All Eyes on CPI - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 204, All Eyes on CPI presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of January 9th. As we've resolved to learn a new skill, meet new people, consume more fruits and vegetables, be more financially prudent, and spend more time at the exercise facility, it's not wasted on us that the juice bar at the gym is still hiring.

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 and financial markets more broadly received several notable surprises primarily on the economic data front, but we also saw confirmation at least that the Fed intends to remain hawkish as 2023 gets underway with at least another 75 if not 100 basis points of rate hikes on offer.

There are arguably two data surprises that are tied as being the most relevant. The first was the unexpected decrease in the unemployment rate to 3.5%. This was versus the consensus of 3.7% and is moving decidedly in the opposite direction of the Fed's objectives of getting the unemployment rate back comfortably above 4.5%. Also add that within the BLS report, we did see a deceleration of the average hourly earnings gains to 0.3% month over month versus 0.4% with downward revisions to the prior month. All of this was good news for the Fed, moderating wages and a still healthy employment market set the Fed up well for the potential for a soft landing. Now, the other major data point that surprised was the ISM services print of 49.6 versus estimates of 55. Now, this is the lowest business sector sentiment data that we've seen since May of 2020.

Given the relevance of the service sector, both from the perspective of outright economic performance as well as inflation, it was then unsurprising to see that the treasury market rallied relatively significantly after ISM with 10 year yields close to 3.60 and back nearly to the level seen in mid-December. Now, we're comfortable with the notion that this is simply pricing out some of the late December weakness that was driven by low liquidity, low conviction, and a general market malaise as 2022 came to an end, but it's also worth highlighting that within the price action we did see the curve decidedly steeper. 2s/10s had flattened back into the negative 70 to negative 80 basis point range. We consolidated around negative 75 basis points for a moment, and then following NFP and ISM, we saw a re-steepening back above negative 70 basis points.

Now, this price action was largely a function of the market questioning whether or not the Fed would ultimately reach its stated terminal policy rate target with an upper bound of five and a quarter percent. Now we'll argue that it's still too soon to fade the Fed's commitment on its promised rate hikes. Nonetheless, the data was supportive of the Fed's broader goals. The FOMC minutes also outlined a key risk of monetary policy in the near term, and that is that financial conditions end up easier presumably as a function of a pivot in the equity market as bad news becomes good again for stocks and this would function as an offset to the Fed's attempt to keep financial conditions well into restrictive territory for an extended period of time. Moreover, if stocks continue to bounce and financial conditions ease, the Fed will likely need to increase rates further to get financial conditions back to the range that they'd like to see them. Overall, it was a very exciting start to the year from a macro perspective.

Ben Jeffery:

Well, Ian, we've got the first jobs report of the year. NFP was stronger. The unemployment rate was lower, both versus previous and expectations, and the participation rate increased, but yet the Treasury market bull steepened.

Ian Lyngen:

January is as January does to be sure, but within the details of the BLS data, what we saw was that average hourly earnings actually came in lower than anticipated and the prior wage print was also revised lower. This brought the year over year gain in wages to 4.6% versus a consensus of 5%. Now, when we think about the recent trend of nominal wages, it's worth highlighting that since June of 2020, the average year over year wage print has been 4.8, so the fact that we're at 4.6 has to be good news for the FOMC and I think that that goes a long way to explain why we bull steepened as a result of the data. That being said, it's certainly worth acknowledging that the bull steepener is 2023 big trade from a macro perspective, and investors are eager to push that narrative.

Ben Jeffery:

And along with the fundamentals of the wage data and some evidence that the Fed is making progress in reaching its goals, it's also worth discussing how the departure point going into the data framed the response coming out of it. The first four trading sessions of 2023 were defined by a decided flattening of the curve with 2s/10s dropping back to negative 77 basis points immediately ahead of the NFP figures and especially given the strength of the ADP figures as well as the overall hawkish rhetoric we heard over the course of the past week, the market was definitely prepared for a strong read on hiring, and so in terms of tradeability, that raised the bar for the NFP release to be strong enough to add further flattening pressure to a twos tens curve that was already within seven basis points of cycle flats.

So the fact that most of the details were stronger than expected but not significantly so combined with the slower than forecasted wage data, I would also argue drove a little bit of a position driven retracement, which might be why we got some of that steepening relief immediately after the numbers. Additionally, and as you touched on Ian, the BLS data was not so surprising as to really be a game changer for the Fed, and really what this means is that the market's attention is now going to shift to Thursday's inflation data as well as the potential for an early setup for January's reopening auctions of 10s and 30s, all of which also added to that steepening notion that we saw on Friday morning.

Ian Lyngen:

When we put this jobs report in the context of the upcoming FOMC meeting and the debate around whether or not the Fed will go 25 basis points or 50 basis points, there's really nothing out of December's BLS update that would give us a bias clearly in either direction. It follows intuitively that if the Fed wants to push the effective Fed fund's terminal rate above 5%, it's advantageous to move 50 rather than 25. After all, there's a lot of data between the February and March meetings that could derail the Fed's ambitions. While we are encouraged from a longer term perspective to see the rally following net non-farm payrolls, we do continue to see upside potential for front end yields. The two-year sector in particular, given that there's a higher probability for the terminal rate to be revised higher than to be revised lower from the current departure point.

Ben Jeffery:

And this is an idea we saw reflected in our pre NFP survey this month. One of the questions posed focused on the likelihood that versus what we saw in the December dot plot with a projected terminal rate at five and an eighth, is it more likely that the Fed would need to go higher than that level or more likely that the realities of the data would prevent Powell from pushing policy rates that high? The split was 68% seeing a higher terminal is more likely while just 32% don't expect that the upper bound of the target range will be able to reach 5.25. Relatedly, we asked what was greater the risk of over tightening and inflicting undue damage on the labor market and the overall economy or the risk that the Fed doesn't do enough in undershoots on the tightening front, which then in turn runs the risk of leaving inflation higher for longer.

The distribution of responses to this question was even more one-sided. 92% of the respondents to our survey saw the risk of over tightening as greater than the risk of under tightening, and beyond simply the size of February's hike and whether that will be 50 or 25 basis points. This means that as we get toward the March meeting, when we'll have another two months of both NFP and CPI reports in hand that the risk at this point is for the dots to climb further from the upward revisions that we saw in December.

Ian Lyngen:

It was also not a particularly confidence inspiring week in Washington DC with the House of Representatives inability to elect a speaker. Now, there could be broader implications from this degree of gridlock, particularly as it pertains to the debt ceiling and the ability for Congress to make the needed adjustments when the time comes.

Ben Jeffery:

And with the newly elected Republican controlled house unable to officially begin its work before electing a speaker, this certainly hints that bipartisan or frankly even partisan agreement in the House of Representatives during this congressional session is likely going to be more elusive than it has in recent memory. Now along with the overall functioning of government as this relates to the Treasury Department, while yes, we did get a spending bill passed in the final week of 2022, the debt ceiling is once again going to become topical. And at this stage, given the uncertainty around corporate tax receipts and just how much the Treasury Department will need to borrow, it's still too soon to say with any high conviction when Yellen's extraordinary measures will need to be implemented with everything that means for the issuance landscape in the very front end of the curve. Obviously still very early days to deliver estimates on when the potential drop dead date might be and when it is that the Treasury market's ritual of debating what would happen if in fact the U.S. government defaulted.

At this point, a rough consensus seems to be centered at some point in the third quarter, so assuming we make it through the beginning part of Q2, the tax receipt numbers become known, it's at that point we'll have a better sense of when the extraordinary accounting measures will need to be implemented, when bill auction sizes will start to drop, and when it is more specifically that there is a risk of a missed coupon payment or missed bill maturity payment from the Treasury Department. Now, Ian, as is always the case when we discuss the debt ceiling, we view the likelihood of a U.S. default as extremely, extremely, extremely unlikely, but that certainly will not prevent investors from discussing the issue or the very front end of the curve from repricing to reflect a small probability of a missed payment as the day gets closer.

Ian Lyngen:

One aspect of the potential for a default slash missed payment that I think it's really important to keep in mind is that there's no cross default for U.S. treasury bonds, so that means simply because a payment is missed that doesn't have broad-based implication for the $14 trillion of privately held treasury securities in the market. An interesting question that came up this week was what happens when the equity market rushes to price a pivot or a rate cut before the Fed is actually done hiking? One could argue that that's part of the price action that we saw on Friday because the wage data came in below expectations. There was a dovish sentiment in financial markets.

Our biggest concern, and we suspect that it's one shared by the Fed, is that as equity prices stabilize and edge a bit higher, we'll see a decline in realized volatility, which subsequently will ease financial conditions. Easier financial conditions in an environment where the Fed's stated objective is to tighten financial conditions and keep them tight for an extended period of time will complicate Powell's job to put it mildly. If anything, as noted earlier, this suggests that there's a bias for the terminal rate to be revised higher rather than lower despite what appears to be peak wage inflation.

Ben Jeffery:

And related to the wage inflation argument and what it means for the Fed over the coming meetings, but also the length on hold that we're expecting is going to be more extended this cycle than we've typically seen is a very good question we received this week on what specific level of policy rates qualifies as restrictive. Ultimately, this is an academic exercise left to far brighter minds than ours, but we will offer the observation that in contemplating where it is exactly restrictive is, it's not necessarily a level that shows itself once we arrive there, but rather after we've passed it and have spent some amount of time above that threshold. Now, rather than headline CPI, the Fed is beginning to emphasize the level of core services ex shelter as a good measure of the impact that tightening is having, and so measuring that core CPI ex shelter measure versus the level of policy rates is something that we expect will take up an increasing share of the market's dialogue as we get February's hike and presumably the final tightening move of this cycle at some point later in the first half of the year.

Notably, the Fed has told us that they want to get rates into restrictive territory and leave them there, which still comes in sharp contrast to the shape of the Fed Fund's futures curve and is a market that is continuing to price in rate cuts over the second half of this year despite the Fed rhetoric itself and also what we saw in the Fed minutes this past week, which is that not many, not several, not a few, but no participants see downward adjustments to policy rates in 2023.

Ian Lyngen:

Also, on the topic of the FOMC minutes, the Fed did acknowledge that financial conditions could be ‘unwarrantedly eased’, which would as mentioned earlier, further complicate the Fed's attempt to reestablish the forward price stability assumption. So Ben, on the topics of stability, unwarranted, and functioning, what do you have planned for January?

Ben Jeffery:

Not during the weekend only on special occasions.

Ian Lyngen:

Or days that end with a letter Y.

In the week ahead, the Treasury market will continue to digest the solid non-farm payrolls print combined with moderating wage data and the disappointing ISM services print. Suffice it to say the biggest question is how the data from December is going to impact monetary policy in February. The active debate between 25 basis points versus 50 basis points remains the operative discussion in financial markets. We're also anticipating a chorus of increasingly hawkish comments coming from Fed officials. All else being equal, we think the Fed will do what it can to get terminal to its projected range of 5.00 to 5.25, which would give us an effective Fed funds of 5.08. There are really two potential scenarios to get to that path in terminal. First, we get 50 basis points in February followed by 25 in March, ending the hiking cycle in Q1. The second would be three rate hikes spread out over the course of the next three meetings.

Now, sure, there's an argument that they could go 25 in February, pause for several months, and then if inflation doesn't come under control, hike further from there. But given the fed's demonstrated reaction function to realized data and perhaps more importantly forward inflation expectations, we see clear incentives for the FOMC to get to terminal as quickly as possible and then gauge the impact of the cumulative tightening that has been achieved. And the week ahead, Thursday also offers the December CPI data. Headline CPI is seen as flat or up 0.0% versus the prior month's gain of one-tenth of a percent. Core inflation on the other hand, is expected to increase three tenths of a percent following November's gain of two tenths of a percent. Nonetheless, this would bring the year over year core measure to 5.7% from the prior print of 6%. This would also conform reasonably well with the peak inflation and subsequently peak 10 year yield argument. As expected, a higher print would leave 50 basis points on the table in the event that the Fed chooses to incrementally front load rate hikes a bit more.

Now, a monetary policy complicating outcome would come in the form of a notably weaker than expected core CPI print. For example, a 0.1 or a 0.0 print would be perhaps welcome by the FOMC, but also reduce the probability that the Fed would choose to go 50 basis points when it meets in February. Let us not forget, the week ahead also sees the first 10 and 30 year auctions of 2023. Wednesday afternoon's reopening auction is 32 billion tens followed by 18 billion thirties on Thursday. All else being equal, the price action we've seen thus far in January speaks to the potential for sidelined investors to get involved in the first major Treasury auctions of the year, and as such, we wouldn't be surprised to see above average indirect participation in 10s and a solid underwriting of 30s.

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. In keeping with the theme of self-improvement, we've learned two important lessons from Congress this week. First, professional resumes and accomplishments are a form of artistic expression. Second, if at first you don't succeed, vote, vote, and vote 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 @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 3:

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