Mayday! Mayday! - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 271, mayday, mayday, 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 29th. As Wednesday's array of fundamental events include the May refunding announcement, the FOMC decision, ADP, JOLTS and ISM. The only word that comes to mind is mayday, and not the European celebration of the beginning of summer, that's two words.

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 passed the Treasury market sold off rather sharply – the underlying motivation behind the move being the higher-than-expected quarterly core-PCE numbers for Q1. Here we saw a print of 3.7% compared to the 3.4% anticipated. As a result, the market came into Friday's core-PCE data for the month of March with a bias to see something higher than the consensus 0.3%. The fact that we got a 0.3% was then subsequently followed by a rally in Treasuries. All of this reflects the market's ongoing angst regarding the trajectory of inflation and what it could ultimately mean for the Fed's intention to begin the process of normalizing policy rates this year. As it currently stands, the market is pricing in one full rate cut for the year and a 50/50 chance of a second move.

Now, we are interpreting this as confidence that the Fed will cut once in December with some probability that the real economy turns dramatically enough that the Fed will feel compelled to deliver a true policy response. By this we mean more than a simple 25 basis point rate cut. Again, this isn't our base case scenario, nor is it something that the market is currently focused on at the moment. Instead, investors are beginning to contemplate the potential for a rate hike rather than a cut being the Fed's next move.

Thus far, after reaching terminal last year, the Fed's reaction function to elevated inflation has been very consistent and taken the form of delaying rate cuts as long as needed. We are continuing to operate under the assumption that the Fed's stance hasn't changed, and while that reduces the chance of a rate cut in the near term, it also shouldn't translate into rate hikes. Of course, if we had a repeat of the beginning of 2023 in which we had much stronger than expected inflation numbers that served to bring into question the true effectiveness of monetary policy, then the Fed should entertain a hike. But, what we saw during the second half of 2023 was inflation start to moderate in line and move closer to the Fed's target. And this afforded investors a bit more confidence that the Fed had the tools and the willingness to reestablish price stability.

All of this has occurred with the backdrop of all remarkably resilient labor market. In the week just past the drop in initial jobless claims reinforced the idea that the labor market remains on strong footing and as a result there's nothing visible on the macro horizon that would convince the Fed to begin cutting rates for economic reasons. At this stage, even a December rate cut would simply be a function of the Fed attempting to lean into the Goldilocks or the no-landing narrative.

Now at the same time, the stickier inflation ultimately proves to be, the higher the probability becomes that the Fed's extended stay at terminal will ultimately do more damage to the real economy than the Fed would like to see.

Vail Hartman:

It was a week that saw a troubling round of economic updates with Q1 real GDP surprising significantly on the downside at a nearly two-year low of 1.6% and personal consumption also disappointed at the lowest since the second quarter of 2023. And on the flip side, and perhaps most troublingly for the Fed, was the 0.3 percentage point upside surprise for the quarterly annualized pace of core PCE in Q1 at 3.7%. And in the wake of the updates we saw each coupon on the curve sell off to fresh year to date lows. And the question has now become whether or not this is a round of updates that bolsters the case for 5% 10s in 2024.

Ian Lyngen:

One key takeaway from the release was the fact that stagflation is once again topical. Now, it's still far too soon to suggest that we're going to find ourselves in an environment with weak growth but continuing to see sticky inflation. But we're nonetheless reminded that for the same amount of nominal growth, the higher inflation is, the lower real GDP becomes. Now it's challenging to take Q1's GDP report and project it out to the balance the year. If for no other reason, then one of the big drags was a decrease in net exports. And we also saw downward pressure resulting from inventories as well. But, as you pointed out Vail, personal consumption did come in below estimates, and that has started conversations about whether or not we're finally seeing the impact of higher prices, higher rates, and greater credit card utilization flowing through to lesser demand. To your point, about 10-year yields reaching 5%. That certainly is doable in a stagflationary environment, although I would offer the caveat that the most likely path there would be the reintroduction of the potential for rate hikes and therefore a bear flattening that puts two-year yields well above 5%.

Ben Jeffery:

And at this point, I think it's safe to say we're all on the same page, that it's still too early to realistically be having the conversation around the potential for rate hikes. Although in the wake of the Q1 GDP and PCE data, the risk that Powell sounds a bit more hawkish next week at the press conference has undoubtedly increased. But the fact that the Fed already had January and February's inflation data and payrolls data in hand before the pre-meeting quiet period, and even the most hawkish rhetoric didn't entertain the idea of a potential for another hike, still means that the hawkish reaction function in response to the latest data is still going to be delaying rate cuts further. And given the latest price action, delaying rate cuts further and still not talking about the potential for a hike holds the potential for a relief rally in the front end of the curve, or maybe more realistically, more bearishness further out in the 5- to 10-year sector as higher for longer continues to be priced in with an added dose of term premium that would add to that bear steepening impulse.

This is a critical divergence from where we were at this point last year when the relative importance of inflation dramatically and maybe entirely overshadowed the Fed's concern on the labor market. And so, had we gotten numbers like we received this week last year, more hikes, larger hikes, and potentially a higher terminal would be on the table. Fast-forward to this year and the rhetoric has clearly illustrated that the Fed is becoming increasingly concerned about a delayed reaction in the labor market, even if it hasn't shown up yet. And that is translating to more caution in terms of upping the hawkish ante from here with policy rates at 5.50%. So the dual mandate is not nearly as one-sided as it was in 2023, and that means that it's still unlikely the Fed is going to talk about hikes again. It's of course not impossible, but for that, we're going to need to see the labor market continue to perform well and inflation begin to re-accelerate more materially.

Ian Lyngen:

And also within the labor market data, we've started to see a rotation away from professional white collar jobs in favor of frontline service sector and lower paying jobs. This is troubling insofar as while the aggregate data might continue to reflect strength in the jobs market, for the upper two quartiles of consumers, greater headwinds could be mounting. Ultimately, as long as consumers are confident in their job prospects, they will be comfortable continuing to spend at an increasing rate. This dynamic could quickly go the other direction in the event that small and medium-sized businesses start to let go those frontline service sector employees, once they realize that the demand associated with the higher earning households has started to flag.

Ben Jeffery:

And to start to see the pullback you're discussing, Ian, it's not necessarily the case that a sharp spike in the unemployment rate would be required. After all, there's multiple channels through which consumer confidence can take a hit and ultimately willingness to spend can take a hit. And that's even before individuals really start to become concerned about the potential for losing their jobs and losing their incomes. Obviously, higher energy prices come to mind as a potential tax on consumption, but also the dynamic we've talked about a lot this cycle, which is that immediately following the pandemic, the negotiating power between employee and employer was unquestionably tilted toward the worker. That translated into very robust job changer wage gains and strong wage growth overall.

But now that labor demand has continued to ebb. And yes, the latest JOLTS report did show an uptick in job changer wage growth, but the fact that the broader term trajectory is lower means that as a potential canary in the coal mine for a more significant spending pullback, ongoing moderation and labor demand both for high and low wage earners implies that there's not going to be as great a willingness to spend. Not to mention the fact that credit card balances remain high credit card delinquencies are on the rise, monthly expenses such as auto payments are obviously much, much higher than they used to be. And this with a backdrop of excess savings that have now more or less been depleted, all leaves the backdrop for the consumer far shakier than it was at this point last year.

Now, does that prevent 10-year yields from making a run at 5% between now and the second half of the year? Not necessarily. After all, we've got a lot of treasury supply to absorb and a soft landing narrative that remains intact. But it's still too soon to draw a direct correlation between 2023 and 2024 simply given how long rates have been this high.

Ian Lyngen:

We've also heard an increase of chatter surrounding the notion that higher rates are inflationary as opposed to being the opposite as traditional monetary policy would suggest. The basics of the argument are relatively straightforward. Savers are now seeing a higher rate of return on their money, and therefore they have greater disposable income to drive up prices further. Now, this isn't necessarily an argument to which we subscribe in the long term, although there are a few nuances during this cycle, which suggests that there might be a bit more validity than is typically the case.

First, as you pointed out, Ben, there have been significant wage gains that have occurred post-pandemic, and there's still a reasonable amount of bargaining power on the employee level. There's certainly expectations for wage growth to continue going forward. The other aspect of the post-pandemic reality is that the events of 2020 brought forward many consumers' life plans; in particular retirement. So as baby boomers continue to cross the threshold into the age of typical retirement, we're starting to see more and more older workers leave the labor force with no intention of returning. Add to that, the fact that this subset tends to have the most significant exposure either directly or indirectly to the performance of the equity market and the wealth effect quickly becomes a key factor in driving incremental spending for early retirees.

And let us not forget that the residential real estate market remains on very strong footing. In part, we know this as a result of homeowners locking in extremely low mortgage rates during the pandemic, and therefore there's not a lot of supply coming onto the market. Nonetheless, as a key store of wealth, this is undoubtedly contributing to consumer's willingness to chase the prices of goods and services higher.

Vail Hartman:

And we've made it this far in the discussion without mentioning one of the key potential volatility risks for the treasury market in the week ahead. And this comes in the form of the Treasury Department's borrowing updates and the process will begin with Monday afternoon's financing estimates, which recall earlier this year were projected at $202 billion. And given that in Q1, Treasury already told us that it does not anticipate boosting coupon auction sizes for at least the next several quarters, we presume that any potential volatility around the updated financing estimates will be more of a bill market story as the front end remains the primary shock absorber for fluctuations in borrowing needs.

And after the aggregate borrowing estimates are known on Monday, the remaining issuance questions will be answered Wednesday morning. Although the refunding announcement is widely expected to confirm a quarter of unchanged coupon auction sizes, which will mark the first quarter that Yellen did not boost coupon auction sizes since August of 2023.

Ian Lyngen:

And Ben, just to return to a topic that you mentioned earlier, I haven't heard that canary in a while, have you?

Ben Jeffery:

Maybe he's just in the coal mine doing some holiday shopping for Vail.

Vail Hartman:

That's not funny, guys. I got a rock last year.

Ian Lyngen:

It was coal.

In the week ahead the Treasury market has an array of fundamental information from which to derive trading direction. It goes without saying that Wednesday's session contains the most new information and, as such, presents the largest number of tradable events. First up, we have the ADP number on Wednesday at 8:15. Expectations there are for a print of 200,000. That's followed shortly by the Treasury Department's refunding announcement where we're expecting to see stable auction sizes in nominal coupons with the 3-year at $58 billion, the 10-year at $42 billion, and the 30-year at $25 billion. We then have the JOLTS data as well as ISM manufacturing. All of this capped by the afternoon's Fed meeting decision as well as a Powell press conference.

From the Fed we are anticipating the official announcement of QT tapering. The mortgage runoff will be unchanged and the Treasury runoff will be halved from $60 billion a month to $30 billion a month. Now ostensibly, this should be good for risk assets and at least on the margin less negative for Treasuries. That being said, we expect that the QT announcement has already been traded and is largely reflected in current pricing.

Let us not forget Monday afternoon's announcement of the Treasury Department's financing estimates. The upcoming quarter was previously estimated to be $202 billion worth of net need, and it will be interesting to see whether that number is nudged higher or lower, presumably as a function of revenues, i.e. tax season. That will also serve as a precursor to Wednesday's refunding announcement. Although it's worth noting that at this stage in the cycle, Yellen has made it clear that nominal auction sizes are unlikely to increase and the bill market will be used to absorb any additional changes in funding requirements by the federal government.

So once the Treasury and the Fed are out of the way, the market will be free to focus on Friday's release of non-farm payrolls. The consensus is for an impressive 250,000 jobs added in April and an unemployment rate that is unchanged at 3.8%. Assuming that those two numbers come in close enough to expectations, attention will very quickly shift to the average hourly earnings print. Recall that March's data showed a relatively benign 0.3% on a month-over-month basis, and that's the consensus for April as well. The relevance of the pace of nominal wage gains comes in the form of what it implies for the supercore measure of inflation. Supercore, in this case, being defined as core services CPI minus shelter. This is the aspect of the inflation complex that the Fed has been emphasizing as potentially demonstrating a wage inflation spiral. Now, thus far at least the Fed has not been convinced that that's the case. Although in light of the Q1 inflation data, it's an open question if nothing else.

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 April fades from memory and flowers replace showers, we're looking forward to seeing the pilgrims again.

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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