CP-Ides of March - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 264: CP-Ides of March, 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 March 11th. And with attention squarely on Tuesday's inflation data, we cannot help but notice that Friday sees the Ides of March, much scarier than Friday the 13th. Sorry, Freddy Scissorhands. 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, it's tempting to focus on the payrolls report and what that might imply for the near term bias on monetary policy, but there were also a couple other things that occurred that are worth addressing. First being the success of Trump and the Republican primaries. Clearly, it is shaping up to be a rematch of Biden versus Trump in November, and while we'll stop short of having any strong bias in terms of how that will ultimately play out, it does remain an important backdrop for the market as a whole. We were cautious against using 2016 as a playbook for how the market might respond to a Trump victory. The reality is, in 2016, Trump's election to the White House was much more of a surprise than it would be in 2024.

So at least from the perspective of the U.S. rates market, the price action will be muted unless there is a GOP sweep that takes both the House and the Senate. And then the implications will be pro-business, marginally inflationary, and presumably bias investors a bit higher on their deficit estimates. The other development of the week just passed that warrants acknowledging is some of the commentary from Powell in his semi-annual congressional testimony. He floated the notion that, while the FOMC might not be fully convinced on the inflation front, it's not that far off, which reinforces our intuition that there will be a heavy emphasis on the realized inflation data over the course of the next couple months, as it will dictate whether or not the Fed is comfortable delivering the first rate cut of the cycle in June, or if it chooses to delay the departure point into the third quarter.

We're somewhat concerned that delaying the first rate cut too far into the year will run up against the September meeting. Now, if we look historically, monetary policy makers are unwilling to embark on a new course of policy immediately ahead of the presidential election. Said differently, if the Fed is on hold in the run-up to the election, they will stay on hold in the meeting immediately ahead of the presidential election. In the event that they're hiking, they'll keep hiking. If they're easing, they'll keep easing. So the departure point for the first rate cut is particularly relevant given the political backdrop. All of that being said, it ultimately comes down to the trajectory of the economic data and perhaps, more importantly, the Fed's perception of whether or not the trajectory is consistent with getting inflation back to the 2% target.

We maintain that the February CPI numbers will be especially influential in determining whether or not the FOMC is willing to signal 75 or 50 basis points worth of rate cuts in 2024 when they publish the SEP on the 20th of March. The dot plot will give context for the Fed's current thinking on the number of rate cuts this year that will ultimately be appropriate. That being said, clearly the dot plot is prone to revisions and ultimately we are in a data dependent mode and the Fed has done everything that they can to communicate that it's retaining as much flexibility as possible as the committee attempts to interpret the incoming economic data.

Vail Hartman:

On the first day of Powell's semi-annual congressional testimony, the Chair said it will likely be appropriate to begin dialing back policy restraint at some point this year, leaving the door open to a wide range of outcomes for the path of Fed Funds in 2024. But on the second day of the testimony, Powell offered better color on the committee's policy stance by saying the committee is not far from reaching the confidence needed to cut rates. And this reassured the market that a cut may be coming sooner rather than later. And, on Friday, the details of February's NFP report and specifically the slowest monthly gain in average hourly earnings in two years helped alleviate some of the inflationary angst associated with sticky wages and supports Powell's messaging that the first rate cut is nearing.

Ian Lyngen:

I think that's a very fair characterization and, to a large extent, the market has been focused on this notion that January, whether it's on the inflation side or on the job creation side, could have been an outlier that was seasonally distorted and therefore created a question mark for the broader policy narrative that could easily be resolved as the February data comes into focus and the non-farm payrolls print combined with the unemployment rate at 3.9% and the notably soft average hourly earnings print conforms to this idea. And the perception very quickly became that the anomalies in January are going to be quickly resolved as the first quarter's data unfolds, and we'll find ourselves in a situation where we're back to the baseline assumption that rate cuts are coming and, while they might not be dramatic, they will start what will ultimately be the cyclical re-steepening of the curve.

Now, we're very much on board with the notion that the most prudent expression of this year's big macro trade is patience when it comes to the re-steepening of the curve. But ultimately, 2s/10s are not only going to end up in positive territory, but given the current departure point, they'll probably be 100 basis points steeper than where we are at the moment. So that puts 2s/10s at positive, let's call it 50 basis points, although it's difficult to have a real conversation about that trade without acknowledging some of the negative carry implications. And to a large extent, it's that dynamic that's really prevented the market from pressing the steepening trade. Although, to be fair, there's also enough uncertainty with where the Fed really is in the retaining terminal for the foreseeable future process that a bit of caution does seem warranted and prudent.

Ben Jeffery:

And in looking at this cycle as a whole. One of the main macro questions has been, are higher policy rates and a restrictive Fed really going to be effective, firstly, at cooling the acceleration in inflation we saw coming out of the pandemic? And secondly, will that policy bias from the Fed actually have implications for the labor market? After all, the hallmark of the post-pandemic economy has been the remarkably resilient hiring landscape and even as inflation has come down, aided in part by supply side factors, but also demand ones as well, the question in the later part of last year became, was Powell really going to be able to do it? Was the Fed going to be able to pull off a soft landing where inflation progressed sufficiently back toward 2% without requiring a substantial softening in terms of jobs?

Now, what we've seen this week via NFP and also the JOLTS on Wednesday that showed another drop in job openings and a decline in the quits rate to just 2.1% have all shown that, while in outright terms the job market is still solid, a 3.9% unemployment rate is hardly a bad thing, but the trend continues to be towards softer, not a re-tightening of the labor market as a function of job openings that are dropping, a quits rate that's declining as jobs become less available, and workers are less willing to leave their current roles, which is all boiling down to a more temperate wage landscape as exemplified by Friday's average hourly earnings numbers, and headline job growth that's solid, but it's not as solid as January's payroll's numbers would have initially suggested.

So while there have been some rumblings about the Fed pushing out cuts to Q3 or even beyond, maybe even reintroducing the potential for a rate hike, now that we've again seen significant evidence that monetary policy is working, it justifies what will ultimately be that first step toward less restrictive monetary policy at some point in the second quarter and a steeper yield curve.

Ian Lyngen:

To be fair, we came into the Non-Farm Payrolls Report assuming that the headline would be largely ignored in favor of the nominal wage growth, and to a large extent because of the magnitude of the revisions that ultimately did end up being the case. And perhaps more aptly, one could characterize the response to the payrolls report as a opportunity to trade CPI before the number actually hit. And I think that that's a fair characterization and, as a result, the onus now is on the official CPI data to confirm that inflation during the month of February wasn't outpacing expectations with a nod to the fact that the consensus is for core-CPI to have gained three-tenths of a percent in February. One of the things that remains a wild card to a large extent is the overall easy financial conditions that are in place. And one of the conversations that has consistently come up among market participants is the notion that the wealth effect that's being created by the gains in the equity market is in and of itself stimulative to inflation.

To a large extent, we can sign off on that. That makes sense given where we are in the overall cycle. However, the trajectory of home prices in this environment I'll argue is probably as if not more important than the incremental gains in the equity market. The nuance worth highlighting here is the fact that mortgage rates remain very high by recent standards, let's call it roughly 7%, and we continue to see stable if not slightly appreciating home values, and that implies that there is a meaningful disconnect. It's worth considering what will happen when the Fed starts the process of normalizing rates lower. Presumably, mortgage rates will edge lower as a result, and that could alleviate one of the core constraints in the housing market, and that's been supply.

Envision a situation in which the average mortgage rate drops by, let's call it, 150 or 200 basis points. Clearly, that's going to bring more supply onto the market. The issue becomes, will that supply be absorbed at higher prices or will that ultimately be the trigger to recalibrate and mark to market home prices in a comparatively higher mortgage rate environment than was the case during the peak of the pandemic? We suspect that the short answer is, yes, prices will drift a bit lower and we will ultimately find a new clearing level. And while it is relatively counterintuitive, we're comfortable with the notion that lower mortgage rates that bring on more supply to the housing market could ultimately result in a recalibration lower in home prices that provides stability and further downward pressure on OER and the shelter component within the inflation series.

Ben Jeffery:

And as another facet of the post pandemic economy, a big driver of that reaction function is, again, probably going to come down to the state of the labor market. To think about housing from the supply side angle and the borrowers that locked in very low rates at some point over the last three or four years, those would be sellers are going to be extremely reluctant to sell their house and accompanying mortgage rate in order to trade into another mortgage rate that is now multiples of where average borrowing costs were just a few years ago. So this means that the downdraft in home prices and what will ultimately be selling pressure that emerges is going to have to come from sellers that presumably don't want to sell their homes but instead have to. And it's not difficult to imagine the unfortunate catalyst for a lot of the selling pressure that will ultimately need to take place in the form of a higher unemployment rate, presumably lost wages, and a general downshift in terms of households' outlooks.

And to bring it back to what you touched on in terms of the equity market, Ian, this again would presumably come with some downward pressure in equity prices, widening of credit spreads, and a more traditional risk off trading environment that would accompany a higher unemployment rate. Now, in February, we saw the unemployment rate move higher from 3.7% to 3.9%. And 3.9% is certainly not high enough to serve as that trigger point, but another month or two of employment data that looks a lot like February's did would be enough to at least start raising that question.

Vail Hartman:

And this week's CPI data will play a crucial role in refining dot plot expectations for March 20th and specifically assumptions around the median 2024 Fed Funds dot. Just before Friday's Payrolls Report, our team's pre-NFP survey revealed that respondents were effectively indifferent whether the SEP would show 50 basis points or 75 basis points of rate cuts by year-end. Specifically, a slight majority, 47%, said 50 basis points would be forecasted. And it was a close call with 45% anticipating no revisions to December's 75 basis point projection. And only 4% responded 100 basis points whereas, on the other end of the spectrum, 4% also answered 25 basis points. Now, I'll argue that on the margin, February's NFP data bolsters the case for 75 basis points projected by year-end, but ultimately inflation remains in the driver's seat at the moment and CPI on Tuesday will cast the most influential vote for expectations. A 0.4% month over month read on core would undermine the assumption that January's bounce in inflation was the anomaly and support the case for 50 basis points of rate cuts by year-end.

Ian Lyngen:

And Vail, in thinking about CPI, there's also the situation going on around shelter inflation and what we've heard a lot of conversation about in terms of rents and OER.

Vail Hartman:

One of the biggest irregularities within January's CPI data was the divergence between OER and rent. Specifically, the 0.6% gain in OER was associated with a relatively more pedestrian 0.4% gain in rent. And the 0.2 percentage point difference between these two gains was the largest in nearly three decades. And this raised alarm for a lot of market participants simply because of how uncommon the divergence was. In the interim, there's been much controversy over what drove the change, and at the end of the day, there remains a high level of uncertainty whether the divergence was attributable to re-weighting factors, seasonal noise, or truly marked an inflection towards higher OER gains, leaving this a space that will surely come under close scrutiny on Tuesday.

Ian Lyngen:

So if nothing else, I think that is fair to say that both monetary policy and the market's broader perception of where we are in the cycle has shifted well into the range of uncertainty above all.

Ben Jeffery:

Well, that leaves one thing for certain.

Ian Lyngen:

Are you sure?

Vail Hartman:

Certainly.

Ian Lyngen:

In the week ahead, as the market continues to digest the non-farm payrolls numbers, the biggest focus will, obviously, be on the inflation profile in the month of February. CPI is released on Tuesday and expectations are for headline inflation to have gained four-tenths of a percent during the month of February compared to three-tenths of a percent in January. Perhaps, more importantly, the market will be watching for the pace of core CPI where we see the consensus is for a three-tenths of a percent gain as opposed to January's four-tenths of a percent increase. Now, recall that within the CPI series we saw the core services ex-shelter component reach its highest level since September 2022, and that really rekindled conversations among market participants about the potential for a wage inflation spiral.

Now, obviously, there's a lot that would need to occur before the Fed would be truly concerned that we are facing another leg higher on the inflation front. In fact, even a higher than anticipated CPI print for the month of February wouldn't necessarily change the Fed's response function to higher than anticipated realized inflation data. Monetary policymakers have made it very clear that they intend to address sticky inflation via delaying rate cuts. Now, the flip side of that is obviously once inflation begins to moderate and move closer towards the 2% target, then it follows intuitively that the Fed would be willing to start the process of cutting rates. Now, it's important to keep in mind that certainly from the Fed's perspective, there is a material difference between cutting and easing. Cutting rates would simply be reducing the amount of restriction that the Fed has placed on the real economy, whereas easing would imply going below the Fed's estimate of neutral.

Given that the departure point is 5.50% for Fed Funds, Powell has a great deal of rate cutting to do before the conversation about easing becomes relevant. That being said, we'll be the first to concede that this is a nuance that the market we suspect is going to continue to struggle with. And in practical terms, this implies that the market would need to see some type of fundamental trigger or, said differently, a more material deceleration of the real economy to justify cutting rates. Powell has done an admiral job of floating the idea that rate cuts are nearing on the horizon if not imminent. In addition to CPI, Thursday sees the release of the February retail sales numbers. Now, expectations there are for a solid increase in both headline and the control group, which would offset the weakness that was seen in January. Recall, however, that the pace of consumption at this stage in the cycle is secondary to what we're seeing on the inflation side with CPI and the broader perception of consumer price inflation driving the next stage of the rates cycle.

We'll also see a reasonable amount of supply hit the market in the form of $56 bn 3-years on Monday, followed by $39 bn 10-years on Tuesday, and capped with $22 bn 30-years on Wednesday. Note that the auction cycle has been brought forward by a day simply because of the timing of the 15th, which is on Friday. All else being equal, we wouldn't typically suggest that the timing of the auction cycle itself would dictate the results. However, given that Tuesday sees both the 10-year auction in the afternoon as well as CPI in the morning, if nothing else, there will be a more limited window for the auction set up, and therefore the take down of 10-year supply might be a bit more precarious than it might have otherwise.

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 anyone else who might've otherwise forgotten, Sunday is the beginning of Daylight Savings Time, although we're still left to ponder exactly what we end up saving on a rainy day. Just a thought. 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:

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