Dear Santa Pause - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 299: ‘Dear Santa Pause…’ 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 November 12th. And as the market continues to debate the chances that Powell pauses next month, we are reminded of our favorite holiday classic, “If We Make It Through December” – the Holly Cole version, because she's Canadian. 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 past, the biggest event was the Presidential election. Trump won the presidency, the majority of the Senate went to the Republicans, and as it currently stands, it appears that the House of Representatives will also go to the GOP. As a result, this effectively Red Sweep triggered a sell-off in the Treasury market that was eventually met with buying interest and 10-year yields peaked just shy of 4.50% before rallying back to roughly 4.25%. The shape of the yield curve has been volatile within a defined range, and as the proverbial dust continues to settle, we remain biased for a curve steepener driven by the front end as we view two-year yields at their current levels as elevated given forward monetary policy expectations. Now to be fair, part of the red sweep implies a debate about whether or not terminal rate assumptions for the Fed should be revised higher, i.e, are we going to enter a reflationary period for the US? And as a result, should the Fed target an end of their normalization cycle above, let's call it, 3%?

Even if the Fed eventually needs to curtail their normalization ambitions by some amount, it won't be a hundred basis points. It's either going to be 25, maybe 50 basis points. So that means that, at a minimum this cycle, the Fed will get us back to 4.50%, which is another 125 basis points from where fed funds currently stands. All of this is supportive for the front end of the curve because it also comes with a backdrop of potential risks for the global economy being skewed to the downside in the event that the incoming administration triggers broad-based trade wars. This would be consistent with Trump's platform and frankly also consistent with his first presidency. Powell's press conference set a more measured tone for the broader outlook. While monetary policy is unquestionably in data-dependent mode, the direction of travel remains towards lower rates. And the question isn't whether or not the Fed is going to keep cutting, it's the pace at which the market should assume forward rate cuts.

We're open to the potential for a Santa pause in December with a nod to the fact that there's plenty of data between now and that point that could skew the Fed in either direction. One of the most relevant complicating factors is the lingering impact from the hurricanes and how it has distorted the October economic data and will likely still have a lingering impact even if it's nothing more than a give back for the November series. And as we contemplate the balance of the year, we do expect that the 10- and 30-year yields will remain in a reasonably defined range. We do think that the fact that the Trump trade brought 10-year yields just shy of 4.5% represents the upper bound of that range for the foreseeable future. So in the event that we see another backup of 10-year yields above 4.40% or 4.45%, we would look at that as a buying opportunity and that's consistent with some of the recent price action and flows.

Ben Jeffery:

Well, even at the start of the year, this week was billed as one of the pivotal ones for the US rates market and, frankly, financial markets as a whole. The US election and what's increasingly looking like a Red Sweep with President-elect Trump set to move back into the White House in January, control of the Senate with the Republicans as well, and what seeming to be the GOP taking control of the house as well was enough to get 10-year yields almost to 4.50%, although not quite. And then we got a 25 basis point cut from Powell and the FOMC followed up by a press conference that acknowledged the progress the Fed has made in cooling inflation may have slowed, but the committee has gained sufficient confidence in the level of restrictiveness of monetary policy that ongoing normalization remains appropriate. It might be at a slower pace, data dependent of course, but nonetheless, the Fed is going to continue cutting and the results of the 2024 election have not changed that reality.

Ian Lyngen:

The price action conformed with a classic ‘sell the rumor, buy the fact’ event. As you point out, Ben, 10-year yields did almost reach that 4.50% level but have since rallied back. And one interesting aspect of the recent market dynamic is the data from the Japanese MoF that showed a record amount of selling in overseas notes and bonds during the week ahead of the election. So this is data back to 2005 and this record weekly flow came in at roughly 30 billion US dollars. So we're comfortable with the notion that Japanese investors to a large extent took risk off the table in the run-up to the election and presumably between now and the end of the year, those positions will be reestablished. Now it's not likely that all of those flows occurred in the week just passed, so we expect that there will be a renewed dip buying bias as we get closer to the Fed's next rate cut.

Ben Jeffery:

And that's consistent on the one hand with what we've seen ourselves on the desk, and on the other, with the conversations we had with clients of all types in the run-up to the election. The run-up in rates we saw towards the end of October certainly prompted more questions than answers given the lack of real fundamental catalysts that got 10-year yields back up to this new higher range. And then what was, we’ll argue, aptly characterized as a buyer's strike ahead of firstly, last week's payrolls report. But then, this week's event risk as well, has resulted in an increased willingness to take advantage of rates that are now back at effectively their highest level since July. The quote-unquote Trump trade has now played out. The ramifications for issuance probably will be defined over the coming quarters, but the fact that reflationary concerns and the positive growth implications from a Republican government are now more or less reflected in the outright level of yields, it begs the question: what remains as a potential trigger to get 10-year yields back to 4.75% or even 5%?

Given that the Fed and other central banks are in the process of continuing to bring rates lower and that the global economy continues to trend softer, we'll argue there's more reasons to like Treasuries, especially in the front end of the curve, than there is to actively sell them.

Ian Lyngen:

And we do remain constructive on the Treasury market more broadly, in part because we view the potential from an increase in tariffs and an escalation of a global trade war as being a net negative for global growth. We do know that tariffs will lead to pockets of inflation. But, if this is comparable to the episode that we saw in 2018 when tariffs more dramatically impacted intermediaries, then it's unlikely that this ultimately translates through to CPI or PCE. It's only in the event of blanket tariffs on finished goods that we would expect that to translate through to the Fed's favored measure of inflation. More importantly, tariffs are one-off increases in prices and they are not, in and of themselves, a repeat inflation event. So instead, we would expect that in the event of a wholesale increase in tariffs across the board that any impact on the realized data would be characterized by monetary policy makers as a tax on consumption as opposed to a trigger for a reflationary spiral.

Now when we put this in the context of near-term monetary policy expectations, frankly the results of the election are not going to have an impact on whether or not the Fed pauses in December. The market is currently pricing in about a 70% probability that the Fed does follow through with another quarter point cut on the 18th of December. And we'll characterize that as about fair because there is a chance that the economic data between now and the middle of December puts the Fed in a position that it would want to pause to reassess the trajectory of inflation and growth. There are three major data releases that will help define the Fed's agenda. First, we have CPI in the week ahead. Now this is October's data and therefore it will be impacted by the hurricanes, and the current consensus is for a 0.3 with an upside potential. So we could actually see a core-CPI print at 0.4. That being said, easy information to dismiss given all the noise created by the hurricanes.

The Fed and the market will then also have the benefit of November's Nonfarm Payrolls and November's CPI before it meets and decides whether or not to pause or cut another 25. So in light of Powell's tone at the press conference and the consistency of the Fed's messaging regarding being data-dependent, monetary policy is now in an ideal place to respond accordingly to the evolutions of the real economy.

Ben Jeffery:

And Treasury supply also remains relevant, especially given the discussion around any impending fiscal changes that may be coming next year. But what we saw this week at both the new issue 10- and 30-year auctions hardly painted a picture of primary market sponsorship for Treasuries that isn't willing to show up at current levels. A dynamic that's made all the more relevant given the volatility we experienced this week and the fact that tens came on Election Day and thirties followed on Wednesday, and on the strength of the thirty-year auction specifically, it's not entirely clear that Wednesday's auction result was a function of foreign buyers coming back in to buy duration given that overseas allocations of thirties are usually far less than what we see at 10s, for example. And what we saw in the Ministry of Finance data this week with what that means for Japanese investor behavior obviously, but also indicative of overseas buyers of Treasuries more broadly, the generally solid results we saw for this week's long-end auctions, even amidst everything else that was going on in the market, is a point of support for the argument that even when coupon auction sizes start growing again at some point in the middle or later part of next year, there's still more than enough demand from domestic and overseas investors to continue to take down Treasury auction sizes that remain unquestionably large, but are also dollar-denominated. And that will continue to be a unique benefit to Treasuries as an asset class.

Ian Lyngen:

Another takeaway from the election, and what we're presuming will be a Red Sweep, is that it lowers the probability that we have another debt ceiling debacle in the year ahead. There's a higher chance that there'll be agreement and a willingness to further suspend the debt ceiling, which, while presumably also associated with an increase in Treasury coupon auction sizes in the latter half of next year, will at least reduce the probability of a delayed payment or a downgrade by one of the major rating agencies. So certainly from a structural perspective, it was a net positive to the Treasury market and at least marginally contributed to some of the dip buying interest.

Ben Jeffery:

And that also means as we get into the early part of 2025, a massive rundown of the TGA is at least marginally less likely, if in fact we'll be able to get through this current debt ceiling episode without too much volatility in the money market space. This also on the margin will tie into what the Fed plans to do with the balance sheet and given what we heard from Powell, which was nothing effectively, on any impending change to the pace of QT or plans to stop the runoff of SOMA anytime soon, this means that as we look towards first, November's month end, but also then more importantly, the end of the year, any similar volatility in repo markets to what we saw at the end of Q3 is going to be an important factor for the Fed to consider as they look forward into next year and ponder just how much further they want to shrink the balance sheet.

Lorie Logan's speech several weeks ago clearly set the table for what we saw in the FOMC statement and heard from Powell at the press conference in that for the time being QT is going to continue as it has been, and that some volatility in funding markets is to be expected and is part of a normally functioning market. Now, where the line in the sand is drawn between normal market volatility and enough of a spike in money market rates that warrants a rethink of balance sheet policy is the trillion-dollar question, but we probably won't get any real clarity on that until the end of the year and what we see play out in the shortest part of the curve as we move into 2025.

Ian Lyngen:

It's worth observing that we're unlikely to have a repeat of that 2023 dynamic as it relates to the balance sheet and the TGA. Recall that at the beginning of 2023, because of the debt ceiling debate, the TGA was being drawn down, which was effectively the Treasury department doing QE at a moment where the Fed was doing QT. They largely offset one another. And so it wasn't until the middle of the summer and the second half of 2023 that we saw what we'll characterize as ‘turbocharged QT’ take place. That was a period in which inflation started to subside and we saw risk assets correct lower. So if nothing else, the election results and the composition of Congress suggest a smoother run down of the balance sheet without the distortive impact of the TGA.

Ben Jeffery:

TGA, the giant account, right?

Ian Lyngen:

Or the Treasury's general account, but truly same, same.

In the holiday shortened week ahead, the most relevant piece of economic data comes on Wednesday in the form of the October CPI series. Expectations are for a 0.3 core CPI print with some probability of an upside surprise. So the market is currently biased for another round of economic data that reiterates some of the stickiness seen in the inflation complex. The most important caveat in this regard is that this is data for October, and so there will be some hurricane impact on prices. That being said, as we saw with the October payroll series, recall headline Nonfarm Payrolls increased just 12,000 during that month, the market was more than willing to downplay any distortions from the economic data and continue in the case of the BLS data from October, pricing in the Trump trade. Now, one of the key distinctions as we move into the CPI release is that investors are not faced with the same amount of election uncertainty.

We now have confirmation on the election front as well as the Fed's November 7th rate cut. And so as a result, the market is in a relatively clean place to respond to the economic data. Recall, that we also have the Fed's Senior Loan Officer Opinion survey, which despite expectations for some degree of tighter lending standards, has continued to show an overall healthy environment for credit generation. This far into the cycle, one might've otherwise expected to see tighter lending standards as a theme, and so the fact that that has failed to materialize certainly reinforces the no landing narrative. The final key data point in the week ahead is October's Retail Sales figures. Given the recently demonstrated resilience of the consumer, even a downsized surprise in October's data will be relatively easy to dismiss given the degree of noise in the series. And as a theme, we do expect that the Fed will de-emphasize the data in October and November simply because of the impact of the hurricanes.

Now, that doesn't mean that the Fed has pulled back from their data-dependent stance, but rather, they will be content to look at the broader trends that were established prior to the hurricanes and, we suspect, extrapolate that into their understanding of the current realities in the US economy. Two of the key takeaways from Powell's recent press conference of relevance were that monetary policy will not respond to the potential for future fiscal changes, i.e., anything that could be reflationary from the administration, anything tariff-wise, anything corporate tax cut-wise. The other takeaway is that Powell intends to run out his full term at the Fed, which means that he will remain the chair of the FOMC until the second quarter of 2026.

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 we look forward to next week's 300th episode of Macro Horizons, it strikes us that we've published approximately 100 hours of our market musings. All that we can say is that if you're still awake, we have failed. 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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