The Final Countdown - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 284, The Final Countdown, 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 July 29th. And as the market counts down the days to the first rate cut, still on track for September, we are reminded of the final countdown into the end of this year's Institutional Investor survey. Polls close on Friday, August 2nd, and we would truly appreciate your support.

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, we saw a stronger than expected second quarter real GDP print as well as some stickiness on the inflation front, at least on a quarterly basis. All of this did little to dissuade the Treasury market from continuing to press the front end of the curve towards lower rates and perhaps more importantly, the re-steepening of the 2s/10s curve appears to have found some momentum and motivation with 2s/10s up against the cycle highs. Now, taking a step back as we contemplate the balance of the summer months, it goes without saying that the political climate will matter, and as the Harris versus Trump presidential race begins to pick up, we anticipate that there will be tradable headlines if nothing else. Now it is far too early for confidence in the polls or for confidence as to the breakdown of Congress.

Whether or not it ends up being a full Republican sweep or a full Democrat sweep has greater bearing on what one should anticipate in terms of fiscal stimulus and the risk of reflation in 2025 and beyond, then does precisely who takes the White House. All of that being said, we're certainly cognizant that the race to be commander in chief will dominate the headlines and the media cycle. With this backdrop, we continue to look at the September 18th FOMC meeting as the most likely departure point for a rate cutting cycle that will, if everything goes according to plan, bring monetary policy rates back toward the upper bound of neutral. Now, it goes without saying that there is a pretty significant debate in the market at the moment regarding where neutral is during this stage in the cycle. Is it two and a half as the Fed had previously signaled? Is it 3%? Is it a higher number?

Our take is that neutral, especially in the wake of a global pandemic that led to supply chain disruptions. It led to a meaningful shift in the behavior of workers and employers. All of this has left R-star and the neutral rate as a moving target rather than a static figure. Even within that context, however, it is notable that by and large the second quarter represented a return to the disinflationary pressures seen in the second half of 2023, all of which affords the Fed ample opportunity to communicate that the first rate cut is on the horizon while maintaining the flexibility afforded to the committee by the July and August CPI numbers, which the Fed and the market will have in hand before the decision in mid-September.

We've been encouraged by the recent price action, which suggests that the traditional bond bullish seasonal patterns remain relevant. And as we contemplate shifting into the month of August, we continue to see downward pressure on rates both in the front end as well as in the long end of the curve. But the relevance of a policy pivot on the horizon suggests that the two-year sector will continue to outperform, all of which feeds back into our cyclical bull steepening bias. And in this context, we anticipate a late summer shift into positive territory for 2s/10s with a nod to the fact that 5s/30s has steepened out rather dramatically and will continue to do so as we move into the next leg of the cycle.

Vail Hartman:

It was a week in which the price action itself was arguably more relevant than any of the new fundamental information that was learned. Recall the steepest the 2s/10s curve had reached since its initial inversion in July of 2022, was negative -11 basis points and that was reached last October. And this week even in the absence of a material shift in the macro narrative, we saw that level once again tested. And looking at 5s/30s, that spread broke out above 40 basis points to reach its steepest levels in over a year.

Ian Lyngen:

You make a very good point, Vail. The bulk of the price action was the curve steepener. Now we know that the big macro trade of 2024 was always expected to be the re-steepening of the yield curve. We saw part of that play out in a bond bearish form a couple of weeks ago, but as it's become increasingly obvious that the Fed will be cutting rates in September, even despite the better than expected GDP print for Q2, the reality is that the most significant steepening that we will see almost by definition has to come in a bond bullish form. Specifically as two year yields drift lower to reflect the start of what is widely anticipated to be a series of rate cuts that brings policy rates back to neutral. It's also worth observing the fact that the Fed is not the only major central bank that is about to or already has shifted into rate cutting mode.

Recall that on Wednesday the Bank of Canada cut another 25 basis points bringing policy rates to 4.50%. And as we contemplate the balance of the summer, eyes will be on both the ECB and the Bank of England, and while they might not necessarily deliver rate cuts, expectations hold that monetary policy makers overseas with the exception of the Bank of Japan will be readying market participants for further cuts. Very consistent with what we're expecting from the Fed on Wednesday, which is not a cut, but Powell laying the groundwork for the inevitable shift in policy direction.

Ben Jeffery:

And after the moves we've seen in the bond market, the steepening that you touched on Vail, and generally the state of financial markets more broadly, the final week of July is poised to be highly pivotal given the updates that we're going to receive, but also I would argue just as importantly, the market's departure point going into the FOMC. 10-year yields are back to their lowest level since earlier this year. The curve both 2s10s and 5s30s is at its year-to-date steeps. And to look at cut pricing over the balance of this year we now have nearly 75 basis points of easing reflected in the futures market over the rest of 2024. As the market has taken notice of the steepening of the curve, the softening in risk assets and generally the increased willingness to own Treasuries, especially in the front end and belly.

And while this echoes of the big turn in the cycle as tighter monetary policy finally begins to weigh on risk assets, as the curve finally begins to steepen and rate cuts are brought forward, there's still a lot investors have to learn, first from Powell on Wednesday and then via the two more jobs and two more CPI reports we get before the September FOMC. And while it's probably not likely any of that is enough to derail a September cut, the amount of easing and outright level of rates across the curve beyond simply 2024 probably needs a bit more justification from the economic data, at least at this point.

Vail Hartman:

In transitioning to the supply front, this week's two-year auction was remarkably well received. The offering saw a 2.5 basis point stop-through for the largest since 2009 and non-dealers took their largest allocation on record. The strong takedown is consistent with the idea that there is ample cash in the front end and as it that we are approaching an inflection point in the policy cycle, there's been a greater willingness to move a bit further out the curve into the coupon space, bringing in a stronger bid for 2s.

Ian Lyngen:

There was also some pretty dramatic price action in FX, specifically the rally in the yen that brought the Japanese currency below 155 in a move that can best be characterized as an acknowledgement that the monetary policy divergence between the Bank of Japan and the Fed is unlikely to persist in its current magnitude indefinitely. Now there's an argument that that was also accompanied by pretty significant buying in treasuries from the region, although it will be a couple of weeks before we have solid data confirming that observation. As we think about the next potential inflection, Ben, as you pointed out, the jobs data matters. That is one of the core sectors that has thus far at least demonstrated a remarkable resilience despite tighter monetary policy for the last, let's call it 18 months.

One of the more topical conversations that we've had with clients recently has to do with the ongoing debate of where precisely neutral policy rates are in an environment where we have a Fed that's running down its balance sheet and residual what one might have previously characterized as transitory considerations on the inflation front, specifically sticky housing prices as the drop in mortgage rates during the pandemic led many homeowners to refinance into rates that make the current housing market unattractive in terms of affordability for a variety of players. We'll argue against the notion of a static neutral rate and suggest that it's as much of a moving target as anything else, especially when one considers the impact of the balance sheet. Recall that in the beginning of 2023 while the Fed was shrinking its balance sheet, the debt ceiling debate resulted in the Treasury's general account being run down to the magnitude of roughly $600 billion. So for all intents and purposes, the debt ceiling created a version of QE at a moment where the FOMC was engaged in QT.

It wasn't until the middle of 2023 when the debt ceiling was suspended yet again that we saw bill issuance increase in earnest to replenish the TGA, and what had been an offset to QT effectively turbocharged QT during the third quarter. It's not surprising then that despite the fact that there was not any rate increases during the second half of 2023, inflation slowly started to cool and the disinflationary pressures that we're now seeing yet again in the second quarter really begin to take hold. All of this is a long way of saying when introducing the balance sheet as a monetary policy tool, estimates of what neutral is become more art than science.

Ben Jeffery:

And in the discussion around neutral it's also important to highlight the price action that we've seen in the TIPS market. Specifically, the decline in 10-year real yields over the course of July has been impressive. Almost 20 basis points lower in 10-year reals. And while yes, we've seen a modest bearish retracement and ten-year tips back up to that 2% level, nonetheless as investors contemplate the level of restrictiveness actually being imparted on the economy, the fact that inflation adjusted borrowing costs are still higher than they were at any point before the pandemic. And even if our star has moved up by 25 or 50 basis points, if we're using 10-year real rates as a proxy, we're still extremely restrictive. And to your point about the lagged impact of the tightening experienced over the last 18 months, Ian, there's a great deal of time when 10-year reals were higher than they were now in terms of economic impact that has yet to really materialize in the data itself.

Now, if looking at the rally in Treasuries over the past few weeks is any indication, clearly the market is expecting for that to materialize in the realized economic data in the not too distant future, and it's going to be that dynamic that justifies the start of the cutting campaign and justifies a long bias in Treasuries even from these yield levels.

Ian Lyngen:

And as you alluded to Ben, there's an important distinction between going from a restrictive policy stance to a slightly less restrictive policy stance. And that affords the Fed plenty of flexibility as long as they continue to characterize any potential rate cuts as reducing restriction, as opposed to being accommodative. And without the backing of a material spike in the unemployment rate or an economic slowdown of some significance, then the most that one should anticipate for monetary policymakers is less restriction and not accommodation.

Ben Jeffery:

And let us not forget that Wednesday also holds the Treasury Department's update on its quarterly borrowing needs via the August refunding announcement. And along with so many things that have changed over the course of 2024, it's been illustrative that the supply angst that began in earnest last year at the August refunding announcement with that big bear steepening of the curve that accompanied higher financing estimates and larger than expected coupon auction size increases, now as the realities of the macrocycle have continued to play out and Treasury auction performance generally has exemplified a global investor base that's still willing to buy Treasuries. The calls for higher rates as a function of the massive amount of Treasury supply that's hitting the market has ebbed. And sure ten-year yields are not at 2%, but nor have very large 10-, 20-, and 30-year auctions catalyzed a repricing to 5% or 6% 10-year yields on a sustainable basis. After all, when the global economy is starting to show signs of slowing, if recent market moves are any indication, Treasury auctions are still going to bring out buyers.

Ian Lyngen:

And let's face it, at this moment, what the Treasury department needs is buyers for Treasuries.

In the week ahead, there are really three major events that will be competing for the slot of the most relevant. First and foremost will be the FOMC rate decision. We do not expect that the Fed will cut rates on Wednesday, nor do we anticipate a great deal of changes in the FOMC's statement. The aspect of the event that holds the most market moving potential will be Powell's press conference. Assuming that there's no rate hike, which again is our base case, Powell will want to begin to lay the groundwork for the Fed to move on the 18th of September. Admittedly, we still have two months’ worth of CPI between the FOMC's decision in July and when they meet again on the 18th of December.

That being said, at the moment, the data is behaving close enough to what the Fed would need to see that one's baseline expectation should be a cut in September. When we look at the market's pricing of such in eventuality, we can see that investors are equally as convinced that September will be the departure point for a rate-cutting cycle of some significance. The second event on the horizon is the combination of Monday afternoon's release of the Treasury's borrowing estimates, and then of course Wednesday morning's refunding announcement. Within the refunding announcement we're expecting $58 billion in three years, $42 billion in 10 years, and $25 billion in 30s. These numbers are consistent with the Treasury Department's prior signaling that coupon auction sizes have reached a plateau, at least for the time being, and any fluctuation in borrowing needs from the federal government will be absorbed in the bill sector. Of course, anything that comes out of the official communications that suggest that Yellen's opinion on this topic has shifted will be a tradable event. That being said, we anticipate that the Treasury Department will favor stability over flexibility at least for the next several quarters.

The third and final event of relevance comes in the form of Friday's release of non-farm payrolls. We'll be watching specifically the unemployment rate, which is currently expected to be unchanged at 4.1% for any evidence that there has been an acceleration of the upward pressure on the unemployment rate as the incoming data has continued to show that the bottom two quartiles of consumers are struggling at a moment where the upper quartile certainly continues to consume apace. And given this still lofty asset price valuations and the ongoing gains in home prices, it's difficult to imagine that the upper quartile won't remain on relatively stronger footing for the foreseeable future. That doesn't however exclude a spike in the unemployment rate that then subsequently undermines consumer confidence and leaves the second quarter's strong spending profile as the outlier, not the new norm for 2024 and beyond.

Given the cross currents that we expect will emerge from these three major events, we'll continue to focus on the shape of the yield curve with 2s/10s drifting back into positive territory over the course of the next several weeks, and a downward bias on 10- and 30-year rates, albeit not as dramatically as we are anticipating in the front end of the curve, as two year yields are primarily a function of near term monetary policy expectations, and as the market is increasingly convinced that the Fed is about to start a cutting campaign, we would expect the bid in 2s to extend.

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 with the final week of the II survey upon us, we would like to extend our appreciation for everyone who has already voted, as well as for those unable to get a ballot but still suffering through the process. The good news is that the telethon is almost over. Operators are still standing by.

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.lynge@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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