Breaking the Wishbone - The Week Ahead

Ian Lyngen:

This is Macro Horizons Episode 249, Breaking the Wishbone, 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 November 20th. And as we prepare for next week's holiday celebration, topping our thankful list are the loyal subscribers to Macro Horizons and how, every week, we get that much closer to our Spotify deal. Still waiting for the call, just like that invitation to Davos, Jackson Hole, the Grammys, and the next FOMC meeting.

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. That being said, let's get started.

In the week just past the Treasury market extended its recent rally with 10-year yields dropping below 4.40%. This price action was welcome for those of us who have had a medium-term bond bullish outlook. And it's interesting that the price action occurred in a relatively consistent manner across the curve, i.e. 2s and 3s rallied as well as 10s and 30s.

This relatively parallel shift led to very little change in the shape of the yield curve, particularly 2s/10s, which is what makes it somewhat atypical. Historically, once the Fed reaches terminal and the market begins debating the timing of the first rate cut, we tend to see a bull re-steepening. The fact that the steepening has been delayed speaks to the fact that what had driven the bulk of the selloff in August, September, and October had more to do with supply and term premium than it did the global macro outlook.

Now that the supply and demand dynamic has taken a backseat to the fundamentals, we anticipate that a bias towards lower rates will continue and only be reinforced particularly further out the curve, the more hawkish the Fed becomes in their commitment to avoid rate cuts for the foreseeable future. Given that investors are once again convinced that monetary policy does work and it works with a lag, that means that the longer it takes the Fed to deliver the first rate cut, the more compression that we'll see in breakevens and forward inflation expectations, and that will drive nominal rates lower.

Our concern in this regard is how the Fed responds to easier financial conditions resulting from lower 10-year yields. Recall that the Fed credited tighter financial conditions for not hiking at the November meeting, which raises the risk that as financial conditions ease, the Fed might ultimately be compelled to deliver another rate hike.

While we don't anticipate that the Fed has another hike left for this cycle, we're certainly cognizant that the Fed wants to introduce a degree of symmetry at terminal, which in practical terms means that they will do everything they can to keep another rate hike on the table for as long as possible. It's unclear whether or not that extends into the May meeting, but certainly the Fed wants investors to believe that at any of the next three meetings, they could move another 25 basis points.

In the week just past, we also saw a more moderate gain in core CPI than was anticipated. And while headline retail sales dropped more than expected, the control group within the series showed ongoing consumer demand. And given the strength that we saw in the third quarter in terms of real GDP growth, the October data sets up the fourth quarter reasonably well in terms of growth, albeit not as strong as we saw in Q3.

When considering the profile of real GDP growth, it's important to keep in mind that 1.4% of Q3's number was an inventory rebuild, which will presumably translate into a drawdown, if not in Q4, then in Q1.

Vail Hartman:

The interesting part about this week's price action was that despite the significant rally in 2s that traded as high as 5.08 on Monday and below 4.80 on Friday, 10s managed to trail not too far behind the front end as the benchmark traded from 4.70 on Monday to below 4.40 on Friday.

This fairly parallel shift in the curve left 2s/10s in a well-defined, narrow zone at roughly negative 40 basis points throughout the week.

Ian Lyngen:

Vail, you make a great point. The nature of the price action, in and of itself, was notable. We did have that parallel shift in the curve with 2s/10s largely trading in a defined range. But what's interesting is that this occurred at a moment where the Fed Funds Futures Market showed that investors have brought forward the anticipated timing of the first rate cut of the cycle.

Now, we anticipate that this will be an issue for the Fed and we expect that over the course of the next several weeks, we'll see an increase in Fed rhetoric reiterating the notion that the Fed has achieved terminal but has no intention of cutting rates for the foreseeable future.

Now, when we look historically, the market has a strong tendency to take the prevailing monetary policy stance and assume it will hold for the next six months. And then price a transition to whatever the logical next stage is. For example, after a rate cutting cycle, when the Fed shifts to being on hold, we tend to price six months on hold and then some probability of a rate hike after that.

When the Fed is hiking, the future's market prices in six months of hikes and then a plateau. Therefore, now that we've arrived at terminal, it's not surprising to see the market pricing in roughly six months on hold at terminal and then rate cuts after that.

The caveat worth adding here is that in the past what has happened is that's simply been a rolling six month window, and the passage of time reduces the probability of near term rate cuts. And as a result, it's that six to eight month forward window where conviction of rate cuts starts to increase, but near-term moves become less and less likely.

So in terms of trading that, this means that any attempt to price in a rate cut at the January or March FOMC meetings will be a fade, at least in the near-term.

Ben Jeffery:

And a big part of that dynamic has to do with the shift that we've experienced in terms of monetary policy communication over the past month or two. And what I'm talking about here is the committee's increased emphasis on the tightening that the market has done for the Fed, given what that means for financial conditions. Remember, that was one of the few words changed within the language of the November policy statement.

Tighter financial conditions means that the Fed can afford to be more patient and not necessarily continue to raise rates, given the fact that the market has done that for them. So the question becomes if 10-year yields at 5%, more or less, represented sufficiently restrictive financial conditions from a market perspective, do 10-year yields back closer to 4.25 mean that the market is now too easy for the Fed's comfort? And somewhat counterintuitively, might this ultimately necessitate a hike?

All else equal, that logic is sound. However, unlike in the time period in the run-up to the November meeting, we now have a softer NFP print in hand via the unemployment rate, participation rate, headline hiring, wage gains, a softer than expected CPI report we got released over this past week, and a jobless claims print that showed initial filers at their highest level since August of this year and continuing jobless claims at their most elevated level since late 2021.

So while all else equal, the Fed would like rates to be higher. We also now have a series of convincing data prints that tighter policy is working, and that certainly adds to the argument that July was the last hike of this cycle.

Ian Lyngen:

It's also worth highlighting that the debate among market participants has shifted from no landing versus soft landing, back to the soft landing versus hard landing conversations. And that's relevant as we think about 2024 and the Fed's commitment to keeping policy restrictive for an extended period of time and what that risks in terms of excess demand destruction.

Recall that the October employment situation reports showed the unemployment rate increasing to 3.9%, which is above where the Fed had unemployment penciled in for the end of the year. Via the September update of the Fed's summary of economic projections, the committee effectively told us that they were anticipating a solid performance of the employment market into the end of the year. Now with the upward trajectory on unemployment extended to the upside, this begs the question, how will the Fed choose to update projections in December?

We anticipate that the biggest takeaway from the December meeting won't be whether or not the Fed hikes because the market has already moved beyond that and the operating assumption at the moment is that we will receive a Santa pause, as it were. But the key tradable event will be what the Fed does with the 2024 dot.

As it currently stands, the Fed is signaling 50 basis points worth of rate cuts in 2024. That 50 basis points is presumed to be broken down into two 25 basis point fine-tuning rate cuts. The market on the other hand is pricing in more than three 25 basis point rate cuts next year.

In the event that the Fed wants to push back more dramatically on the market's pricing, it's not inconceivable to see that 50 basis points worth of rate cuts reduced to 25. While it's difficult to conceive of the Fed signaling zero rate cuts in 2024, there is a risk that if the committee wants to err on the hawkish side, going from 50 to 25 is a low cost alternative as it were. Low cost from the Fed's perspective, but perhaps not low cost for risk assets.

Ben Jeffery:

And in many ways, that reaction function has been a big part of the Fed's playbook so far this year. The June FOMC meeting represented an important inflection given that Powell felt enough tightening had been delivered, that the emphasis began to shift from getting policy as restrictive as possible, as quickly as possible, to telegraphing that willingness to tighten again if needed, which obviously happened in July.

And given the market's focus on the dot plot, even if it's forecasting power is ultimately suspect at best. That means that by continuing to leverage the dots and diminishing the projected amount of policy easing in any given forward year, Powell will be able to stick to the idea that while the Fed doesn't want to hike, the next meeting, whatever that next meeting might be, the more likely outcome is a hike rather than a cut.

And given the fact that a December move is now all but priced out and clearly we view a January hike as a very low probability event, what this means is that as we get November's jobs data and inflation report, the Fed's going to need to communicate that maybe they will hike in January, maybe they will hike in March.

And to your point, Ian, that introduces asymmetry around the trajectory of the 2024 dots skewed higher, not lower.

Vail Hartman:

Our conviction that there will be no rate cuts in the near term was reinforced by the fact that this week we heard from all four of 2024's new voting members on the FOMC in Barkin, Daly, Mester, and Bostic, who all communicated a message that was consistent with Powell's comment last week that the committee is not currently discussing rate cuts.

And while these policymakers have been encouraged by the progress made on the inflation front, I'll highlight that Fed President Barkin said that he's not convinced that inflation is on a smooth glide path down to 2%. Specifically, he said that much of the drop has been a partial reversal of COVID-era price spikes, which were driven by elevated demand and supply shortages.

What do you guys make of the idea that the easy part of bringing down inflation is out of the way and the hardest part is yet to come?

Ian Lyngen:

I think that that observation is spot on, but I'll also note that embedded in that comment was the idea that, in fact, the Fed did get transitory right, they just got the timeframe for transitory horribly wrong. But nonetheless, that last mile on the inflation front is going to be difficult and it's going to be complicated by the fact that we have seen the potential for lingering upward pressure on nominal wage growth as a result of the actions of unionized workers and collective bargaining power.

Now, setting aside what that might ultimately do in terms of corporate profitability and the potential fallout for equities and risk assets, the reality is that the Fed is still facing the prospects of a wage inflation spiral. And I'll note that as the Fed's messaging transitions from hiking to retaining terminal, we anticipate that incremental progress made on the inflation front will galvanize the Fed's focus on forward inflation expectations, specifically the survey-based measures.

Recall that the most recent University of Michigan survey showed the highest five to 10 year inflation expectations since 2011 at 3.2%. That, in and of itself we'll argue, is sufficient to keep the Fed from even talking about talking about rate cuts.

Ben Jeffery:

And ultimately what this means is that the hurdle for rate cuts has been raised. Yes, realized inflation was softer than expected, but is still multiples of the 2% inflation target. The unemployment rate has begun to move higher, but is still below 4%. And to the inflation expectations point, we've started to see what had been an encouraging downward trend begin to inflect higher, all with the backdrop of a consumer, at least if the retail sales data was any indication, that remains undeterred and continuing to provide a pillar of strength for the overall state of growth.

While obviously the Fed doesn't target growth specifically, as long as wage gains remain lofty, even if they are cooling, that means that the Fed can't afford to begin really talking about lower policy rates until the necessary demand destruction is actually delivered to continue to bring realized inflation, but also inflation expectations and overall confidence lower.

Ian Lyngen:

On the topic of what the Fed can and can't afford, how can anyone afford anything with rates this high?

Ben Jeffery:

I've thought of myself as a serial renter anyway.

Ian Lyngen:

Well, we're eating cereal for dinner at my house.

Vail Hartman:

Cereal's great.

Ian Lyngen:

In the holiday shortened week ahead, the Treasury market will have very little in terms of economic fundamentals to drive the direction of US rates. There's a 20-year auction on Monday, which because of the market closure on Thursday and the early close on Friday, has been brought forward to earlier in the week. That's $16 billion that will hit the market on Monday afternoon.

And it's important to keep in mind that unlike tens and thirties, the 20 year wasn't increased this quarter. That supply event is then followed by Tuesday's 10-year tips auction of $15 billion. The takedown of 10-year tips has tended not to have any obvious implications for the nominal market.

And that results from the fact that if a TIPS auction goes well, that means that investors are worried about inflation and willing to pay up for inflation protection. Therefore, one would assume that nominal yields should be higher and the opposite holds as well.

So as we contemplate what the tips market might actually mean for the overall direction of US rates, it will be more of a hedgeable event than anything else. So for all intents and purposes, that leaves next week's highlight as the FOMC minutes from the November meeting.

Now, in light of the fact that at the November 1st meeting, the Fed hadn't seen the benign core CPI numbers or the retail sales figures, it will be interesting to see how the Fed frames the discussion around their decision to not hike earlier this month because financial conditions were tighter. The market has been tightening for the Fed, and therefore policy rates haven't needed to increase in the very front end.

Now, as the rally continues, whether or not the Fed emphasizes easier financial conditions as a reason to put a rate hike back on the table will be the biggest question between now and the December 13th FOMC meeting.

Let us not forget that immediately ahead of the December meeting, we'll get the November CPI inflation figures. That being said, given how benign inflation was in October, we struggled to see any upside surprise in the November CPI numbers that will actually lead to a December hike.

That's not to say that accelerating inflation couldn't lead the market to price in a much higher probability of a January move. And as the economic data continues to evolve, we expect that the probability of a January hike will increase even though we don't ultimately expect one will be delivered.

In the week ahead, the attention of investors will also shift to the beginning of the holiday shopping season. And as a gauge of the resilience of the consumer in light of higher borrowing costs, headlines associated with the holiday spending will unquestionably garner attention. And if nothing else, provide some incremental trading impetus for US rates.

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 for those who are looking to replace tryptophan usage with a non-chemical solution, we'll offer the reminder that the number one off-label use for Macro Horizons remains as a treatment for insomnia.

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.

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Speaker 4:

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