What's Powell Got To Do With It? - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 224, what's Powell got to do with it, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery and Vail Hartman to bring our thoughts from the trading desk for the upcoming week of May 30th. In an nod to the late great Tina Turner, we'll observe that, in fact, Congress needs another hero. Just saying.

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 passed, the price action in the Treasury market was defined by the bearishness seen in the front end of the curve as two year yields continue to reflect a degree of optimism that the Fed will ultimately be able to keep policy rates on hold throughout the balance of 2023. Now, the on again off again headlines related to the debt ceiling added to the overall volatility, although there is an argument to be made that some of the push towards higher rates was a carry through from what's been going on in the bill market.

In the bill market, yields have spiked to reflect the possibility that the Treasury Department misses a payment or delays a payment in early June in the event that Congress and the administration are unable to cobble together some type of deal that suspends or raises the debt ceiling. Now, the extent of the deal and its composition remains to be seen, although we're reasonably confident that at the end of the day Congress won't allow the US to default on its obligations.

The other aspect of this dynamic in which we have a fair amount of confidence is that it's in the incentive of all negotiating parties to wait until the 11th hour to fully announce a deal and then quickly rush it through the voting process. The holiday weekend has certainly complicated the precise timing of a deal. But nonetheless, at the end of the day, we do anticipate that there will be some type of resolution. The week just passed also showed notably strong demand for Treasury auctions.

The $42 billion two year stop through 1.4 basis points, the $43 billion year five year stop through one and a half basis points, and even the $35 billon seven year stop through a more modest eight-tenths of a basis point. This ongoing demand for US Treasuries is constructive for the asset class as a whole and also indicates a willingness on the part of investors to take advantage of higher rates as 10-year yields managed to push above 375. There's an argument to be made for 4% 10-year yields, although we don't think that comes to fruition.

In fact, buying interest between 375 and 385 has been notably strong and we anticipate that that will continue to define the next several weeks of trading in US Treasuries. That being said, there certainly appears to be an increase in probability that the Fed is in fact able to keep terminal in place through 2023 and well into 2024. Now, it goes without saying that the Fed's commitment to terminal is going to be a function of how the economic data evolves and whether or not inflation ultimately conforms with the Fed's longer term objectives.

Within the set of risks for the next several quarters is the possibility that the magnitude and the pace of rate hikes that the Fed has executed during this cycle have yet to be fully reflected in the economic data. If nothing else, the employment landscape has given the Fed a longer runway to attempt to orchestrate a soft landing, but we're reminded that both soft landings and hard landings appear the same in the beginning of the process.

Vail Hartman:

To say it's been a bearish several weeks in the US rates market would likely be an understatement. Over the past week, we've seen two year yields deviate drastically from the long-held magnetism of 4% as they reach 450 and beyond, and the odds of a hike in June have now reached a coin flip.

Ian Lyngen:

I think it's fair to say that at 50/50 odds of the Fed moving in June, it really does come down to two primary factors. The first being whether or not Congress is able to cobble together some type of a deal that avoids a default and the second being the performance of the economic data, and the week ahead will provide insight on both of those topics. First, the assumption is that by June 1, there will be a deal, at least a can kicking one, that takes a default off the table, and then we have nonfarm payrolls for the month of May with expectations for a moderate level of growth at roughly 175,000 jobs.

What will be more interesting is to see the evolution of the overall unemployment rate and how the labor force participation levels have continued to evolve. One of the questions that we have received a number of times recently is whether or not we believe there have been any true structural changes in the way in which the labor force participates in the jobs market. To some extent, almost by definition, the answer is going to be yes to that question, particularly in light of the shift toward a hybrid work-from-home model and what that might mean for commercial real estate, for example, and more practically, the mobility of employees between firms.

Previously, when we talk about mobility, it had a geography component. But in a fully remote environment, which some industries are and will most likely continue to be, mobility ceases to be a question of whether or not one is willing to physically relocate and one has to concede that as at least part of what has contributed to the ongoing strength in the labor market, despite the dizzying array of headlines about high profile tech sector layoffs.

Ben Jeffery:

And as we think about what the labor market means for the Fed, the likelihood of a June hike, maybe a July hike, or even something beyond, obviously this rationale has been a large driver of 2s/10s back down to -77 basis points to conclude this past week. What's important to consider is that monetary policy is in a far different place than it was at the beginning of 2022. Outright policy rates are now well into restrictive territory. The balance sheet rundown is continuing a pace, if temporarily masked by the lower TGA over the past few months, and all of this means that there's still a great deal of lagged influence that has yet to make its way into the real data.

Ian, all the factors you highlight means there's little question that the job market remains in a very strong place. However, as we think about the path forward for the Fed from here, remember, the Fed's goal is not to crush the jobs market. The Fed's goal in their hawkishness is to continue to moderate inflation. In thinking about the reaction function around a still strong or weakening jobs market, this means that a robust hiring landscape need not necessarily correlate with a renewal of higher terminal assumptions.

What I think it does do is push any potential rate cuts even further into 2024 simply given the fact that we've heard from the Fed that they would prefer to retain optionality and a degree of data dependence from the current monetary policy stance. That's a different story from inflation where I think a re-acceleration of consumer price growth would reintroduce the risk of more rate hikes. However, as long as the trend in inflation remains encouraging from the Fed's perspective, so a grind lower, even if it's not necessarily as fast as Powell would like, that will allow the committee to stay on hold even if it's for much, much longer.

Ian Lyngen:

Ben, I think you make an interesting point about the potential for inflation to continue to moderate, but prove somewhat stickier than the market was anticipating. That, to a large extent, seems to be priced in at the moment. What I suspect will be a more interesting evolution of the data series would be a acceleration of the moderation that we've seen in OER and rent at a point when the Fed is attempting to reinforce the notion of higher for longer. This really begs the question of, how does the Fed deal with this?

When we look at breakevens, they're continuing to drift lower, consistent with the risks across the commodities complex and obviously with what we've seen on the headline CPI front. But as you point out, inflation is the Fed's current objective, but it goes beyond the realized inflation data. In fact, forward inflation expectations on the survey based level are very important and specifically relevant when we think about how the Fed could transition the macro conversation to higher for longer because inflation expectations on the household level have failed to moderate back to pre-pandemic levels.

That's a risk that we suspect will become increasingly relevant in the second half of the year, assuming that the core inflation complex behaves as anticipated.

Ben Jeffery:

Looking ahead to this week specifically and that risk of another rethink of the Fed's reaction function, it's also important to remember the second derivative result of a debt ceiling agreement. What I'm talking about here is the state of the Treasury's cash balance that dropped below $50 billion over this past week and the quickly arriving necessity for Yellen to refill the government's coffers via what we're expecting is going to be a massive ramp up in bill issuance, something on the order of a trillion dollars. Now, half of that is simply going to go back into the TGA while the other half will be used for normal operating procedures, debt service included, from the Treasury Department.

But from a monetary policy perspective, what this is going to mean is that the injection of liquidity from the cash balance that's been happening since extraordinary measures were enacted a few months ago is going to flip on its head. Rather than offsetting the impact of quantitative tightening and $60 billion worth of Treasuries that continue to be run off the Fed's balance sheet every month, the inverse is going to be happening where we're actually going to see bill issuance remove cash from the system, likely operate as a reserve drain and exaggerate the impact that QT is going to have. We've seen some estimates that the TGA rebuild is worth more or less 25 basis points of monetary policy tightening.

And when combined with Powell's balance sheet policy, this introduces a unique set of risks facing the economy and the financial system over the next six weeks. Away from the balance sheet and on the inflation expectations point, Ian, you touched on some of the benchmark survey based measures, and it is worth highlighting that within the University of Michigan survey, we saw that 5- to 10-year measure of forward inflation expectations revised lower to 3.1 from 3.2 after that number reached its highest level since 2011 in the initial read.

The one year ahead price expectations component also declined, although admittedly, that may be mostly a function of gas prices. But nevertheless, the downward revisions helped take some of the edge off the anxiety that resulted from the initial look at those numbers two weeks ago.

Ian Lyngen:

You make an interesting point, Ben, about the correlation between gasoline prices and household inflation expectations. That's one of the challenges that the Fed is going to have once they reach terminal, and it's been in place for several months, is that presumably the dollar will begin to weaken pretty significantly, and that will mean that we're importing headline inflation via higher energy prices, and that will feed back into those survey based measures of inflation expectations and complicate Powell's job all the more.

Vail Hartman:

Another notable event this week was the May FOMC minutes that reinforced a primary takeaway from recent official communication that the committee would like to retain its optionality heading into the June meeting as any indications that inflation is not demonstrating a downward trajectory may warrant further rate hikes.

Ben Jeffery:

And also within the minutes, an area of emphasis was uncertainty and specifically the uncertainty around how much credit tightening was going to result from the regional banking crisis and the concern that the pullback in lending standards from smaller banks was going to disproportionately impact smaller businesses in regions that heavily rely on access to credit from smaller and medium-sized banks. As the minutes communicated, this risk was seen as being viewed as worth a bit of monetary policy tightening. And while that was three weeks ago and we've made it this far without another bank failure, clearly the reverberations from the banking crisis are still on the collective mind of the committee.

Ian Lyngen:

I do think that it's notable how quickly the market has been willing to move on from the implications from that credit tightening. One could argue that the relatively benign figures in the most recent senior loan officer survey have contributed to the idea that perhaps we manage to avert a system-wide crisis, i.e. additional bank runs, and simultaneously managed to see a relatively small impact on overall credit conditions.

I'll argue that the behavioral changes that are going to occur for lenders on the front lines in the small and medium size institutions will take more than three or four weeks to manifest, and instead, over the course of the next five or six months, want you to anticipate a material tightening of lending standards throughout the system, save, of course, for the big multinationals lending to the big multinationals.

Ben Jeffery:

As for some of the more tactical considerations, after the scale of the repricing we've seen, one of the most frequently fielded questions we got this week was the likelihood that 10-year yields get back toward 4%. I'll highlight an important technical level before a four handle, and that's 390 in 10-year yields. That's an opening gap that was formed in the early days of the regional banking crisis.

Based on the evidence we've been having with clients and some of the flows we've been hearing of as well, it's become clear the lack of a true fundamental driver behind this latest selloff is enticing a fair amount of demand from the sidelines to take advantage of the cheapening that we've seen. I would say this week's auctions with three solid stop throughs also exemplified that fact.

Ian Lyngen:

Well, you know what they say about 10-year yields, if you liked them at 390, you'll love them at 4%.

Vail Hartman:

Yes, Ben. The three stop throughs this week means that we've now seen every coupon auction since the May FOMC meetings stop through minus the 10-year auction. The most notable takeaway from this week's supply was the impressively high indirect bidder allocations, which hints of renewed foreign interest in US debt following the latest selloff. Moving forward, we'll be looking to the June 7th release of the investor class data to see if it really was overseas demand that supported these strong results.

Ian Lyngen:

The one observation that I'll make, Vail, is that I truly hope that on June 7th, the thing that we are interested in is the investor class data, keeping in mind the ramifications of missing a payment from the Treasury Department in the interim.

Ben Jeffery:

Deal or no deal?

Ian Lyngen:

Or a no deal deal. Deal?

Ben Jeffery:

Done.

Ian Lyngen:

In the holiday shortened trading week ahead, the US rates market will have a variety of fundamental inputs including but not limited to the May nonfarm payrolls survey print, which is expected to show an increase of 178,000 jobs and a modest uptick in the unemployment rate to 3.5%. More importantly, will be whether or not Congress is able to solidify a debt deal before the June 1st X date. Now, there remains a reasonable amount of uncertainty as it pertains to the exact moment in which the government will cease to be able to pay its obligations.

But as Thursday quickly approaches, we anticipate that the headlines from Washington will continue to drive the macro narrative. That being said, once there is some type of debt ceiling relief, market participants are widely anticipating that there will be a surge in Treasury issuance, primarily in the bill market. Estimates are as high as 1.1 trillion in bills that will need to be issued over the course of the next three months, in part to return the Treasury's general account balance back to levels that it's more comfortable with.

Our concern in this regard is that the Treasury Department has, for all intents and purposes, been conducting a stealth QE program at the same time that Powell has been attempting to run down the balance sheet and create QE. Come the middle of the summer, we'll have QT from both the Treasury Department and the Fed, which will make risk assets particularly vulnerable at a point when from a seasonal perspective, stocks tend to underperform. In addition to the obvious risk coming out of Washington, DC, we'll also see a variety of Fed speakers midweek.

Now, expectations for a June rate hike remain mixed with a reasonable probability, although less than 50/50, being priced in for the Fed to actually execute another quarter point, bringing the upper band of policy rates to 5.5%. Now, we see the path of least resistance at the moment being no rate hike, keeping 525 as terminal for the cycle, but we're certainly sympathetic to the Fed's attempt to add a sense of symmetry around terminal, because the last thing that the Fed wants is to be forced to cut by the end of the year simply because they've failed to communicate how committed they are to keeping terminal in place for an atypically long period of time.

For context, on average, once the Fed reaches the end of the cycle, policy rates are unchanged for about seven months. That at least theoretically puts the December meeting in play. But from a practical perspective, we don't anticipate that the Fed will be willing to cut rates anytime before the March 2024 meeting. 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 the tornado of headlines from Washington, DC continues to drive the macro narrative, the expression not in Kansas anymore becomes particularly apropos, as does the notion that the road to seeking opportunities is paved with positive carry.

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. 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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