This Is Strategy - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 295: "This is Strategy" 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 October 15th. And as the autumn has unquestionably arrived and we're on our sixth viewing of The Nightmare Before Christmas, we're reminded of the sage words of Jack Skellington, "I believe this is our most horrible yet." Thank you everyone. We're pretty sure he wasn't talking about our podcast, but if it fits.

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 past, arguably, the most relevant piece of data came in the form of the September inflation figures, which on an unrounded basis showed core up 0.31%. That compares to August gain in core CPI at 0.281%. So technically it was both above the 0.2 consensus, as well as a slight increase from the prior month. As a result, the year-over-year pace unexpectedly upticked to 3.3% from 3.1% previously.

Within the details we saw owner's equivalent rent increased just three tenths of a percent and used cars were also up three tenths of a percent. However, when focused on the super core measure, what we saw was an increase of 0.55% for core services ex-shelter, and that marked a decided acceleration from the prior month's 0.239%. It also marked the third-highest supercore print over the last two years with the number one spot being held by January and the number two spot being held by March of this year.

Long story short, not only did we see an increase in nominal wages during the month of September, but that also corresponded with an increase in the super core measure of inflation. While we don't think that the US economy is poised for a wage inflation spiral, the relevance of this correlation is nonetheless notable if for no other reason than the fact that the Fed has commented on it several times and presumably, it will factor into the Fed's November and December decisions.

The one surprisingly relevant data print that moved the market was the increase in initial jobless claims for the week of October 5th. Here we saw a print of 258,000, which was the highest since August of 2023. Now, the market was content to attribute a lot of the upside to idiosyncratic factors, specifically the recent storms as well as some of the reshuffling in the auto industry, but nonetheless, it served as a meaningful offset to the stronger than expected payrolls print in September. So as the month of October unfolds, it goes without saying that the market will be very closely tracking the trend in initial jobless claims for any insight as it pertains to what we should expect from the official BLS data for the month.

Overall, the price action in the US rates market was best characterized as choppy. We saw an initial sell off following the higher than expected core CPI print, but that ultimately resolved into lower two-year yields as the initial jobless claims figures drove the narrative. It then follows logically that we saw a re-steepening of the curve on net. Now, it's important to acknowledge that 2s10s dipped momentarily into negative territory on October 7th only to end the week comfortably in the middle of the range between zero and positive 25 basis points.

Ben Jeffery:

While it was always going to be a big week primarily as a function of September CPI data, and while the core figures came in higher than the official consensus at 0.3% month over month versus up two tenths, which was the expectation, we'll argue the market was really looking for something in the mid to high 0.2 percents. And so when taking the market's expectation combined with what was realized in terms of the data, the fact that we got a knee-jerk sell off only to see 10-year yields end the day lower on Thursday shows that for all the anxiety that's resulted in the market following the NFP print, CPI was as expected enough to not truly call into question whether or not the Fed is going to continue cutting rates.

We also heard from Bostic in the wake of CPI that if the data justifies, he would be open to skipping a meeting, but nonetheless, with a lot of data yet to be realized over the balance of the year, there was nothing contained within this week's new information that suggests the committee is actively entertaining taking November off, at least not yet.

Ian Lyngen:

And we also saw the jobless figures for the first week of October. Those jobless figures, I'll argue, were what really drove the bid in the front end of the market. Yes, it was counterintuitive that we had slightly higher than expected core CPI that was then subsequently followed by rally in the two-year sector, but when we put it in the context of the fact that so much of the recent backup in rates had been a function of the September payrolls print and the broader implications, it follows intuitively that any indication that the October employment profile might be deteriorating was a tradable event.

Now, there are a few key caveats as it relates to this particular jobless claims number that are worth exploring. First of all, they were heavily influenced by some of the recent storms. We saw an increase in claims from Florida and North Carolina, which we're comfortable assuming were largely driven by the storms. It's also notable that there was a sharp increase in claims from Michigan, which were surely linked to the auto industry, furloughs and some reshuffling in that sector.

Now, while it is tempting to dismiss the initial jobless claims print outright, those increases didn't account for the entire upside surprise, and if nothing else, the report serves as a reminder that the next several months worth of economic data will be distorted by the storms. This presents a fresh new challenge for the Fed because it's safe to assume that not only will jobless claims be distorted, but so will retail sales, the overall jobs picture, as well as even inflation between now and the end of the year.

So that begs the question, how will the Fed choose to incorporate this new degree of uncertainty at the November and December meetings? We maintain the 25 basis points in November is a path of least resistance. It is worth flagging, however, that at present, the probability implied by the futures market of a November rate cut is 85%. Interestingly, the probability of a December cut is 96%.

I'll argue that that should be reversed. If the Fed doesn't go in November, there's a lower probability that they go in December as well. Logic there is relatively straightforward. If the data is strong enough in the employment report to convince the Fed they should skip November, then such a trend will be unlikely to be reversed by December.

Ben Jeffery:

And to use one of our favorite monetary policy cliches, the Fed's already driving looking in the rearview mirror, and so to add the uncertainty around the data itself that's going to result over the balance of this year, what really becomes the most important dynamic to consider in terms of the Fed's reaction function is the trend and the longer-term path of policy that started to get laid out over the course of the summer once it became clear that the FOMC was satisfied with the progress they'd made in bringing inflation lower and concerned enough on the state of the labor market that any further softening in jobs would be unacceptable.

It's that reality and the fact that the Fed is not operating on a week-by-week or month-by-month basis that leaves the paths forward for yields as lower. Sure, it might be at a slower pace than 50 basis points every meeting and maybe there's even an outside risk that we take a meeting or two off as the Fed slowly reduces the level of restriction it's imparting on the economy. But as for what it means for the market and particularly the front end of the curve and the shape of the curve more broadly, if the Fed is cutting and if central banks globally, besides the Bank of Japan, are cutting, then unlike at any point over the last several years, there's going to be more and more demand waiting to take advantage of sell-offs and treasuries, especially in the more monetary policy-sensitive areas of the curve like twos and threes. And as we start to think about the term premium implications from a less restrictive policy stance coming into an election year, it's just another reason that we continue to expect the curve will extend its grinds deeper.

Ian Lyngen:

This also sets up the ideal environment for market participants to once again begin the conversation about positive term premium. A lot of emphasis has recently been placed on the deficit and regardless of whether Trump or Harris wins the election, the baseline assumption is that deficit spending will persist if not increase over the course of the next few years. And therefore, conversations in the market about higher treasury coupon auction sizes have become very frequent. While we continue to see the August refunding as perhaps the earliest point at which the Treasury Department would consider increasing auction sizes, we're all too cognizant that the market is very eager to get ahead of this dynamic. As a result, the recent backup in 10 and 30-year yields has proved to be a bit more durable than we might have otherwise expected.

Four handle tens are in place, and while we continue to view this as the upper end of the yield range, we're certainly aware that it will require a shift in the fundamental outlook to really encourage dip buying from here. In the very front end of the curve, as you pointed out, Ben, it's a monetary policy story and it's important to keep in mind that when the Fed is cutting rates, that's when term premium invariably increases into positive territory and extends. So this implies that positive term premium is the path of least resistance as the Fed starts to lower rates, and we don't necessarily need to see a more significant increase in nominal rates.

However, a key nuance of the composition of ten-year yields comes in the form of forward inflation expectations and breakevens. When the Fed starts the process of normalizing rates lower, they are implicitly being less aggressive on fighting inflation and therefore it has not been surprising to see 10-year breakevens, which bottomed at 201 basis points in early September, grind higher to the 230 range, give or take. We anticipate that that range for breakevens, let's call it 200 to 240, will persist for the balance of the year.

Ben Jeffery:

And it's exactly that tightrope that Powell is going to need to continue walking as the Fed on one hand attempts to head off any further weakness in hiring without stoking a return of realized inflation. And to the breakevens point, another surge in inflation expectations like what we saw during 2021 and 2022 as the risk of a wage inflation spiral and the expectation of higher prices begetting higher prices ran the risk of undermining the Fed's credibility as an inflation fighter.

To look at the release of the FOMC minutes this week, the messaging was fairly balanced and more or less in line with what investors were anticipating and that not every committee member was fully convinced a 50 basis point cut was justified, but everyone was onboard with getting the normalization campaign underway. The consistent party line from the FOMC has been that the risks between employment and inflation are now much more balanced, and this means that running policy in such restrictive territory is no longer necessary. Does it mean that rates are going back below 2% anytime soon? No, but it does suggest that the dial of restriction can be turned back to more closely align with the balance between jobs and inflation going forward.

Despite several client conversations this week centered around the potential for more information about the balance sheet to be revealed in the minutes, it was most informative to see what we didn't learn, and that was that the only guidance the minutes offered was that the balance sheet is going to continue to run down and that any changes to balance sheet policies should be communicated well ahead of time.

Now, I would argue given the payrolls report, the minutes were stale from a level of restriction perspective. They were also rendered a bit outdated from a money markets one. After all, the Fed convened before quarter end and the uptick in funding costs that we saw, the increase in SOFR that showed more demand for liquidity than has been the case recently, so while the minutes were stale, it was important to see the committee's frame of mind and biases going into the jobs report and what we saw in terms of money market dynamics around the calendar turn.

Ian Lyngen:

And obviously since quarter end as well as NFP, the messaging for monetary policymakers has been very consistent, still cutting rates, no emphasis on the balance sheet at this point, and the conversation around the funding market has been primarily among investors and not an issue that has been addressed by the Fed thus far. As it currently stands, we don't think there's a great deal of appetite on the committee to end QT before year-end. However, those in the funding space will be closely following the end of October for any signs of residual scarcity. And of course, the year in turn will be the ultimate test.

Ben Jeffery:

'Tis the season.

Ian Lyngen:

SOFR, so good.

Ben Jeffery:

Whatever happened to LIBOR?

Ian Lyngen:

In the holiday shortened week ahead, the Treasury Market will have very few influences from which to derive trading direction, at least from the perspective of economic data. There are two key releases on the horizon. Both are slated for Thursday morning. The first will be the September Retail Sales figures. Here expectations are for a three-tenths of a percent increase in the headline number. As always, we'll be looking at the control group, which is most closely correlated with consumption within the GDP figures.

Now, while we might be worried about some of the data distortions created by the recent hurricanes, that's unlikely to materially factor into the September Retail Sales figures. So as September represented the final month of Q3 consumption, it will be a key input in further refining expectations for Q3 growth. Perhaps more importantly will be the claims figures on Thursday morning. In light of the recent spike in the elevation in the claims figures will further contribute to putting concerns that the employment market might not be as strong as the September payrolls print suggests.

All of this occurs at a point when the recent Treasury Market sell-off has brought 10-year yields back above 4%. Now, we're well into the zone that we consider to be relatively cheap for the 10-year sector. And as we contemplate the balance of Q4, we ultimately expect that what we'll see is the 10-year yield holding a range of 350 to 415, and so that implies that any foray above 4% will ultimately be a buying opportunity.

That being said, we're more constructive on the front end of the curve given the market implications from the next two Fed meetings. In the event that the Fed chooses to follow through with the quarter-point cut in November, as well as a quarter-point cut in December, by the end of the year, the rolling 24-month window that is represented in two-year yields will not only have adjusted to the hundred basis points of rate cuts that the Fed delivers in 2024, but will presumably incorporate another hundred in 2025 with a bias for even more. As a result, our curve steepening expectations remain in place and we could readily see a breakout above positive 24 basis points in 2s10s, which would put a move to 235 to 240 easily on the radar.

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 visions of reflation continue to dance in our heads and the focus is on the long weekend, we're reminded that there's no such thing as a bad market holiday, except the ones that SIFMA doesn't recognize.

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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