Approaching 300 - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 296: Approaching 300, 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 October 21st. And as we can now see our 300th episode approaching on the macro horizon, we cannot help but draw the parallels with the Spartans. They all survived, right? 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 fundamental updates included a decline in Jobless Claims, which is a net positive for the outlook, as it pertains to the labor market, and a higher than expected Retail Sales print for the month of September. This held true both for headline Retail Sales, as well as for the control group, which has the highest correlation with consumption within the real GDP series. The net takeaway was an upward bias in rates, but one that has occurred within a defined range. And as we look forward, we anticipate that the theme will be one of consolidation, as opposed to a dramatic range break in either direction. The recent Fed rhetoric has, if nothing else, reinforced the notion that the Fed's comfortable shifting to a rate-cutting cadence of 25 basis points per meeting, at least between now and the end of the year, and there's no significant urgency with the pace of rate cuts.

This is very consistent with the messaging from Powell and is also reflected in the higher than 90% probability via market pricing of a rate cut in November. There's also been an uptick in the number of conversations regarding how the Fed might or might not respond to the result of the presidential election. We are of the mind that it certainly won't have an impact on the November decision. And until there's a clear shift in policy, it might not be a consideration until well into 2025. Historically, the Fed has been most comfortable basing policy decisions off of the prevailing known economic data and the trajectory of the real economy, as opposed to any potential shifts on the fiscal side. We struggle to envision that that is going to change anytime soon. We are, however, cognizant that, in the event of a GOP sweep, that many market participants expect that that will either slow the Fed's process of normalization or at least put a floor on terminal to the downside.

So this is also consistent with the general thought that upward pressure on rates will emerge, regardless of who takes the White House and the composition of Congress. We're on board with the notion that the longer end of the curve will cheapen into the end of the year, in the event of a sweep in one direction or another, although we struggle with estimating precisely how much of that is currently priced in. The direction of travel for policy rates is clear and lower, and we do know that there is a change in the White House coming, either to Harris or Trump. We are concerned that this sets the election outcome up to be a classic ‘sell the rumor, buy the fact’ event, i.e., cheapen up the Treasury market into the actual results. Once the results are known, the passing of the event risk, in and of itself, could provide enough incentive to bring in otherwise sidelined buyers.

Such a dynamic has played out several times over the course of this cycle. Originally, when the Fed was hiking rates, the market didn't know when the Fed was going to stop. Once the Fed arrived at terminal and it was clear that policy rates would not be pushed any higher, we saw a wave of buying in the Treasury market. Similarly, once it became obvious that the Fed was going to be in rate cutting mode, we saw a wave of buying that supported Treasuries. We suspect the combination of the emphasis on the election and its eventual resolution will serve as another inflection point that will bring in buying in the Treasury market, thereby capping the degree to which some of the reflationary concerns can push 10 and 30 year yields higher.

Ben Jeffery:

It was a week in the Treasury market where the fundamentals were, frankly, not really in the spotlight. Sure, we got an Initial Jobless Claims print that was a bit stronger than expected and an upside surprise in the Retail Sales Control Group for September. But neither of these data prints held the needed economic weight to really recast the way the Fed is approaching the next meeting or two, or frankly, the market's operating assumption around the forward path of Treasuries and how the interest rate landscape is going to evolve. Instead, one of our biggest takeaways from the week just passed was the price action itself. As the short week began with an extension of the bearishness in Treasuries, only to resolve in dip buying interest and rates that pulled off the highs and while not back to the lows we reached in September, the fact that NFP and CPI have left 10-year yields comfortably below 4.25 demonstrates the bid that continues to keep any sell-off in Treasuries relatively well contained.

Ian Lyngen:

And it's also notable that we have seen breakevens continue to edge a bit higher, and that follows intuitively, given what we have seen play out with the global central banking bias having gone from retaining terminal to a clear concerted effort to lower policy rates, with the exception of the Bank of Japan. We just saw the ECB cut another 25 basis points, as expected, and as we think about the forward path of inflation expectations, we ultimately anticipate that 10-year breakevens won't break above 2.50. But, consolidating between 200 and 240 basis points certainly resonates as we move through in the cycle. This will also contribute to the renewed conversations about the potential for term premium to shift back into positive territory on a sustainable basis. Recall that positive term premium and an upward sloping yield curve tend to go hand-in-hand, although not necessarily. As the Fed moves further along the path of normalization for policy rates, we anticipate that the yield curve will continue to grind steeper.

In the very near term, we continue to expect that the Fed lowers rates by 25 basis points in November, followed by another 25 basis point rate cut in December, and then, shifting to a quarterly cadence in 2025. Now, using that as our base case scenario, we are all too cognizant that the Fed is very much in a data-dependent mode, and as the real economy evolves over the course of the next few quarters, we'll remain on guard for a shift in messaging, as it pertains to the Fed's preferred path of normalization. We find it difficult to envision a scenario in which the Fed simply cuts three times in 2024 and leaves policy rates stable throughout 2025, although we're certainly cognizant that the terminal on the downside debate remains very active.

Ben Jeffery:

And related to all of this and the extent to which the longer end of the curve can see a meaningful return of term premium are the implications of the quickly approaching election, not only from a deficit standpoint, and when it is, coupon auction sizes are going to need to start growing again, but also, from a growth and inflationary perspective and what that means for term premium further out the curve.

Firstly, as it relates to issuance, almost regardless of the outcome of the election in November, both in terms of the White House and the composition of Congress, the earliest we realistically see coupon auction sizes needing to start to climb again is next summer. And frankly, to handicap whether that's the May or August refunding announcement, we'd lean more toward the latter than the former at this stage. Obviously predicting political outcomes and policy agendas that ultimately end up getting passed is well outside our wheelhouse, but at least in the near term, it seems that the conversation around larger auction sizes and the potential for an imminent re-ramp-up of supply in the longer end of the curve is unlikely. And instead, that's going to be a second half of 2025 issue.

However, that doesn't preclude the growth and inflationary implications of either a Republican or Democratic sweep from stoking reflationary concerns pushing breakevens wider and adding a government spending driven boost to growth assumptions over the next few years. We'll argue that the biggest difference, in terms of the market's reaction around the election, is not between whether it's all red or all blue, but rather if it's a sweep by either party or a split government. It's the split government scenario that likely means more difficulty in passing any grand initiatives, and that ultimately will keep the economic impact of the election comparatively muted.

Ian Lyngen:

And within this context, I think it's notable that we have not really seen the polls influence the direction of yields, nor some of the higher profile appearances of either candidate. It seems as though the market, at least for the time being, is content to wait until we have clarification following the election, before investors are comfortable positioning for any potential future changes. That being said, there is a general consensus that, regardless of who takes the White House, that there will be an increase in deficit spending. As a slight offset to that, the Fed's forward path of policy rates will be lower and the Treasury Department is borrowing heavy in the bill market, which means that as front-end yields start to decline, the interest expense component of the deficit spending will be biased slightly lower.

Now, while this certainly isn't going to be significant enough to reframe the conversation around deficit spending, when combined with a strong performance of the real economy, i.e., higher tax receipts, we might see a de-emphasis of the deficit story, as 2025 unfolds. It's also worth considering that, in the event that there's not a sweep, either to the GOP or the Democrats, that the middle of next year, as the debt ceiling issue becomes topical once again and the government is unable to agree on a budget, we could see the potential for another government shutdown, conversations about a delayed payment, et cetera. At this point, it's a very well-traveled path, but nonetheless, something worth keeping on the radar, as we ponder the year ahead.

Ben Jeffery:

And in a market environment with all these moving pieces and no shortage of uncertainty, there is one dynamic that is seemingly very consistent, and that is the continued resilience of risk assets, with equities continuing to make all-time highs, despite monetary policy that's still in restrictive territory, but now, becoming less so. We frequently discuss the implications from stocks that only seem to go up, both in terms of the wealth effect, with what that means for consumer confidence, so willingness to spend, but also, the overall level of financial conditions, as diminished equity volatility and real rates, that have come well off their peaks, continue to be the cornerstones of a financial conditions landscape that is still very easy.

Obviously, the Fed is well aware of this dynamic, and so, despite the 50-BP cut we got last month, the fact that, going forward, the operating assumption is that future moves will be of the 25 basis point variety, it's not wasted on us that even with financial conditions so easy and equities at the highs, the Fed's bias is to continue to bring rates lower. And so, in that context, it's difficult for us at least to make the bear case for domestic stocks.

Ian Lyngen:

And as we watch the market continue to consolidate in a very clear and defined range, one clear theme has emerged, and that is that investors are very much in a “wait and see” stance at the moment. We all have our operating assumptions about the pace of Fed rate cuts and will concede that, to some degree at least, the Fed's path to normalization will undoubtedly be data dependent. In practical terms, however, that means that investors need to see each incremental data point before either solidifying or undermining one's core assumption about each incremental move. Said differently, we are clearly in an environment where the Fed is data dependent, the market is data dependent, and the outlook is data dependent, and so, investors are appropriately content to play the extremes of the range, as we wait and see.

Ben Jeffery:

So where are 10-year yields going? I think we got our answer. It depends.

Ian Lyngen:

If nothing else, we're in a mode that we're doing a lot more waiting than we are seeing. In the week ahead, the Treasury market will have remarkably little in terms of fundamentals from which to derive trading direction. We do have the $13billion 20-year auction on Wednesday, followed by a $24 billion five-year TIPS auction on Thursday. Economic data is limited to Existing Homes on Wednesday, New Homes on Thursday, and of course, the weekly Jobless Claims update. Claims will be less relevant in the week ahead, because Nonfarm Payroll survey week has already passed. Now, this doesn't mean that the market is poised for a particularly strong October payrolls print, rather that, as we make it all the way through the September data cycle, the data theme for October in particular will be one of uncertainty, because of the impact of the hurricanes on the real economy.

Now, that comes in the form of consumption, as well as inflation, and of course, hiring. The challenge for monetary policymakers will quickly become that they'll be flying effectively blind into the next couple meetings, in the event that we have any meaningful degree of distortion in the realized data. Now, while we don't expect that this will prevent the Fed from cutting rates per se, it does go without saying that another half point cut is off the table, at least for the time being. We also have the midweek release of the Beige Book. Now, while, historically, the Beige Book has not been a significant market moving event, it is worth highlighting that the prior Beige Book was, in fact, followed by some meaningful price action, and that's primarily because it indicated a downshift in outright activity, as reported by the regional anecdotes. Now, in the event that we see a repeat of the uninspired recent Beige Book, it'll be interesting to see how the market chooses to trade that divergence versus the strength that we've seen in the September data.

All else being equal, we expect that the Beige Book will show a modest rebound in the anecdotes, if nothing else. From a trading perspective, while we continue to anticipate lower yield levels by year end and a steeper yield curve, the process of trading the prevailing yield range has become the most prudent approach. In the 2s 10s curve, that range is effectively zero to positive 15 basis points, and in the 10-year sector, with the focal point of 4%, we could see yields back up to 4.15, maybe even 4.25, in the event of a strong bearish impulse, but ultimately, drifting back towards 3.75 will prove the path of least resistance as the year end comes into focus.

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 Halloween quickly approaches, one thing is clear: this year, Vail will be going as a ghost. 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 3:

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