The Journey to Neutral - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 292, the Journey to Neutral, 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 September 23rd. And as Powell has followed through with a 50 basis point reduction in the Fed's policy rate, we're left humming the tune to the late-60s classic, First Cut is the Deepest, by Cat Stevens. Who knew?

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. That being said, let's get started.

In the week just past, we finally got the departure point for this cycle's rate-cutting campaign. The Fed delivered a 50 basis point reduction in the policy rate leaving the upper bound at 5%. Clearly, this move resolved the debate over 25 or 50, and if anything, it made it clear that the Fed intends to start the process of bringing policy rates back toward neutral. We also did get a little bit of context for the Fed's thinking on where neutral is during this cycle. The longer run dot was revised slightly higher to 2.9% versus the 2.8% prior level, and we also see via the Fed's forward projections that the FOMC believes that 2.9% is neutral, at least for the time being. Now, this isn't to suggest that it would be impossible for the Fed to push below that level, however, a policy rate materially below 3% would need the justification of a sharp deterioration in the economic outlook, which would prompt the Fed to move into easing territory.

As it currently stands, the messaging from the Fed is simply that the progress made on the inflation front is enough to justify bringing rates back from the extremes of the restrictive policy that is currently in place, and the process will be gradual. Our assumption is 25 basis points, a meeting from here until we get back to 3% and then the Fed will reassess, and given the prevailing trajectory of the real economy at the time, one should expect that the Fed will be on hold until either there is evidence that reflationary pressures have returned or there is more downside in either the employment market or the pace of consumption.

None of this we expect to be resolved in the very near term. Instead, the market will continue looking at the strong performance of risk assets and the implications for the wealth effect. One of the biggest risks that the Fed runs by cutting 50 basis points is that the market prices in a swifter return to neutral than the Fed will ultimately be able to deliver. As a result, financial conditions have become much easier than a 5.0% fed funds rate would otherwise suggest. It's the easing of financial conditions that creates the biggest risk for another rebound of inflation in 2025 and beyond.

Now, obviously, the Fed is cognizant of this risk, and in making the decision to move 50 as opposed to 25, Powell seems to be content with the idea that front-loading rate cuts with at least one 50 basis point move will afford the Fed the opportunity to take a more measured and well-telegraphed pace back toward 3%. On net, the combination of the 50 basis point cut and the dots for 2024 and 2025 left the market with the impression that it was a balanced half-point cut as opposed to a hawkish or dovish one. The resulting price action was a bear steepener, which we're characterizing more as a buy-the-rumor-sell-the-fact dynamic as opposed to any interpretation of the forward path of policy rates or any implied risks on the part of the FOMC.

Ben Jeffery:

Well, it was one of the more hotly debated Fed meetings in recent memory as the question of 25 or 50 basis points was finally answered this past week with Powell delivering the first cut of the cycle and it was of the half-point variety. We also received an updated dot plot that showed another 50 basis points in rate cuts over the balance of this year, followed by another hundred next year and terminal being reached by the end of 2026 at the Fed's best guesstimate of neutral. We also learned at the press conference that this past week's move does not imply anything about the magnitude of future cuts and the main reason why the committee opted to deliver 50 basis points instead of 25 this time around was simply not to risk falling behind on the path toward normalization. Interestingly, as the dust settled follow the release of the statement and the SEP and as Powell left the podium, we actually saw treasure yields end the day modestly higher, although the curve consistently benefited from the steepening pressure that continues to drive 2s/10s and 5s/30s back toward new steeps.

Ian Lyngen:

It is interesting that the takeaway was a net bond bearish one from a 50 basis point rate cut. All else being equal, one would've assumed that a half-point cut would've provided a bond bullish impulse across the curve, but the fact that so much of the price action was absorbed in the very front end of the curve really speaks to the notion that it was a classic buy-the-rumor-sell-the-fact event. By that, I simply mean that the market was positioned very bond bullishly in the run-up to the Fed, and when we got the Fed's decision in hand, the price action was simply to give back some of the prior gains. Now, that doesn't mean that the tone has now changed indefinitely, i.e. toward higher rates for the foreseeable future, but rather that we are back in a classic range trading environment where, as we progress through each upcoming rate cut, the two-year sector will benefit accordingly and the yield curve, all else being equal, will steepen out. Now the debate has quickly become whether or not the Fed is going to ultimately end up stoking reflationary concerns as opposed to being behind the curve in cutting.

It's amazing how quickly the broader narrative has changed over the course of just a few trading sessions. We'll point to the increase in ten-year breakevens as a logical expression of the risk that we might see reflationary concerns come back into the market over the course of the next several quarters. All of this being said, there's no question that the next two quarters are the make-or-break window for the soft landing narrative.

Ben Jeffery:

A critical component of the Fed's soft-landing aspirations is naturally that the unemployment rate continues to be well-behaved. Another dynamic that was reflected in the SEP, which showed the Fed's expectation that the unemployment rate is going to top out this cycle at just 4.4%. As we've discussed before, if history is any guide, it seems unlikely that we're going to get a modest increase in the unemployment rate that is then followed by a gentle move back lower, in terms of the overall state of joblessness in the US economy. So in this vein, to square the economic projections within the SEP with the policy rate ones, sure it makes sense that the Fed will deliver another 50 basis points in cuts this year and a relatively modest hundred basis points in easing next year from a still very elevated departure point, if in fact we continue to see labor market resilience and if in fact we continue to see disinflationary pressures keep the progress toward 2% good enough to justify continuing to cut.

Said differently, the Fed has laid out the roadmap for if all goes according to plan over the next several quarters, but if we've learned anything over the past several years, it's that things rarely go according to plan. It's also worth revisiting what Powell said at the press conference in terms of 50 basis points in September not necessitating more 50 basis point moves, and represented the chair's effort to talk investors into the baseline assumption being 25 basis points and larger cuts only necessary if the data surprises to the downside, although, to look at FOMC pricing out in November and December, clearly the market is not convinced of that, at least until we get September's payrolls data and obviously the CPI print to follow.

Ian Lyngen:

One thing that the market is convinced of is this idea that the Fed is going to cut at every meeting until we get policy rates back to 3% or slightly below 3%. And if we look at the futures market, that's priced in by June or July of next year. Now notably, that pricing is more aggressive or reaches neutral more quickly than the SEP implied, but for all intents and purposes, it's probably not that far off what the committee is actually thinking. When we look at the spread between the 2024 and 2025 dots, what we see is, as was the case in June, the Fed is telling us they're going to cut a hundred basis points next year, as you pointed out. Now, spreading a hundred basis points worth of rate cuts over an entire year would imply quarterly rate cuts as opposed to a move at every meeting, but we suspect that the reality will ultimately be that it's difficult for the Fed to justify pausing unless we see a resurgence of reflation, and in that case, the pause will most likely be for more than simply one meeting.

As a result, we're going into this process assuming that the rate cuts are 25 basis points per meeting until we're back to the range of 2.75 to 3%, and it's at that point that the Fed will have enough information to truly reassess and then will subsequently communicate to the market whether or not they can envision justification for needing to move below neutral.

On another note, there has been a fair amount of discussion around the fact that the difference between the 2024 dot signaling 50 versus 25 basis points of further rate cuts came down to a single dot. Now, I'll make the observation here that, as was the case in June, the dot plot was arguably stale even upon publication. Logic here is pretty straightforward. The SEP projections are submitted at the beginning of the two-day meeting, and if, in fact, enough of the committee members were going into this event thinking 25, maybe 50, it follows intuitively that 2024 dot would've assumed a 25 basis point move at the September meeting. In the case that enough committee members were swayed from 25 to 50, which was undoubtedly the case, this implies that we should be looking at the 2024 dot with a fair amount of skepticism.

Ben Jeffery:

In discussing what ultimately came to pass on Wednesday, we would be remiss not to mention the dynamic that we heard discussed fairly frequently in the lead-up to the meeting, which was the extent to which the market "bullied" the Fed into delivering a half-point cut as opposed to a 25 basis point one. Yes, there were several articles from the financial media, along with a few opinions offered from former Fed presidents offering some unofficial guidance on the size of the cut, but the fact of the matter is that, whether through official channels or not, by allowing market pricing to reach over 40 basis points of a cut priced in, what the Fed ran the risk of doing by only going 25 basis points was delivering a financial conditions tightening impulse at a moment when, clearly, the bias is to normalize the level of restriction that's being delivered on the economy. It's not just the outright level of financial conditions that matter, but also the pace of change in the tightening, which of course, is a derivative of equity volatility and the rate of change of real rates themselves.

What this means as we look out toward November and December and as the 25 or 50 basis point cut debate will inevitably once again pick up steam, the question will become how explicit the Fed will be in messaging their intention to only go 25 if in fact that's what the data warrants. Because if, as we approach the November meeting, to say nothing of the uncertainty around this year's elections, and we have a similar magnitude of cuts priced in, the Fed will find itself in a very similar situation, being forced to choose between acquiescing what the market is looking for and, optically at least, remaining independent and not beholden to what the market is doing.

Ian Lyngen:

On the topic of remaining independent, it will be interesting to see how, if at all, some of the political implications come into play for the November move. Recall that in November, the FOMC meets after the general election closes, although even at that point, it's probably unlikely that the nation will know who won, and it's certainly unlikely that we'll know the composition of Congress per se. If nothing else, the next several months will be a relatively volatile time for the macro narrative as investors weigh the prospects of the Fed attempting to ensure a soft landing while there's more likely than not to be some at least marginal evidence of sticky inflation on the path back to 2%.

It's with this backdrop that we continue to like the steepening trade. 2s/10s is the obvious expression of this bias, but that also holds for 5s/30s as well. Now, as a theme, we have been on board with the compression of 10-year breakevens, and in a more typical environment, we would assume that 10-year breakevens would soon be breaking below 200 basis points. The Fed's decision to move 50 and telegraph a relatively swift return back to neutral has provided a bit of support for breakevens. After all, the Fed is no longer as aggressive in fighting inflation. One should be open to the notion that it will take longer to get back to the 2% level.

Ben Jeffery:

Ah, 2%. You'll know it when you get there.

Ian Lyngen:

Yeah, because you'll be at 2%.

In the week ahead, the Treasury market will have an array of Fed-speak from which to gain a better understanding of the Fed's thinking about the forward path of policy rates. We hear from Bostic, Goolsbee, Kashkari, Williams, Powell, Barr, and what's surely to be a few late additions to the roster as the Fed endeavors to further refine the messaging surrounding the 50 basis point cut as well as provide a base-case scenario for November. We are operating under the assumption that 25 basis points in November will be the Fed's preferred move, unless of course the data dictates otherwise. The week ahead also contains key Treasury supply in the form of $69 billion in 2-year notes on Tuesday, followed by $70 billion 5-year notes on Wednesday, and capped with $44 billion 7-years on Thursday. While Friday the 27th isn't month-end, that's obviously the following Monday, September 30th, we do expect that there will be some degree of month- and quarter-end demand as September comes to a close, and that could be evident as soon as the close of this week.

Our trading bias for the market remains very much intact. We continue to favor the steepener with an acknowledgement that even the 2s/10s steepener continues to carry poorly in this environment, and we're cognizant that some might be skeptical of the sustainability of the kneejerk steepening that followed the Fed.

Moreover, while it might not be the most exciting trading bias in the market at the moment, we do think that duration has shifted into the stage of consolidation, and we would expect that the post-Fed bearishness will quickly run its course. We will see a stabilizing bid emerge and rates will drift back into a familiar territory. Now, there's certainly an argument that this could offset some of the steepening pressure, and to some extent that might be the case. However, we nonetheless see 2s/10s in positive territory and we'll look to strengthen the two-year sector to really define the agenda for the curve.

The recent unexpected decline in initial jobless claims has refocused the market on the upcoming September employment report, which is published on October 4th. Our focus there will be on whether or not the unemployment rate, which recently ticked lower to 4.2, regains its upward momentum and brings into question whether or not there's still more downside yet to be seen on the jobs front, which frankly, is our base-case 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, and as we reflect on the recent price action, it strikes us that policy rates are down, Treasury yields are up, and stocks are at record highs, leaving only one real question. What could possibly go wrong from here?

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 3:

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