Waiting For Wyoming - The Week Ahead

Ian Lyngen:

This is Macro Horizon's episode 236: Waiting for Wyoming, 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 August 21st. Term premium has been the defining debate of the last few weeks and we're reminded of the cost of paying up for premium, a little more legroom than economy. No ads interrupting the music or the podcast as the case may be, and a little higher octane than regular unleaded. Just don't get it confused. With Diesel, we won't make that mistake twice.

Each week we offer an updated view on the US rates market and a bad joke or two, but more importantly, this 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 the US Treasury market sold off rather dramatically. 10-year yields pushing back nearly to the cycle highs and the broader tone in the market was a bearish one. On the economic side, we did see stronger-than-expected retail sales data. We also heard from the FOMC via the minutes and the tone was very clear. There is a balance of risks as we move into the next point of the cycle, but the market has been very focused on term premium, and embedded in this is the notion that there's concerns over who's ultimately going to be willing to step up and underwrite the larger auction sizes.

Recall that the August three refunding auctions threes, tens, and thirties at least were taken down with reasonably little concession. And in fact, while the long-bond auction tailed, which it nearly always tails at refundings, it came effectively at the highs or the low-yield marks of the day. So the fact that the market is focused on the need for an additional concession strikes us as preemptively pricing in not the supply over the next several weeks, but rather the supply over the next few quarters. And in that context, if we're looking at 10-year yields at 4.32 or 4.33 and real rates increasing with relatively stable breakevens, this suggests that by bringing forward this concession, we're in the process of defining the upper end of the trading range as opposed to embarking on another significant bear repricing.

The shape of the curve remains very topical. We have seen some re-steepening, but it has been decidedly of the bear steepening variety, and as a result, it's not the major cyclical re-steepening that will eventually occur once we move past the point in which the market assumes that the Fed has no chance of cutting rates. As it currently stands, all of the information both from monetary policymakers as well as the performance of the real economy suggests that the Fed is going to be able to retain terminal until the second half of 2024.

Now, this assumes that the jobs market remains resilient or at least resilient enough and defining the amount of damage that Powell is willing to do to the real economy and specifically the jobs market has yet to become challenging during this cycle because the unemployment rate is still for all intents and purposes at the cycle lows. It's not until we start to see a consistent increase not decrease in initial jobless claims translating into a weaker or even negative non-farm payrolls sprint that we will really have a conversation as a market about what the Fed is willing to absorb in terms of economic downside. For now, it's very much a version of the best-case scenario for the Fed inflation, particularly on the core side is beginning to moderate in line with expectations, the real economy continues to perform and frankly, outperforming the expectations of many at the beginning of this year, ourselves included. And as a result, monetary policymakers have a much longer window in which to orchestrate a soft landing or even a no-landing scenario.

Vail Hartman:

It was a week where the price action in US rates resolved somewhat counterintuitively to the new economic updates and official communication. US Treasuries bear steepened, despite the strong retail sales print where the control group doubled consensus and the Atlanta Fed GDP now measure was revised higher to 5.8%. Additionally, the FOMC minutes revealed that most of the committee members view the inflation risks as skewed to the upside and that could require further hikes. And this has all been reflective of growing anxiety over the potential implications for structurally higher inflation in the post-pandemic era and the need for higher term premium specifically ahead of Jackson Hole where the topic of discussion will be structural shifts in the global economy.

Ian Lyngen:

Jackson Hole is really setting up to be a potential pivot point for the outlook, both in terms of the market but also in terms of monetary policy and monetary policy-makers’ reaction functions to the ways in which the real economy has structurally changed in the wake of the pandemic. Now, in the event that the market takes away from Jackson Hole an understanding that R-star is higher and that the Fed will need to respond more aggressively to get inflation back in line with expectations, then the bearishness that has been priced in ahead of the event makes sense and will ultimately prove durable. We have now seen another attempt to breach the cycle highs in 10-year rates and the long bond did manage to establish new yield peaks for this cycle.

All of this comes in the wake of the refunding announcement and despite the fact that we have now seen two core CPI prints of 0.16 and 0.158 respectively for the June and July numbers, the reality is monetary policy is working -- it's working with a lag. However, the supply considerations come at a moment when the no landing narrative appears to be the path of least resistance. Now, if Powell confirms the structurally higher inflation concerns that the market has, that will be an important inflection point for the market as a whole and certainly increases the floor for 10-year yields. We came into 2023 assuming that 10-year yields would hold the traditional 110 to 120-basis-point range and that would be centered at 350. The first half of the year and the beginning of the second half have brought this assumption into question and if anything, the range trading notion continues to hold, but the center point might be closer to 375.

Ben Jeffery:

And that idea of a higher midpoint for what's probably going to be a longer-term trading range in the 10-year sector certainly resonates with the strength of the data that we've seen during the first half of this year, even as inflation has begun to moderate and we now have, as you touched on Ian two back-to-back months of encouraging disinflationary prints as it relates to CPI. However, in addition to lower inflation, we've also now seen two very strong quarters in terms of real GDP with the prominent feature in both those reads, a still resilient underlying domestic consumption profile. Now, strong consumption in the US is a derivative of still impressive wage gains, which in turn is a derivative of a still very strong labor market.

Remember, the unemployment rate is still at effectively the cycle lows despite the aggressive hiking campaign we've already experienced. And really what this all has done is delayed what was expected to be a year defined by sluggish growth, maybe a recession, a higher unemployment rate, a capitulating Fed, into what's looking like not just later 2023, but arguably the early or middle part of 2024. That helps explain why we have 30-year real yields north of 2%. That's the highest 30-year inflation-adjusted rates have been since 2011, while 10-year yields are effectively at 2%, back to their highest since 2009.

Vail and Ian, you both touched on it. I would also say in addition to the growth outlook and the optimism around the state of the economy, Treasury supply is also now more impactful for the level of yields than it has been for quite some time, simply given the fact that rates are higher, so the amount of debt is more important and the size of the deficit continues to grow, so clearly, investors are starting to demand more compensation to move further out the curve. Now while that's translated through to a bear steepening of the curve, 2s/10s is still decidedly in negative territory and 5s/30s has only been able to make it back to flat, which suggests that while term premium may be higher, in outright terms, it's by no means high. And that brings us to the coming weeks' highlights before Jackson Hole, which is going to be a test for both nominal duration and Wednesday's $16 billion 20-year auction, but also a gauge of just how attractive 30-year real yields are now that they're the highest they've been in 12 years.

Ian Lyngen:

Ben, you make an interesting observation about the reluctance of the yield curve to push back into positive territory, particularly 2s/10s , but perhaps more importantly, 5s/bonds has struggled to commence the cyclical re-steepening that one should have otherwise expected. Part of this is most likely a function of the Fed's consistent signaling regarding their intention to keep policy rates higher for an extended period of time while simultaneously the market is assuming that we're at terminal, and the bar for a quarter point from here is higher than the data will ultimately justify.

And as a result, investors have been content to push rate cuts off further into the future and that's contributed to higher yields in threes and fives simply because they're going to be the most sensitive to the trajectory of the rate cycle. Whereas tens and thirties are being driven to a large extent by the term premium argument at this moment. It will be notable to see who ultimately steps up to take down the 20-year auction. We know via the Stone and McCarthy survey that real money is very long, currently, at 101% of their asset-weighted duration target, which means the pain trade remains toward higher yields. Said differently, the participation of domestic players at Treasury auctions might be biased a bit lower, and the auction results could be contingent on foreign investor demand at the upcoming auctions.

Vail Hartman:

This week's pair of supply events certainly comes at a potentially pivotal time for the direction of long-dated Treasuries. The outright discount on offer at both events will certainly bring in dip-buying demand, but the event risk posed by Jackson Hole certainly may lead to some hesitation a bit aggressively. On 20 specifically, recall this auction size will be the smallest increase for all the longer-dated Treasuries, and we'll be curious to see if this translates to a stronger takedown. Nonetheless, we're of the mind that the more relative value consideration would be the underperformance of the long end versus the front end over the past several weeks. On tips supply, there are several confounding factors that'll play into the demand that meets the event.

On the one hand, we've now received two CPI prints that have been bearish for inflation protection, along with the increasing prospects for a soft landing and a Fed that has remained resolute in its intentions to restore price stability. On the other hand, the FOMC minutes certainly could have renewed demand for inflation protection given the majority of the committee members still view the inflation risks as skewed to the upside.

Ben Jeffery:

And while we'll need to wait a couple of weeks to see who exactly it was that bought this week's auctions, the issue of foreign demand or more specifically, the lack thereof also was very frequently discussed over this past week. Obviously, we came in from the weekend on the news that the PBOC delivered a surprise rate cut in order to stimulate what is becoming an increasingly dim Chinese economic outlook, and that in turn has weakened the renin B back to effectively this cycle's extremes, and that is the weakest Yuan has been since 2007. Following up the rate cut news, there were also headlines making the rounds that state-owned banks in China were instructed to step up their efforts at currency defense, which all translates to the frequently offered question in the Treasury market, what happens if China sells?

Now, as we've talked about previously and using historical evidence, the outright size of the Treasury market means that even substantial selling flows as a result of concerns on a China slowdown have usually been overwhelmed by the broader flight to quality impulse of a slowing global economy given the share of the world's output that is accounted for by China. We saw it in 2015 and 2016, and then again in 2018 and 2019, where a bit counterintuitively, in an environment where China needs to sell, presumably the world is in a macro space that would benefit safe haven assets, Treasury is chief among them.

It's also worth acknowledging that unlike in the mid-2010s when China owned 14% of marketable debt outstanding, the combination of China trimming their Treasury holdings over the past several years along with the fact that the broader Treasury market has grown by $19 trillion since the end of 2013 means that versus 14%, a little bit less than 10 years ago. Now, China holds right around 3% of the total market outstanding, which suggests that the influence of any selling flows there would be less bearish than they have been historically, and even historically, they weren't all that bearish.

Ian Lyngen:

The one counterargument to looking at the historic relationship between Chinese selling and a flight-to-quality bid for Treasuries as an asset class is based on the assumption that the post-pandemic world is materially different than 2019. Specifically, the combination of de-globalization has deemphasized the perception of the relevance of the Chinese economy for the US outlook, and as we know, the US and China have had decidedly different experiences during and after the pandemic in terms of economic performance, in terms of realized inflation, in terms of consumer confidence, and on a variety of different measures.

So it's not inconceivable that should the Fed choose to push forward the conversation about structurally higher inflation in the US economy, we could see investors pointing to Chinese selling to defend their own economy as a reason to target higher Treasury rates. That being said, and as you articulated well, Ben, our base case assumption remains that if we enter an environment where there's wholesale selling from China, that the initial response might be incrementally bond-bearish, but ultimately, it will refocus investors on the global slowdown risks.

It goes without saying that there are a lot of risks for the macro outlook both domestically and abroad. On the topic of risks, do either of you recall the board game risk?

Vail Hartman:

I've heard of risk. You sunk my battle ship.

Ben Jeffery:

Where's my $200?

Ian Lyngen:

It was Colonel Mustard in the library with a candlestick.

In the week ahead, the most significant event will be the Kansas City Fed's monetary policy symposium in Jackson Hole. Conversations surrounding how structurally different the US economy and presumably the global economy may be as a result of the pandemic and the general evolution of the global economy over the last 10 to 15 years will be particularly topical.

One of the reasons that market is so concerned about whether inflation is structurally higher is interconnected with the term premium argument. If in fact, monetary policy is not as restrictive as 550 has implied in the past and R* is in fact higher, then investors will need greater compensation to move further out the curve; that should bear steepen the curve. Our biggest question is, how much of that is already priced in? The second other question is, if the Fed concedes that inflation has changed post-pandemic and because of a tighter labor market, because of friendshoring, because of some of the underlying ways in which workers have changed the relationship with the employment market, that inflation is structurally higher for the foreseeable future, then one needs the question, the prudence of the 2% inflation target.

If the Fed chooses to hold the 2% inflation target and not start a conversation about widening a band around the inflation target or making it an even longer-term average or something of that character, then one simply has to assume that the Fed is going to engage in sufficient excess demand destruction to get inflation back to that 2% target. Our take is that the Fed from a credibility perspective simply cannot give up the 2% inflation target until they have proven to the market that they have the ability to bring consumer price inflation back in line with the stated objective.

By changing the rules mid-game, the Fed would lose all the credibility that they have been seeking to reestablish by addressing inflation aggressively in the latter half of next year, and by signaling that they're going to retain terminal for an extended period during this cycle. We also have a couple supply events during the week ahead, 16 billion 20-year auction, as well as the 8 billion 30-year tips auctions, both unique in so far as the 20-year didn't see as large of an increase as the 10 and 30-year nominals, and 30-year tips will provide an important litmus test for inflation demand on the heels of two core CPI prints that came in on the low side of estimates.

Let us not forget that we're also entering what has historically been a slow period for global financial markets. Now, the volume statistics suggest that that hasn't been the case yet for us Treasuries and in fact, the choppy price action has left a great deal of focus on US rates with 10-year yields at or near their cycle highs, and the long bond managing to set new cycle highs as the conversations around term premium and precisely who is going to underwrite the upcoming Treasury auctions remain topical and define the direction of US rates far more so than the realized inflation series. Something of a surprise in that regard to be sure. However, with all the uncertainties linked to Jackson Hole, we're unwilling to stand in front of the bearish move for the time being.

We've reached a 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. With monetary policymakers gathering beneath the Tetons and the debate around headier economic issues of our time promising to yield some insightful conversations, we'd like to express our profound gratitude for being able to attend, but we weren't invited. Maybe next year.

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.

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Speaker 4:

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