Fun back in Refunding - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 272: Fun Back in Refunding, 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 May 6th. As we look forward to celebrating Cinco de Mayo, we're reminded of the importance of gathering with friends, family, and an adult beverage, or two.

Each week we offer an updated view on the U.S. 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 Treasury market had several key inputs from which to derive trading direction. First, we had the FOMC rate decision and the accompanying press conference by Powell. Here, Powell, for all intents and purposes, took a potential rate hike off the table, which while not committing to a rate cut anytime soon, certainly reinforced the market's understanding of the Fed's reaction function to higher-than-expected inflation data at this point in the cycle, i.e. the Fed will delay rate cuts but not consider hiking rates further. As a result, the front end of the market outperformed and the curve steepened at least incrementally, but generally this was viewed as bond bullish. In addition, the Fed announced the tapering of QT. The $60 billion a month in Treasury runoff was reduced to $25 billion. Now, that was arguably a slightly larger than anticipated reduction, but generally in keeping with the Fed's prior messaging.

We also received the refunding announcement where the Treasury department chose to leave auction sizes unchanged for the quarterly refunding. And this came despite the fact that the Treasury's borrowing estimates on Monday came in a bit higher than the market had been anticipating. The Treasury Department also announced the commencement of its buyback program in the beginning of June, which is designed to be deficit neutral and liquidity enhancing. Although, in light of the fact that the auction size increases have already been executed and absorbed by the market, investors were content to view this as incrementally bond bullish as well. All of this created a bullish backdrop as we came into the employment data, which disappointed. Now, it didn't disappoint to the extent that one would look at the jobs data and say that there was trouble on the immediate horizon, but rather it reflected the type of balance that the Fed has been attempting to reintroduce in the labor market. And if nothing else, it removed the jobs picture as a potential hurdle to future rate cuts once the inflation data dictates it’s time to begin that process.

There were a few data points that surprised on the upside, most notably the employment cost index for Q1 and unit labor costs. Now, the market did offer a knee-jerk response to these numbers, but they didn't define the broader trading environment. And we suspect that this dynamic is a function of the fact that Powell acknowledged that the progress on inflation had stalled during the first quarter and delivered the Fed's policy response, which was to delay rate cuts. And given that the unit labor costs and the ECI data was for Q1, that made it an incrementally less tradable event in the traditional sense. The takeaway from the weeks’ worth of price action was that we move from a period of consolidation near the peak of the yield range to an environment in which it is increasingly looking like the peak yields for 2024 have been established and therefore we anticipate continued downward pressure on yields across the curve with an emphasis in the front end.

Vail Hartman:

While the economic data for the month of April has shown increasing evidence of the lagged influence of tighter monetary policy, it hasn't yet mounted to a point that would imply any true urgency for the Fed to begin the process of normalizing rates lower. Non-farm payrolls disappointed in April, with the 175,000 payrolls gain representing the lowest since October 2023, and the unemployment rate unexpectedly ticked up to 3.9%. There was also a moderation in wage growth, with average hourly earnings printing at a benign pace of 0.2% month over month. And this brought the annual pace down to 3.9% and the lowest since May 2021. So following January's troubling 0.5% month-over-month average hourly earnings gain, this series of cooler prints we've seen over the last three months has brought the three-month annualized rate of average hourly earnings back down to 2.8% from 4% in March, which is a trend that bodes well for the trajectory of super core inflation in the coming months.

Ian Lyngen:

And it also returns us to pre-pandemic levels where the year-over-year pace tended to range between 3% and 3.5%. So with that annualized rate, as we head into the balance of the second quarter, I think that there's a reasonable debate that while we are seeing some moderation in the strength of the employment market at the moment, there is nothing truly troubling from the perspective of the Fed. 175,000 new jobs added to the payrolls in April combined with a sub-4% unemployment rate is strong in a historical context. But as you point out, Vail, it does suggest that we're starting to see some evidence that the cumulative impact of prior rate hikes is beginning to flow through to the real economy.

Speaker 3:

And especially after the FOMC meeting, from a higher level, what April's jobs data really did was provide some justification for the Fed's more dovish shift that was delivered in December and the acknowledgement by monetary policy policymakers that the labor market is now playing a greater role in determining their reaction function as opposed to solely pursuing softer inflation almost regardless of what was going on in jobs, as was arguably the case in 2022 and 2023. And to look at the market's reaction to the FOMC and specifically Powell's press conference where he reiterated that a rate hike is not being actively considered and at this point the Fed firmly sees the next move in policy rates as lower.

That from a departure point of yields that were effectively back to year-to-date highs and the first rate cut this year being pushed back to fully priced as late as December meant that Powell confirming that the next move will be a cut was enough to drive the impressive rally we saw in Treasuries and steepening of the curve as some of the tail risk associated with maybe no cuts this year or even some small probability of a hike was priced out to the disproportionate benefit of the front end.

Ian Lyngen:

It's important to keep in mind that a softer employment number than expected doesn't translate into the commencement of the cyclical re-steepener. We are on board with steepening over the course of the year, but at this point it's more of a tactical nature, i.e. once we get back to the topic of the range, presumably there is a potential for a breakout to negative 15 in 2s/10s on a supply concession ahead of the refunding. But ultimately, to get sustainably back into positive territory, we're going to need to see the inflation data begin to conform with Powell's objective of re-establishing price stability. And, frankly, the first opportunity that the market will have in this regard doesn't come until the 15th of May with the release of the April core-CPI numbers. When we think about the potential shift in Fed messaging at next month's FOMC meeting, it's difficult to ignore the realized inflation data during the first quarter.

Moreover, the SEP will offer an updated dot plot and the market's operating assumption at the moment at least is that the debate among monetary policymakers is whether or not to signal 25 or 50 basis points worth of rate cuts in 2024. We suspect that for all intents and purposes that decision will be made the 15th of May. Our logic here is relatively straightforward. If core CPI doesn't print at 0.3% or below, it becomes very difficult for the Fed to argue that they are sufficiently convinced on the trajectory of inflation with a single data print offered on the 12th of June, i.e. the May CPI numbers. So at the end of the day, the front end of the curve will be and should be very sensitive to the mid-May release of inflation.

Speaker 3:

And before moving on to some of the details of the refunding announcement and what we learned about the Fed's balance sheet, another critically important labor update that we received this week wasn't the Payrolls Report, but rather what we saw within March's JOLTS data and the fact that Powell explicitly cited the JOLTS report in his press conference makes the decline in outright job openings to their lowest level since February 2021 and the drop in the quits rate back to its lowest level since COVID is another indication along with NFP that tighter monetary policy is flowing through to hiring decisions and, especially as it relates to the quits rate, workers are becoming less and less willing to resign either as a function of the fact that wages available elsewhere are not as compelling as they used to be or because of a general decline in confidence and a preference to retain current employment rather than rock the boat and seek jobs elsewhere.

Vail Hartman:

And before the JOLTS data, we also saw the refunding announcement on Wednesday, which confirmed unchanged nominal coupon auction sizes for the coming quarter; in line with the consensus and consistent with the Treasury Department's prior messaging. And it was also notable that the Treasury department said that, based on its projected borrowing needs, it does not anticipate needing to increase coupon auction sizes for at least the next several quarters, which implies that coupon auction sizes will be stable for the balance of 2024.

And within this month's installment of our team's pre-NFP survey, we posed the question, when will the Treasury department next increase nominal coupon auction sizes? And among the four refunding announcements in 2025, the February refunding showed the largest probability of a boost to nominal coupon auction sizes, taking 36%, and then came the May refunding with 23%, with the August refunding at 20%, and the November refunding with 8%. It was also notable that 13% of respondents indicated ‘Later’, suggesting that Yellen will be able to make it into 2026 without having to increase nominal coupon auction sizes.

Speaker 3:

And part of this dynamic has to do with another thing we learned on Wednesday, which is that the Fed is going to be in tapering the QT process by trimming the monthly cap of SOMA runoff from $60 billion to $25 billion. And even though SOMA's auction add-ons are exactly that, add-ons to the normal Treasury auction process, that funding nonetheless represents money that the Treasury does not need to borrow from the public and to look at the composition of the balance sheet and what it means for the additional money, the Fed will be sending back to the Treasury Department via reinvestment. It's on the order of $500 billion over the course of the next year that the Fed will be reinvesting. It's our assumption that the slower taper pace will last for a quarter or so.

There's an argument that it could be a bit longer, but nonetheless, the messaging around the balance sheet made it clear that the Fed is comfortable slowing and probably sooner rather than later, stopping the shrinking of its balance sheet. Importantly, as it relates to the Fed's mortgage holdings, that cap remains unchanged, and the realities of mortgage prepayment speeds averaging right around $14 billion a month means that mortgage holdings are going to continue to run down at a slightly slower pace. But as we've heard from several Fed officials, in the pursuit of SOMA holding only Treasuries and eventually holding no mortgages, even after the Treasury runoff stops, it's not unreasonable to expect that the MBS runoff will continue.

Ian Lyngen:

On the topic of running off for the long weekend, it's still two more weeks until Memorial Day. Thanks, SIFMA.

In the week ahead, the Treasury market will have very little on the data front with which to contend. However, the May refunding auctions will most likely define the direction of U.S. rates. We see $58 billion 3-years on Tuesday, followed by $42 billion 10-years on Wednesday, and capped with $25 billion 30-years on Thursday. We anticipate that, in light of the less hawkish tone that Powell struck and the more moderate gains in the April Employment Report, that supply will bring out buyers and the refunding will be easily underwritten, leaving intact our bond bullish bias for the moment. We're reminded that, although we do see 10-year yields below 4% by the end of this year, it's ultimately going to be a function of how the inflation data behaves, and that means that any near-term bullishness will be contained, an in-range affair, and ultimately limited until we receive the May 15th CPI update.

This means that the week ahead will, to a large extent, be a placeholder. One caveat on the data front is that we do see the Fed's Senior Loan Officer Opinion Survey on Monday afternoon. Recall that in the wake of the regional banking crisis, a lot of emphasis was put on this measure of tightness in the credit market. We didn't ultimately see any wholesale tightening of credit standards, which was notable, and to a large extent has de-emphasized the Loan Officer's Survey as a potential market event. That being said, we are now far enough into the tightening cycle that it wouldn't be surprising to begin to see some strain in terms of willingness to extend credit or requiring tighter credit standards that reflects the broader macro trend as opposed to being idiosyncratic to the regional banking crisis. Said differently, it's something that's certainly on our radar and for a week that generally lacks new fundamental information, it's a data point worth watching.

We'll also hear from a variety of Fed speakers that we expect will on net reinforce the messaging from Powell, that being that rate hikes are not seriously being considered. However, it's far too soon to start talking about precisely when the Fed intends to begin the process of normalizing rates lower. We do like the curve steepener into the 10-year auction, but would ultimately position to come out of the auction process long with the expectations that rates will resume the drift lower as the week comes to an end. 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 here in the Tortured Strategist Department, we're still looking to firm up dates for our stadium tour, Duration Supernova.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macro horizons. 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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