Before Q4 - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 293, before Q4, 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 September 30th. And as the third quarter comes to an end and our attention quickly shifts towards Halloween, it's notable that this year's top 10 costumes include Ghostbusters. The more things change, the more it feels like the 1980s all over again. What's next? Goonies?

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, there were two primary themes in the Treasury market. One theme was that of consolidation. We saw the 10-year yield focus on 3.75%. Now we got higher, we got lower, but at the end of the day, the market seems to be settling into a reasonably defined range. Now, this follows intuitively given that the Fed has delivered its first rate cut and been reasonably successful in defining forward expectations for monetary policy, all with a backdrop of most other major central banks already cutting rates with the exception of the Bank of Japan.

The other theme was that of a re-steepening of the yield curve. 2s/10s pushed up toward that 25 basis point level before consolidating a bit, all of which is consistent with our outlook for the 2s/10s curve to remain in positive territory between now and the end of the year. In fact, we think that the days of inversion are behind us for this cycle, and as the Fed moves forward with rate cuts, the two-year sector will march incrementally lower in yield, thereby steepening the curve. In addition, supply considerations and conversations about the return of positive term premium should prevent 10- and 30-year yields from dropping too far, even in the case of a flight to quality bid. Said differently, the cyclical re-steepening of the yield curve has finally commenced.

It's also notable that the variety of Fed speak that we heard in the week just past did little to push back against the fact that the futures market is currently fully pricing in a 25 basis point rate cut in November, and with a probability greater than 60% of a 50 basis point rate cut. This pricing is very comparable to what we saw in the run-up to September, and in the event that this pricing holds, we think that it's highly likely that the Fed delivers another 50 basis point rate cut.

That being said, there's little question that the Fed is squarely in data dependent mode and therefore the probability that the market is pricing in will simply be a function of how the realized data performs. Nonfarm payrolls will be an obvious inflection point for revisiting what's priced in for the Fed and refining those expectations further, and of course the October 10th release of Core-CPI will also be instrumental in setting those expectations. Let us not forget that the Fed will also have the additional data input of the October payrolls release, which comes out on the 1st of November. So this implies an atypical amount of clarity on the jobs front for the Fed's next decision, and also leaves wide open the debate whether or not the Fed will go 25 or 50. One thing that is abundantly clear however, is that the Fed will cut in November and it's only a question of magnitude at this stage.

Ben Jeffery:

Well, the market has had a little bit over a week to digest the first rate cut of the cycle with now the benefit of August's core PCE data and frankly, the biggest takeaway from this week has been what's increasingly seeming to be a durable range in treasuries with ten-year yields holding steady between call it, 3.70% and 3.80%. And if anything, the unifying theme of our conversations with clients this week has been, can the market not really sell off or can the market not really rally? So to put that in another way, it's been a range-trading environment even after the core-PCE data and there's little reason to expect that will change barring any unforeseen surprise ahead of next week's payrolls report.

Ian Lyngen:

There's also an embedded question within the market's price action, and that question is, can the Fed afford not to go 25 or can the Fed afford not to go 50? And I think that that question is going to define the trading range between now and the point when the FOMC meets and decides on the next move. Our base case scenario at this point, frankly is that 50 basis points has become the new 25 and barring an upside surprise in either the labor market data or the next core inflation read, that the path of least resistance is to deliver another 50 basis point move. It's worth putting the concept of front-loading rate cuts into what we are assuming is going to be a cycle that brings Fed funds back to the Fed's definition of neutral, which is a range, let's call it 2.75% to 3%.

If one thinks of that series of rate cuts as being 6, 7, 8 moves, then by only adding an additional 25 basis points to the first move, the question becomes has the Fed really front-loaded anything? Or was the Fed attempting to set 50 basis points as the temporary new norm until they sufficiently front-loaded rate cuts to a point that the committee becomes comfortable down-shifting to 25 basis point moves? Now, nothing that has come out of the Fed over the course of the last week has pushed back against the idea that 50 might be the new 25 and unless and until the combination of the economic data and the incoming Fed rhetoric pushes back against 50, we're comfortable using that as our base case.

Ben Jeffery:

And obviously the path matters and the path of policy rates will especially matter over the next several quarters as we get the answer to exactly that question, Ian, whether or not 50 is the new 25. But beyond that and looking ahead into next year, the next big Fed unknown is going to be where it is that policy rates are going to end up. And implicit in that conversation is the continuing debate around how our star may or may not have moved on the other side of the pandemic. But for the time being, by pretty much any measure, monetary policy remains in restrictive territory and even after potentially another few 50 basis point rate cuts, we're likely going to still have fed funds above most estimates of neutral, and especially if we continue to see inflation trend down, the real policy rate is going to remain elevated as well.

So while yes, neutral rates will certainly feature prominently in the market's discussion over the next few quarters. For now it's the level of restrictiveness and the real economy's evolving response to policy rates that have only just come off their highest level in a few decades. That's going to drive the price action and outright rates and the shape of the curve between now and the end of the year.

Ian Lyngen:

On the topic of the Fed's ability to reestablish price stability, the potential for port strikes in LA have once again become topical. The notion being that goods shortages could drive up prices over the balance of this year in the event that the work stoppage extends. Now, what's interesting about the potential monetary policy implications from such an event at this stage in the cycle is that goods prices have been trending lower. It's actually service sector inflation that the Fed remains primarily concerned about. So even in the event of supply chain disruptions at this stage in the cycle, we suspect that if anything, the Fed would reframe that as a tax on the consumer as opposed to the type of inflation that would warrant a monetary policy response. Nonetheless, it does remain topical as we enter the final quarter of the year.

Ben Jeffery:

And it's that tax on consumer debate, frankly, the state of consumption as a whole and what it means for the likelihood of a recession or not. That's worth delving into a bit given what we're starting to see in some of the labor market data. This week's consumer confidence data was disappointing and defined by the narrowest labor differential since March 2021. As uncertainty around the job market is beginning to show up in the outlook on the individual level and then throw in disappointing personal income and spending figures that we got on Friday and what has been a very strong consumer in the US, is now starting to appear marginally less so.

Looking at Q2's GDP revisions, by no means behavior consistent with a recession, but now that we have consistent evidence of wage growth starting to cool, of household confidence coming under a bit of pressure, and obviously uncertainty generally being quite high, what that ultimately may resolve in is a more significant pullback in consumption, particularly for those parts of the population that are not benefiting from real estate appreciation from equity prices at all time highs and who will likely be the first to feel the more material turn in the labor market, that will be the driver of a lower growth landscape going forward.

Now does that mean it's going to be a severe recession with multiple percentage points of negative growth quarter-over-quarter? Not necessarily, but real GDP expanding only modestly or maybe contracting slightly is nonetheless an environment that advocates for lower rates over the medium and longer term.

Ian Lyngen:

It's also not wasted on us that within the same report that showed us disappointing income as well as spending, we also saw the lowest savings rate since the latter part of 2023. Declining savings in an environment in which we're seeing in increased defaults and delinquencies speaks to, as you point out Ben, a consumer base that's under strain. Now that might not be universal across all quartiles, but we are starting to see mounting evidence that this is an issue that won't ultimately be contained just to the bottom quartile. So as we contemplate the balance of risks between now and the point when the Fed returns monetary policy back to neutral, it's difficult not to be biased for something to go wrong in the interim that ultimately leads the Fed to shift from removing restriction to actually needing to be outright accommodative i.e. truly easing as opposed to just cutting.

Ben Jeffery:

And as the fourth quarter gets underway, obviously one of the biggest uncertainties is going to be the outcome of November's election. We learned a long time ago not to try and predict the outcome of the election itself, but most importantly for the treasury market is going to be what it means for deficit spending, fiscal plans, tax cuts, and all the other economic implications of a potential change in congressional control or the occupant of the White House. As we think about the treasury supply dynamics surrounding the election, what really comes to mind is that whether Trump or Harris are victorious, large deficits are going to continue to be a feature of US fiscal policy for at least the next four years, if not beyond.

And so while there's certain to be a lot of discussion around what the election means for auction sizes, we would actually argue, one of the more significant economic impacts of whatever political changes ultimately come to pass will be from the angle of growth and the impact that fiscal spending has on the aggregate economy as opposed to specifically the Treasury Department's borrowing needs. So increases in growth, refining estimates around personal consumption resulting from tax cuts. It's these factors that will likely be more impactful in the event either party sweeps the executive and legislative branches. But for that, and in keeping with our near-term range trading bias, we're going to have to wait and see.

Ian Lyngen:

This also raises the nearly age-old question, who's going to be the marginal buyer as the Treasury Department increases its auction sizes? What we have seen recently via the MOF data from Japan is that Japanese investors have once again stepped up and been buying overseas notes and bonds. In fact, we have seen net buying during six of the last seven weeks for a total of $64 billion. Now, presumably the vast majority of that is going into Treasuries, as has historically been the case, and that also conforms with the price action in the run-up to the FOMC's September decision. Now whether or not the post-Fed price action has been more about profit-taking and position squaring as opposed to anything else, remains to be seen, and we expect that that question will be resolved in the response to the nonfarm payrolls print.

Ben Jeffery:

And we mentioned it earlier, but this week's conversation wouldn't be complete without revisiting an equity market that's at record highs. Given what that means for the wealth effect and the overall level of financial conditions, particularly in the context of a 50 basis point rate cut to not risk triggering material tightening of financial conditions. Between the move toward lower real rates and the rally in equities, there's little debate that the overall level of financial conditions remains quite easy. And as we think about the fed’s less discussed shadow third mandate, which is the effect of functioning of financial markets. From that perspective, at least, conditions are easy enough. Market functioning is still relatively resilient that the policy response we're going to get over the next few meetings is hopefully not going to be a result of market volatility. Instead, its payrolls on Friday and the validation Powell will or won't receive in terms of his concern about the labor market that will likely be most influential in determining whether 10-year yields stage another approach of 4% or if 3.50% is going to be the next stop.

Ian Lyngen:

I do think that it's difficult to understate the impact of the wealth effect. I know personally, the recent rally in the stock market has brought forward my retirement date by five years. What was 2075 is now 2070.

Ben Jeffery:

And I'll see you in 2096.

Ian Lyngen:

In the week ahead, the Treasury market will be almost exclusively focused on the September payrolls report. As it currently stands, expectations are for roughly 125,000 jobs to be added to aggregate payrolls and for the unemployment rate to be unchanged at 4.2%. Recall that the Sahm rule has been triggered and the 3-month moving average of the unemployment rate is now 57 basis points off of the 12-month trailing low. Now, historically, this has been a clear indication that the economy was slipping into a recession. The primary counterpoint, and it's a valid one, is that the outright level of the unemployment rate is still so low that a recession shouldn't be a foregone conclusion.

And in fact, one could argue that this is precisely why the Fed was willing to start with a 50 basis point rate hike in September and leave open the possibility of another 50 basis point move or two by the end of the year. Said differently, the Fed is doing what it can to ensure a soft landing in the event that one is actually attainable. We offer that last caveat simply because of the delayed impact of monetary policy. In effect, the rate cuts that the Fed is delivering at this moment are unlikely to feed through to the real economy until the latter half of 2025. So what we will see in terms of the real data over the next several months will be how resilient the real economy was to Fed funds at terminal for 14 months.

The week ahead also has a variety of Fed speak, none of which we anticipate will deviate from the broader messaging and the messaging being that the Fed is in rate cutting mode, the direction of travel is clear, the magnitude of the rate cuts will be a function of the evolution of the real economy and the final destination i.e. terminal on the downside is anticipated to be neutral, which the Fed is defined as 2.75 to 3%. The obvious risk associated with this is that the economic outlook dims more dramatically than expected. Presumably this would be associated with a spike in the unemployment rate, which underscores the market's focus on the employment landscape and the BLS report on Friday.

Let us not forget that we have the ISM series, both manufacturing and services ISM, which has sentiment indicators from the business sector, have been influential in setting the tone for US rates. That being said, there's an argument to be made that the manufacturing sector has been contracting for some time, and that contrasts with the strength in the service sector. Investors will also be watching the Jolts release, particularly the quits rate within that series, which has declined back to pre-pandemic levels and suggests that the Fed's efforts to restore balance into the labor market have been successful. The biggest risk in this context is that the momentum overcompensates on the downside.

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 the fall sets in and the days get shorter, rest assured that the Macro Horizons legal disclaimer will stay the same length. It just feels a bit longer.

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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