Dancing in the Range - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 267, Dancing in the Range, 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 April 1st, and with our favorite holiday at hand, we're left to ponder why limit April's foolishness to a single day. Just a thought.

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 the primary theme in the Treasury market was settling into a post FOMC trading range. We now have 10-year yields, comfortably between 4%, and the 4.35% support that has held several times. Embedded in the range trading theme is that we're going to see a period of consolidation ahead of the next two major data events, one being in the form of the April 5th release of March's payroll's data and then obviously followed by April 10th release of March's CPI report.

Volatility is clearly on the decline, this is evidenced in both the MOVE index as well as the VIX, and this is very much in keeping with the recent messaging from Powell. Specifically, the Fed has shifted into a mode that we are characterizing as more time dependent than data dependent per se, and this implies that the onus is now on the economic data to dissuade the Fed from cutting in June, otherwise, the Fed will be content to reduce policy rates by 25 basis points at the June meeting, followed by a September cut and a December cut. That's currently our operating assumption for the rest of the year contingent of course on the next three CPI prints. That's data for March, April, and May, all of which will be in the hands of monetary policymakers by the time they decide at the June meeting.

One notable development in the week just passed came from comments from Bostic who noted that he only expects one rate cut in 2024. Now we'll caution against interpreting too much from this observation. If for no other reason, then Bostic has historically been one of the more hawkish leaning members on the committee. Nonetheless, it did start conversations about what happens in the event that inflation doesn't ultimately conform with what the Fed would like to see. Our take is that the highest risk of stagflation being problematic for the Fed was really at the beginning of 2023. Now that enough progress has been made on the inflation front, even if the last mile to get back to that 2% inflation target ends up being more difficult to achieve than the Fed would like to see, monetary policy is still in a position where if there were an unanticipated spike in the unemployment rate or a material downshift into a negative growth profile for the US economy, the Fed would be reasonably well positioned to respond.

To be fair, we've been impressed with the resilience of the real economy and continue to observe than in a more typical environment, one would've expected a spike in the unemployment rate to have already occurred. Now, to be fair, at 3.9%, the unemployment rate is half a percent off of the cycle low, and from here we're biased to see that increase further. Returning to the observation about the Fed being faced with a potentially stagflationary outcome, we think that it ultimately comes down to how quickly the economic outlook turns.

A sharp decline in demand and hiring would intuitively be disinflationary going forward, and that would allow the Fed to respond with deeper cuts. A more challenging scenario for the Fed would be a more gradual increase in the unemployment rate combined with sticky inflation because in that scenario, the 75 basis points worth of rate cuts will be viewed by investors as responding to the slight weakness in the real economy and therefore used as evidence that the Fed is more comfortable allowing inflation to run above its 2% target for an extended period of time.

Now, this isn't our base case scenario, given that we expect inflation to return to the trend that was in place in the second half of last year. Nonetheless, conversations regarding sticky inflation have been very front and center over the course of the week just passed.

Vail Hartman:

The new economic data revealed in the week just passed fell short of offering a compelling catalyst for trading and Treasuries, although the information was never going to factor heavily into investors near term monetary policy expectations. The choppy sideways grind that's defined the bulk of the price action in the wake of the FOMC, may very likely remain the operative theme until the April 10th release of CPI, assuming there are no major surprises in this week's updates from the BLS.

Ian Lyngen:

The holiday-shortened trading week and the lack of any significant economic data left investors to focus overseas on the recent weakening in the Yen and what that could mean in terms of official intervention in support of the Japanese currency. So, as we think about translating that to any potential price action in the Treasury market, one should keep in the mind the fact that the Japanese Ministry of Finance has significant cash reserves on hand, so they might not necessarily need to sell Treasuries simultaneously with intervention, but eventually this should bring some selling into the Treasury market. And historically, those flows have tended to favor the two and three year sectors.

Ben Jeffery:

And there's a line of thinking as it relates to what Japan may or may not do in terms of yen support, that's simply along the lines of waiting as long as possible to ultimately step in, in the hopes that one day eventually maybe the Fed will begin the process of lowering rates and that in turn will flow through into the currency markets in terms of a weaker dollar. So exactly to your point, Ian, if in fact the Ministry of Finance in The Bank of Japan want to slow play the process of stemming some of the weakness in the Yen, it's prudent to first utilize cash on hand and let that run out slowly before needing to sell Treasury holdings that are still at historically cheap levels, especially in the context of the last two or three years.

And remember, while Dollar Yen might be the most impactful for Japan, there's also Sterling Yen, Euro Yen, Swiss Yen, and other aspects of the broader FX complex that presumably will start to buoy the yen overall as the BOE and the ECB presumably will begin cutting sooner. And obviously the Swiss National Bank already took that first step, so as for what it means for Treasuries, might it be marginally bearish, the very front end of the curve? Absolutely, but the potential for official Yen support will likely not be the determining factor whether 10-year yields break the current 4% to 4.35% range to the upside or to the downside.

Ian Lyngen:

Ultimately, the medium term direction of the Treasury market is going to be a function of the fundamentals of US inflation and to a lesser extent in the current environment, overall growth. The first quarter is currently tracking at a growth rate of roughly 2.1%, and while that might represent a modest downshift from what was seen in 2023, the reality is it's above trend and given the outright level of the unemployment rate and the ongoing resilience of the labor market overall, there isn't anything on the immediate horizon that would suggest that the treasury market is due for a wholesale repricing of any type.

In fact, when we look at the future's market, we see that fed funds have 78 basis points of rate cuts priced in between now and the end of the year. Our underlying concern is that with that degree of precision priced into the market, we're pricing in a bit too much perfection as it were, and that's one of the concerns that we have as we think about the period between now and the June 12th FOMC meeting where it's widely assumed that the Fed will deliver the first rate cut as the incoming economic data adds to the market's understanding of the likelihood that the Fed will deliver that first cut.

We do expect episodes of increased realized volatility, but they will largely be limited to the major data releases.

Ben Jeffery:

And Vail, You started the conversation with the relevance of next week's payroll's report, and for better or worse, that's the next potential inflection point to derail this low volatility regime. But as we think about the shape of the very front end of the curve and the amount of easing that's priced in over the balance of this year and into 2025, there's absolutely asymmetry as it relates to cut pricing, particularly around the May and June meetings. To look at May specifically just three basis points of a cut priced there and all the way through June, there's only 20 basis points of easing priced in, given that some forward-looking labor market indicators have already started to trend lower, and we've heard some chatter around the potential for downward NFP revisions and maybe the start of a not quite as robust hiring trend to kick off at the end of the first quarter into the second quarter.

It strikes us that using the May meeting as an example for three basis points of downside with potentially 22 basis points of upside in the event that a May cut becomes fully priced, not our base case, but also probably not an impossibility if in fact we get a series of weaker labor market reports. Given what we learned in the SEP and despite the Fed's consistent pushback against near term rate cuts, one thing has become clear and that is that no one on the FOMC even the most hawkish is realistically entertaining the idea of another rate hike.

And for argument's sake, even if we get an upside surprise in terms of NFP next week, a strong jobs market won't make the Fed hike. We would need to see an inflation re-acceleration to realistically have that conversation. And so in thinking about the risk reward profile of the shape of the fed funds futures curve, if only as a potential hedge for a weak hiring report, there's at least some value to be had there.

Ian Lyngen:

And to your point, Ben, there is a reasonable amount of asymmetry in the market going forward, not only in terms of pricing each individual meeting, but also further out the curve when we think about the outright level of 10 and 30 year rates. The worst case scenario for duration, however, comes in the form of the combination of stickier inflation with a material weakening in the jobs market, but not a dramatic one. The logic here being that if the unemployment rate increases slightly and it corresponds with the Fed's already signaled intention to start cutting in June, the market could interpret that as the Fed taking a softer approach to inflation, which would increase longer term break evens and could potentially lead us to a scenario in which the steepening that the market has been looking for doesn't come in a universally bullish or bearish fashion. Instead, we have the classic tale of two markets with the two year sector rallying while tens and thirties come under pressure in outright terms.

Ben Jeffery:

And that dynamic wouldn't be exactly the same, but a similar version to what we saw last year in the wake of the August for refunding announcement and the reintroduction of term premium further out the curve versus the levels we reached last year. Term premium still remains very low. And if we do enter an environment that you're discussing, Ian, where the soft landing narrative can persist-ish with a slowly creeping higher unemployment rate and inflation that remains stubborn, all while the Fed has continued to acknowledge that maybe the finish line for this cutting cycle is not going to be as low as previously assumed, then that argument starts to make sense that we might need to see higher term premium in the longer end of the curve to say nothing of the size of Treasury auctions.

And while we know that supply is not going to continue growing, nearly $2 trillion of net issuance this year still needs to be underwritten. And while in its own right that won't be enough to justify a material move higher in yields, it also probably will limit the degree of downside we see in Treasury rates at least over the medium term.

Vail Hartman:

Well, there was little sign of supply indigestion at this week's record size two and five year auctions. The former tailed buy 0.4 basis points and the latter stopped through by one basis point, but it was notable that both auctions saw a strong take down from end users and elevated indirect bidding stats. I think it was particularly notable that we saw such strong demand at the five-year auction, despite the SEP's upward revisions to the 2025, 2026, and the long run dots, which has contributed to greater uncertainty around the outlook for fed funds beyond 2024. I think at the end of the day, this speaks to investors' willingness to overlook the Fed's longer run projections in favor of trading the committee's near-term policy expectations.

And in keeping with the balance of risks around the outlook for inflation and the labor market, we've heard several policymakers come out and emphasize the need for a careful approach to monetary policy. On Monday, we heard Fed Governor Cook say the risks of easing monetary policy too much or too soon is that it could allow above trend inflation to become entrenched and halt the progress that we've seen. On the other hand, Cook acknowledged that easing too late could also do unnecessary harm by holding back the economy and depriving people of economic opportunities. While Cook's comments and comments from Chicago Fed President Goolsbee resonate more with the SEP's 2024, 75 basis point rate cut outlook, on the other end of the spectrum, Atlanta Fed President Bostic has several times now reiterated his call for one rate cut in 2024. Now this comes in stark contrast to the futures market pricing in roughly 75 basis points of rate cuts this year. Do you guys think that the market is currently underpricing the risk of one rate cut this year?

Ian Lyngen:

I think that to a large extent what the market has effectively done is they've reverted to pricing in the SEP and the dotplot. Now, recall at the beginning of the year, the market took a much more aggressive stance pricing in effectively twice the amount of rate reduction that the Fed had been indicating previously. The fact that the Fed held 75 basis points and the market is now pricing to 75 basis points speaks to a collective unwillingness to fight the Fed at the moment.

Specifically to your question, should we be taking Bostic more seriously as a market? I would say that we tend to have an increase in the divergence of Fed speak in the run-up to a change in policy direction. The hawks are allowed to say their peace as are the doves, and at the end of the day, the chair and the key members of the FOMC will cast the deciding vote as it were. So guys, what do you have planned for April Fool's Day on Sunday?

Vail Hartman:

I thought it was on Monday.

Ian Lyngen:

You know gullible is in the dictionary twice.

Ben Jeffery:

Really?

Ian Lyngen:

In the week ahead, the treasury market will have an array of very traditional economic indicators to provide incremental trading direction. Now we are maintaining our range trading call for 10 year rates between 4% and 4.35% with a nod to the fact that the march payrolls numbers will be a tradable event even given that we're not anticipating any great drama from the release.

The consensus forecast for headlined non-farm payrolls is currently at 210,000 with the unemployment rate seen unchanged at 3.9%. We are cautious of a move higher in the unemployment rate that carries with it some headline risk. Even a one tenth of a percent increase would get us to 4.0 and surely be used as evidence that the broader jobs market is cooling. Let us not forget, we also have the February JOLTS data, which in and of themselves, while flawed on a number of different levels, do tend to provide incremental trading direction and we'll be watching for the quits rate within this series.

Do note that the data is for February, so it's already been incorporated to the known trajectory of payrolls in the middle of the first quarter. In addition, there is a variety of Fed speak including voters Williams, Mester, and Daly, all of which we anticipate will reinforce the tone set at the FOMC meeting, but simultaneously reiterate that the Fed is in something of a wait and see mode. While there isn't any inflation data per se in the week ahead, we do have Friday's average hourly earnings report, and within the release, the market is looking for a three tenths of a percent increase in nominal wages. Now, in light of the high correlation between nominal wages and the core services ex-shelter component of CPI, it's not unreasonable to expect that the bulk of the market's response to Friday's employment update will be focused on wages, especially in the absence of any major surprises on the unemployment rate or headline payrolls.

In terms of the direction of the US rates market, we continue to expect an extended period of consolidation, both in terms of outright yield levels across the curve, but also in the shape of the yield curve. 2s/10s at negative 35 to negative 45 basis points represents a reasonable range to target in an environment where there's enough uncertainty on the data front as to whether or not the Fed will ultimately be able to deliver that June rate cut or if cuts get delayed further into 2024.

There's also the looming change on the balance sheet i.e., the tapering of QT. QT tapering has been on the table for some time, and given the tone of the March FOMC meeting, we expect that QT tapering will be announced at either the May or June meeting. Now on the margin the market has been trading this potential as bond bullish. Therefore, once the change is official, we expect that that could ultimately clear the path for a bit of steepening in the yield curve. 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 just as a reminder, there's still plenty of time to prepare pranks for April Fool's Day or what's affectionately known as Strategist Day.

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 4:

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