A Rally, Deferred - Macro Horizons

Ian Lyngen:

This is Macro Horizons Episode 262: A Rally Deferred, 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 February 26th. And with Leap Day quickly approaching, we thought it appropriate to take up the tradition of writing letters to our future selves to be opened four years later on the next Leap Day. But then, that just assumed so many positive outcomes. And let's face it, we're not in the positive business, so buy bonds.

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 past, the most relevant developments actually occurred in the price action itself, as we have now seen a decided shift in sentiment away from the prospects for a near-term rate cut and investors beginning to contemplate whether or not the Fed will choose to start the process of normalizing rates at any point in 2024. Now, obviously, the pendulum of sentiment has a tendency to shift to extremes before correcting and eventually settling into something that's close to the Fed's guidance. And what we've heard from the Fed thus far is that January's CPI print could be a one-off, but ultimately the committee simply wants more time to evaluate whether or not the progress on the inflation front is going to be durable.

And we're certainly sympathetic to this, which is consistent with our operating assumption that we won't see the first rate cut until the June meeting. Now this is, of course, contingent on core inflation behaving over the course of the next several months. If we do find ourselves in a situation where core services ex-shelter inflation remains elevated over the course of the coming months, even if core-CPI itself begins to drift lower, that will create a challenging environment for the Fed insofar as the biggest risk of a wage inflation spiral comes between the correlation of nominal wages and the super core measure of inflation. So while we're certainly open, at least at this moment, to a June rate cut, we're also cognizant that the Fed's progress on inflation might not ultimately be as durable for the super core measure as monetary policy makers need to see.

Now of course, there's a lot of economic information between now and June that could help the market further refine expectations on the policy front. The economic outlook is still very much in the no-landing Goldilocks scenario, the unemployment rate at 3.7%, inflation potentially re-accelerating in the first quarter. All of this suggests that Powell has plenty of runway and flexibility to avoid cutting rates for the foreseeable future. Whether or not that ultimately ends up being necessary remains to be seen.

We'll also note that the performance of risk assets continues to create an environment where overall financial conditions are much easier than they were during September and October of last year when stocks were selling off. As the major equity indices remain at or near record highs, it follows intuitively that overall financial conditions continue to edge easier and easier.

This as well further complicates the Fed's decision-making over the course of the next several meetings. If we find ourselves in a scenario of depressed equity volatility, which contributes to easier financial conditions, even in the event that year-over-year core inflation numbers slide lower thereby making real policy rates tighter, we struggled to imagine that the Fed would be overly eager to begin the process of normalizing rates until they are completely convinced on the inflation front, which in the wake of the January CPI just got extended by several months.

Vail Hartman:

It was a week that saw fresh year-to-date high yield marks achieved across the Treasury curve as the market continued to ponder the implications from the new fundamental information received this year. With little in the way of new economic data to drive the price action, although we did see initial jobless claims during February's NFP survey week dropped for the third consecutive week into a five-week low of 201K, we did receive a fair amount of updates on the official communication front. And it was notable that the FOMC minutes said that most participants noted the risks of moving too quickly to ease the stance of policy and emphasize the importance of carefully assessing the incoming data and judging whether inflation is moving sustainably to 2%.

Ian Lyngen:

I think it's very clear that the messaging from monetary policymakers in a broad sense has been wait and see, evaluate the data as it comes in, and respond accordingly. And frankly, that's not all that different than what the Fed has been saying for the last several months. The reality is that the Fed will need further convincing that the path of inflation is conforming with their long-term objective. Now, the January CPI print clearly extended that runway, and the FOMC will need more time to be convinced that normalization is the correct path.

It's notable that in conversations with clients over the course of the last week, there has been a decided tone shift. Previously, the debate was, "When will the Fed start cutting, and how many times will they cut this year?" And now the debate is more focused on the broader question of whether or not inflation is structurally higher as a result of the pandemic and the dislocations that followed. And if that's the case, whether or not the Fed will actually be able to cut rates in 2024. That shift in sentiment has clearly translated into a bond bearish move. And we're sympathetic to the weakness in the front end of the curve, because even if the Fed does end up cutting three times this year, those moves might be contained entirely during the second half depending on how the next couple months of inflation data unfold.

Ben Jeffery:

And we've mentioned this before, but the start to 2024 is starting to look an awfully lot like the start to 2023. What I mean by that is the market came into this year generally expecting an end to the rate cycle, a move toward lower yields, and a steepening of the curve. But obviously, last year that crowd was left a bit disappointed given that the Fed continued hiking through a regional banking crisis it's worth adding, and brought the policy rate much higher than the market was expecting to be the case at the end of 2022.

So while we're sympathetic to that correlation versus the current episode, it's important to remember the critical distinction, and I think one of the more important things that was flagged within the minutes that you touched on, Vail, and that is that most participants, which we read as basically the whole committee, sees policy rates at their peak this cycle. And so, while another rate hike is not an impossibility, based off the last six months of CPI data, even after taking into account the higher-than-expected January print, in the Fed's opinion, there is enough evidence that monetary policy is sufficiently into restrictive territory to bring inflation lower. And while of course, there are upside risks to consider on both the demand and supply side, it would take a meaningful upward inflection and re-acceleration of core inflation for the Fed to begin really entertaining the idea of another rate hike.

And even the most hawkish members of the FOMC aren't calling for that yet. It doesn't mean it couldn't happen, but at this stage, to your point, Ian, the reaction function of more hawkishness is going to be pushing out rate cuts later and later, even if that might not be till June, July, or depending on how the labor market holds up, potentially even later.

Ian Lyngen:

It is worth highlighting that the FOMC minutes were presumably focused on the time period before the market saw that stronger-than-expected January inflation print. Nonetheless, I think the argument still holds, and all of the Fed rhetoric that we've heard since CPI was released just reinforced the notion that a single data point does not make a trend. And that's very consistent with the Fed's messaging and unsurprising, frankly. And we would expect that this all translates into a more concentrated debate on whether or not a Q2 rate cut will be on the table.

We've been in the June cut camp, and obviously we'll be watching the next two CPI prints very carefully for any indication whether or not we should roll our first rate cut expectations forward to July. But for now, we appreciate the symmetry of June, September, December. 25 basis point cuts because the Fed will also be afforded the opportunity of the SEP to further refine medium-term guidance.

Ben Jeffery:

And to talk a little bit about the market moves themselves this week, we saw an impressive extension of the selloff into and then through the 20-year auction that tailed by over three basis points. And as investors continue to debate just how far the selloff can run in an environment with stickier inflation, a strong labor market, large deficits, and a consistently hawkish Fed, the fact that even a solid intraday concession wasn't enough to prevent a big tail at the new issue 20-year auction begs the question of how much more of a discount long-end investors are going to need before becoming more interested in buying duration.

We've heard some anecdotal evidence out of Japan that that crucial foreign buyer base of Treasuries was initially targeting the 4.20%-4.25% area in 10-year yields to begin buying, but the combination of the jobs and inflation reports to start this year have once again backed those targets up. That's for the long end of the curve.

However, looking at the 2-year sector and 2-year yields that crossed back above 4.70% this week, we are of the opinion there's increasingly a case to be made for a dip buying bias in the very front end of the curve, given that the Fed scenario that you laid out, Ian, and those quarterly 25 basis point cuts later this year, is nearly reflected in front-end valuations. Add into that some insurance premium that the intentionally ambiguous "something" goes wrong between now and the end of 2025, and it's not unreasonable to look at the 2-year sector as holding some value, to say nothing of the 2s/10s curve that's quickly closing back in on negative 40 basis points.

Ian Lyngen:

It's also worth revisiting the parallels between Q1 2024 and Q1 2023. Yes, very sympathetic to the price action being something of a mirror of what we saw at the beginning of last year. However, one of the key distinctions is that the benchmark CPI revisions revised away all of the perceived progress made on the inflation front during the second half of 2022. This year, however, the same CPI revisions didn't erase the progress made in the second half of last year. It's simply the single data point of January that has the market concerned the Fed still has much more work ahead of them.

So one interpretation of the dynamic that's unfolding in the Treasury market at this moment is investors were waiting for stability on two fronts before they re-engaged with the Treasury market, the first front being monetary policy stability. And Powell offered that via the December pivot. The market became comfortable with the idea that the Fed was done hiking for the cycle, and that served as an important inflection point that saw investors come back in and buy duration.

The second point of stability was on the supply side. Yellen had been steadily increasing auction sizes throughout the course of last year, and this was capped in February with the clear communication that nominal auction sizes are unlikely to increase again this year. So that was another degree of stability that aided investor confidence in buying duration.

Now, the reason that the January CPI number was so impactful for the Treasury market is that to some extent it has put back on the table the potential for the Fed to deliver another rate hiker or two. Again, not our base case scenario, certainly something that's not reflected meaningfully in the Treasury market. Nonetheless, it has undermined that sense of monetary policy stability that the Powell pivot in December created. So we're certainly sympathetic to investors stepping back, biding their time, and waiting for another clear round of clarification from Powell and the other members of the FOMC.

Vail Hartman:

And while policymakers have expressed some reluctance to place too much weight on the January CPI data, the implications haven't gone entirely overlooked. And this week we heard from Richmond Fed President Barkin, who underlined the challenge in the recent data that's shown a greater dependence on falling goods inflation, while shelter and services prices remain sticky. Specifically, Barkin said, "You do worry that when the goods price deflation cycle ends, you are going to be left with shelter and services higher than you like."

Now, we're still early in February's data cycle, and ultimately the question of whether or not January's data will represent the new norm or an anomaly won't be answered until the March 12th, February CPI release. And this means there likely isn't to be any information revealed on the immediate Macro Horizon that triggers a material rethink of the trajectory of monetary policy.

Ian Lyngen:

So Vail, what I'm hearing you say is that there's nothing material on Macro Horizons.

Ben Jeffery:

What you mean, Ian? We've got great material. Haven't you heard the jokes?

Vail Hartman:

That's what I meant.

Ian Lyngen:

In the week ahead, the Treasury market will have a variety of inputs from which to derive trading direction. Given that month-end falls on Thursday, February 29th, Leap Day for those keeping score at home, the auction schedule has been front-loaded with $63 bn 2-years on Monday morning, $64 bn 5-years on Monday afternoon, followed by $42 bn 7-years on Tuesday afternoon. All of this front-end supply will contribute to the upward pressure that we have seen in 2-year yields.

Now, obviously, a greater concession for 5s and 7s will likely be warranted as well, but given the depths of the inversion of the 2s/10s curve and the fact that so much focus has been put on pushing forward rate cut assumptions, we think that the broader and more interesting implications from the final coupon supply of February will come in the form of pushing the yield curve even flatter from current levels. Let us not forget that we also have durable goods for January as well as a variety of housing updates. The revisions to Q4 Real GDP are unlikely to be headline-grabbing, although Q4 Core PCE numbers could provide greater context for the progress the Fed has made on the inflation front.

Perhaps the single most important data point in the week ahead comes in the form of January's core PCE numbers. Now, obviously in the wake of the higher-than-expected Core-CPI print, the bias will be skewed a bit higher, and the consensus currently stands at 0.3%. Presumably, that's a high 0.3% and could readily round to 0.4% in the event that some components reveal more underlying inflationary pressure than previously assumed.

And throughout the week, we also hear from a variety of Fed speakers. Now, it's worth noting that in the wake of the FOMC Minutes from the January meeting, the January CPI report, and the subsequent Fed commentary that we have received, it's pretty evident that the tone from policymakers is, "Let's wait and see how core inflation performs over the course of the next several months before really starting the conversation about whether or not rate cut assumptions should be deferred into the second half of the year."

The March 20th FOMC rate decision will also be accompanied by an update of the SEP and the dot plot. So in the event that the development of the real economy has the Fed less convinced that they'll need to cut by three 25 basis point moves this year, then they could easily signal 50 basis points' worth of rate cuts in the year ahead.

Now, we would interpret that as signaling a September and December rate cut. The one caveat in that regard comes from the fact that it would be atypical for the Fed to start a rate-cutting campaign immediately ahead of a presidential election. And we're certainly sympathetic to Powell's attempts to distance monetary policy from the political cycle. And to a large extent, that's why we think that he delivered a December policy pivot as opposed to waiting until March or June. Nonetheless, it has clearly created a great deal of uncertainty and complexity for investors at the beginning of this year.

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. As we look forward to the next Leap Year in 2028, it strikes us that we will have offered condolences to listeners 470 times by the next occurrence of February 29th. Clearly, we have a lot of sympathy to express. Sorry about the jokes.

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:

The views expressed here are those of the participants and not those of BMO Capital markets, its affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.