orchestrate a soft landing, but also as you allude to Vail, we're pretty much up against the logical extension of how good, good can actually be. At some point, we will start to see a disappointing consumption number or a further spike in the initial jobless claims figures that gets the market concerned that perhaps the Fed might have overdone it. The one nuance that I'll add in this context is that if the Fed does start the process of normalizing rates sooner rather than later, then that increases the probability that they're able to avoid a more material slowdown and that will only serve to reinforce the Goldilocks narrative.

Now then the bigger question from our perspective becomes what happens to ten-year yields in that scenario? The initial bull steepening that followed the stronger than expected GDP figures certainly resonates insofar as it appears to reinforce the case for a March rate cut. Now, we still don't think the Fed has the needed urgency at this moment to deliver on those expectations, but we're certainly sympathetic to the market's attempt to push that trade a bit further. When we think about ten-year yields on the other hand, lower realized inflation combined with moderating inflation expectations should intuitively put downward pressure on breakevens and over the course of this year continue to pressure nominal yields lower. We're very comfortable at this stage with our 10-year yield forecast for the end of the year at 3.5%, and given the current trajectory of inflation, we see the balance of risks skewed a bit lower from that 3.50% level.

Ben Jeffery:

And there's also an aspect of the market's transition from what the operating price action was in 2023 to now what the primary drivers of the macro discussion have become in 2024. Last year, the main uncertainty was by how much is the Fed going to hike? When is the Fed going to stop hiking? Are higher policy rates even effective at combating higher inflation? And all those macro variables from a broader backdrop perspective combined with the soft landing optimism that has unquestionably received the benefit of the realized GDP data across all four quarters left the stage ideally set for a period of supply driven bearishness that was ultimately the catalyst that got 10-year yields briefly to 5% before the inverse of that logic in the November refunding announcement catalyzed the rate move lower into the end of the year.

That was last year. And as we look ahead over the course of this year, and to your point Ian about the potential distribution toward an even lower rate finish line for 10-year yields at the end of the year, we're now discussing annualized rates of core PCE that are now back below 2%, the timing and pace of the Fed's cutting cycle and the sustainability of a still strong labor market. So the fact that the arc of the macro narrative has swung from the effectiveness of higher rates, how high do rates really need to go, is inflation ever going to come down to now how quickly inflation is falling, how fast the Fed is going to be cutting, and a general increased willingness from a real money investor base to buy dips in the Treasury market all leaves a far more constructive picture for duration in 2024 than what we got in 2023.

Ian Lyngen:

And it also affords the market the opportunity to once again begin the discussion about whether supply matters in a Treasury market and if it does matter, by how much should the market be willing to cheapen to accommodate what are generally expected to be a repeat of the November auction size increases revealed via the upcoming refunding announcement. Now, we're very much on page with the notion that we'll see a $2 billion increase in 10s per quarter, no increase in 20s, and $1 billion for 30s. But the question quickly becomes how much of that is already priced in and should the knee-jerk response be more focused on any forward guidance that the Treasury department chooses to offer about the May or August refunding cycles? We're assuming that to break 10-year yields above 4.25%, we would need to see either an upside surprise in the actual size of auctions or guidance from Yellen that there are more significant increases yet to come.

Ben Jeffery:

And beyond just the bumps that will be coming in coupon auction sizes, there's still the question of the overall composition of the market as it relates to the share of Treasuries outstanding that are accounted for by bills. Remember in August and November, the messaging from the Treasury Department was very clear that given the realities of the dynamic and the front end and what's still been a fairly impressive demand profile for bills, that they're comfortable continuing to run bills over the 20% upper bound of the guidance that they've previously offered. So it's no surprise to see that bills are currently sitting at right around 22% of marketable debt outstanding.

But looking ahead, this leaves the question of just how much larger bills can grow before there would be more significant worries about the yield levels that would need to be offered to clear growing bill auction sizes. Is it 23%, 24%, 25%, maybe something even a bit higher. It's this uncertainty that front-end market participants are hoping to glean a bit more clarity on Wednesday, especially given the fact that this quarter's survey of primary dealers asked specifically about the outlook for money markets. And this conversation has plenty of nuance even before considering the potential for the Fed to announce a slower pace of QT and the unknown around when the tapering process will begin and by how much SOMA reinvestment will start increasing. So that's another factor to consider as Yellen continues to craft the plan on just how to fund such a large deficit.

Ian Lyngen:

And it's also notable that we've continued to see the RRP decline over the course of the last several weeks, and that frankly is very consistent with what monetary policymakers would like to see as they remain successful in their endeavors to drain reserves from the system. It was a pretty interesting week in terms of the very front end of the market because we also heard from the Federal Reserve that they're putting a floor on the borrowing rates for the bank term funding program. They're effectively saying that banks will no longer be allowed to use the facility to borrow at rates below what the Fed pays for reserves.

Now, it follows intuitively given the fact that there was an arbitrage there, i.e. small, medium-sized banks could use the facility to borrow term money for a year for a lower rate than they could make by simply parking the money at the Fed. So from a mechanical perspective, it was arguably an overdue change, but it also reflects this ongoing divergence between what the Fed expects to do with rates in the near term and what the market is willing to price in. That is investors remain very eager to bring forward the first-rate cut, and to say that that debate is going to define the first quarter would be an understatement.

Vail Hartman:

And on the topic of supply this week, we saw a strong result for the two-year auction that stopped through 0.1 basis points, but on Wednesday we saw a poor result for fives that tailed by 2.0 basis points and non-dealers took their smallest allocation in over a year. This result extended the intraday down trade and pushed yields to fresh session highs as it wasn't particularly indicative of strong demand at current valuations in the belly of the curve.

Ben Jeffery:

And as the final round of auctions before the refunding announcement, a theme that has certainly been topical in our conversations with clients recently is going to be the performance of 10s and 30s, in particular in February, given what will presumably be larger auction sizes. And so as we think about the distribution of risk around the direction of rates over the next two weeks, it's still reasonable to have a tactical bearish bias given the information we're going to receive first on Monday via the financing estimates, then on Wednesday with the refunding announcement, and Powell's press conference where the messaging around the likelihood of a March cut also obviously holds market moving potential. And then a payrolls report that probably won't be the one that shows an inflection in the labor market all teeing the market up for a heavy week of duration supply, and investors won't necessarily wait for the auctions themselves to price in a concession. And that opens the door for a drift, if not necessarily a spike toward higher rates over the coming week.

Ian Lyngen:

As the February refunding auctions approach, we're reminded of two relevant market adages. First is auctions bring out buyers, and second is there's no such thing as a bad bond, just a bad price.

Ben Jeffery:

Unless it's a bond villain.

Ian Lyngen:

Bond. Long bond.

In the week ahead, there's a variety of economic data inputs and fundamental developments that will drive the overall direction of rates. Wednesday is arguably the big day as it contains ADP, the employment cost index, the refunding announcement, and the FOMC rate decision. On top of that, it's month-end, so one should expect some flow-driven price action into the close as is typically the case. In terms of the refunding announcement, we're expecting $54 billion three years, $42 billion 10 years, and $25 billion 30s, and we'll argue that this is reasonably consensus at this point, and perhaps more importantly, within the refunding details will be the utilization of the bill market as well as confirmation of the timing of the Treasury Department's buybacks.

As for the Fed, more of the same is our base case assumption. There's no incentive for the Fed to begin laying the groundwork for a March rate cut. Certainly not at this stage, unless of course they are a 100% committed to the move, and we simply struggle with that notion given the fact that there's a lot of economic data between now and the 20th of March. We could see some discussion, most likely at the press conference and not in the statement, about the potential for the Fed to start tapering QT. Whether that's formally announced at the March meeting or sometime in the second quarter remains to be seen.

But one surprise potential for Wednesday would be a more thorough discussion of what Powell plans to do with the balance sheet. And let us not forget that February 2nd is nonfarm Payrolls Friday. As it currently stands, the consensus is for 150k-155k jobs to be added in the month of January, and the unemployment rate comes in at 3.7%. We've been impressed with the resilience of the labor market, but within the employment proxies, i.e. jobless claims, etc., we don't see anything that would imply that there is a spike in the unemployment rate or an underperformance on the payrolls figures themselves.

That being said, we're certainly cognizant of the divergence between the household survey and the establishment survey, as that tends to portend a shift in the broader direction of the headline payrolls figures. Playing for such a move in recent months has been unfulfilling at best, and so we find ourselves a bit reluctant to go into the January employment report with a strong positional skew. If anything, we expect that the risk of a downside number on Friday will prevent the market from more aggressively pricing in an auction concession for the following week's 10 and 30 year supply. So as a result, any rally immediately following nonfarm payrolls, we'd view as a fadeable event as the market readies to take down the following week's supply.

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 January quickly comes to an end, we're not looking forward to a month containing only one three-day weekend. Downright uncivilized SIFMA. 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:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/ macrohorizons/legal.

 

Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Ben Jeffery US Rates Strategist, Fixed Income Strategy
Vail Hartman Analyst, U.S. Rates Strategy

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