Finding Balance - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 301: Finding Balance, 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 25th. And as the bearishness in the Treasury market appears to have stalled out at 4.50 10s and the crosscurrents have stabilized rates, it strikes us that we could all use a little more balance, especially jugglers on unicycles. Man, should have never left the circus.

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 themes in the Treasury market were relatively straightforward and they were those of consolidation and dueling market narratives. The first being the reflation trade that has been very consistent across the last several weeks and that eventually pushed 10-year yields as high as 4.50%. Now, the market did receive a stabilizing bid on geopolitical tensions and that brought 10-year rates back into a very familiar environment. And we've been focusing on the nine-day moving average, which is 4.40%, as the new anchor for benchmark 10s until there's something more decisive from a macro perspective. We're certainly open to a retest of 4.50% in 10-year rates in the event of a material change in the macro narrative.

That being said, we see a more compelling case towards lower rates in the near term, with the 4.25% level as an obvious initial target followed by the 4.20% level, which represents the 200 day moving average. Now, it's difficult to make a particularly compelling case to move below 4% before the end of the year without confirmation from the Fed that not only is the process of normalization still their base case scenario, but a pause will only be temporary and a resumption of rate cuts with the goal of returning policy rates to roughly 3% is the path of least resistance. Now, we're certainly cognizant that there's a very big debate in the market at the moment between whether terminal should be penciled in at 4% or the market should hold on to the Fed's prior estimates at 3%. We are going to err on the side of taking the Fed at face value with a nod to the fact that the December SEP could see a modest increase to the 2025 and 2026 dots, but the order of magnitude being a quarter-point, not 50 or 75 basis points.

As a result, we continue to like the two-year sector as it should benefit in the event that the Fed does cut rates in December as anticipated, and the SEP reflects only a modest increase in the terminal assumption, if at all. In fact, given that Powell has been very consistent in his messaging that monetary policy won't be adjusted to a future potential change from Washington DC on the tariff or trade side, one might be better served to err on the side of assuming less change to the dot plot as opposed to more. It goes without saying that the two-year sector will benefit the most from any dovish takeaway from the Fed. Although it is important to keep in mind that between now and the 18th of December, the Fed will have the benefit of the November payrolls report alongside November CPI figures, all of which could easily confirm the 25 basis point rate cut that we're using as our base case scenario.

At the same time, the pendulum of economic sentiment could swing further to the positive side, thereby laying the groundwork for a Santa Pause, as it were. Again, not our base case, but we have to be cognizant that as the Fed has been consistent in its messaging, that the pace of normalization is going to be data dependent. The data still has a vote in whether or not the Fed moves in December. And nonetheless, we do remain constructive on the Treasury market and we expect that by the end of the year, we will look back at the extremes that are currently priced in in US rates as attractive buying opportunities as the market refines expectations for 2025 and beyond.

Ben Jeffery:

Well, after last week's pivotal events, we came into the current trading week without the same marquee macro events to offer trading direction. And so really, the question was – would 10-year yields be able to break sustainably above 4.50% or has the market settled into a new trading range as investors await the next key pieces of information to inform the trajectory of the real economy and what it means for the Fed's decision in December, but also throughout the course of next year, and ultimately when and where it is that Powell will reach terminal? And while maybe there was a chance at a bearish breakout to start the week, instead what we saw was a reminder of the safe haven status of Treasuries as an asset class as escalations between Ukraine and Russia, and a reminder of the role that geopolitics plays in dictating the level of 10-year yields was enough to bring rates off the highs, certainly not enough to bring us back to 4% tens, but Treasuries are still an insurance product for "something going wrong."

Ian Lyngen:

And it does seem that almost invariably something does go wrong. I will note that the fact that 10-year yields appear to be anchored at 4.40%, which is the nine-day moving average, speaks to the fact that the lack of fundamental inputs has left the market to trade in a relatively technical range. Now, 10-year yields did momentarily touch 4.50% before drifting back to 4.40%. And the crosscurrents created by the geopolitical tensions do speak to the idea that we are in a consolidation mode for the Treasury market and we'll need something far more significant than what has occurred over the last several weeks to break us out towards 4.75% or even 5% 10-year yields. Our expectations are the opposite and we anticipate that yields will drift a bit lower from here as the market, as you point out Ben, does refocus on Treasuries as an insurance product in case something goes wrong, as well as the notion that as a theme, the market has underpriced the risk of economic downside in 2025 and 2026.

The no-landing narrative has become investors' default for all intents and purposes. So we'll argue that from this stage, any softer data will trigger a more dramatic response than any data that simply confirms that the labor market remains on strong footing and the US consumer is in a position to continue driving domestic growth. Now, we did manage to make it through what was arguably one of the biggest single earnings reports of the season, via NVIDIA. There was no lingering impact in the US rates market, so if nothing else we're content to characterize this as the passing of an event risk as opposed to a defining event per se. Now, in conversations with clients, one of the most topical issues at the moment is how cheap the two-year sector continues to look versus what is widely viewed to be a Fed intent on continuing the process of normalization.

It's important to keep in mind that when the FOMC meets on December 18th and presumably delivers another quarter-point cut, effective Fed funds and two-year yields, at current levels at least, will be right on top of one another. And when we think about what that implies for the next 24 months of monetary policy, the market is either saying that the Fed won't cut again over the next two years or the Fed will cut a few more times but then need to increase policy rates in 2026. Neither of those scenarios are especially consistent with what we have been hearing from monetary policy makers. Although to be fair, Powell has done a reasonably good job of preparing the market for a pause at some point. We have it penciled in for January as opposed to December. But we are cognizant of the relevance of the November payrolls data as well as the November CPI series, both of which the market and the Fed will have before its next meeting.

Ben Jeffery:

And even though this week didn't really hold any needle moving data releases, there was no doubt a heavy slate of Fed speak. We heard from Collins, Cook, Goolsbee, and others who all reiterated this idea that yes, the economy is performing well, and up to this point, the resilience that's been demonstrated in the labor market and in terms of overall growth doesn't necessitate another 50 basis point cut. And if we continue to see solid performance, maybe it will be appropriate to pause rate cuts at some point or move at a slower rate back toward neutral. The critical aspect of this line of thinking, and similar to what we saw within the language of the November FOMC statement, is that the Fed has more or less declared victory on inflation and they've now seen enough in terms of inflation's response to tighter monetary policy that they're comfortable continuing on the path of normalization.

We also heard from several of those FOMC members over the past week that there are still risks present in the labor market. And given the well-discussed lagged impact of monetary policy, that means that if there's risks facing the labor market and there's more damage yet to be realized from a departure point where Powell has told us that any further softening in the labor market would be undesirable, then all that means is that the path forward is still toward lower rates. And so, exactly to your point Ian, barring communication from the Fed that cuts are over and that the next move from the Fed might potentially be a hike, that should leave the forward path of overnight rates as downward sloping. And so having two-year yields being even close to flat to effective Fed funds on the one hand incorporates no insurance premium for something going wrong and on the other is inconsistent with the messaging we've seen from the FOMC. Although clearly as we continue to watch two-year yields hold at these levels, investors are waiting for a catalyst to drive that move before really taking advantage of rates at these levels.

Ian Lyngen:

I think that that's a fair characterization. And as we contemplate the path forward for monetary policy rates, it's important to keep in mind an observation made by Powell that as we get closer to neutral, he anticipates that the pace of rate cuts will slow. Now putting that in the context of whether or not the Fed moves in December, it'll be difficult for Powell to communicate that they're going to skip December, resume in January and still hold the terminal projection that we saw in the September SEP, which is effectively 3%. One of the biggest wild cards for the December 18th meeting will be whether or not the Fed chooses to simply mark to market the SEP to reflect what the futures market is pricing in at the moment. For context, and at the risk of oversimplifying the issue, the market is suggesting that the Fed's terminal rate for this cycle is 4%, whereas the Fed has been communicating it being 3%.

Now, we find it very difficult to envision the Fed increasing the 2026 dot by 100 basis points to match what's priced in the market. We may get a 25 basis point net increase, but that will still leave a meaningful divergence between what the market is pricing in and how the Fed sees events unfolding. At its essence, there is a debate about whether or not the incoming administration will create an environment that is reflationary enough for the Fed to need to respond via a higher terminal rate. Powell has already come out on a number of occasions and said that monetary policy won't be changed based on the potential for policy changes out of Washington. And that messaging clearly translates into the Fed being likely to keep the 2025 and 2026 dots where they were in September with a modest risk that they increase somewhat.

It's also worth considering how the Fed views tariffs versus how the market views tariffs. We're anticipating that when Trump takes office in January, that he will announce a variety of targeted increases in tariffs primarily on raw inputs. Using the 2018 episode, one should expect those types of tariffs that translate into profit compression for the intermediaries as opposed to propping up headline or core CPI. What becomes more interesting is that later in 2025, one should expect more far reaching increases in tariffs that encompass a large portion of the goods coming into the US. Now, this is the type of inflation that will actually hit CPI and the realized inflation measures. And it warrants considering how the Fed would characterize these type of increases in consumer prices.

First, tariffs represent a one-off level set change in prices. So they're not the type of demand-driven inflation that the Fed tends to worry more about. Equally as importantly is the fact that the Fed's emphasis on the super core measure of inflation, which is core services ex-shelter, excludes anything on the goods side. And so, while goods inflation might increase core-CPI for a month or two, it will more likely than not be characterized by monetary policy makers as a tax on consumption as opposed to true demand-driven inflation. Which lessens the probability that the Fed chooses to respond to it with either fewer rate cuts or a higher terminal.

Ben Jeffery:

And the new incoming administration's impact on the economy and the market goes beyond just what will likely be new tariff policy. But as we continue to see President-elect Trump's cabinet picks, we've also heard the idea offered that the emphasis on streamlining the operations of government and increasing efficiency in Washington actually runs the risk, and a risk that is underpriced from the market's perspective, of the inverse implication of what we saw with the, "Trump trade." If in fact the point of emphasis for the new administration is going to be cutting costs and reducing spending, firstly, what that does is moderates the risk of a sooner or larger increase to Treasury coupon auction sizes.

And secondly, there's growth and employment negative implications from less fiscal support from the White House and Congress. And what that all ultimately points to, in addition to the potential growth negative impacts from tariffs, is a slower growth environment, perhaps less robust hiring and issuance that is maybe not as large of a concern as was initially thought to be the case. And while grand policy changes on the fiscal side are certainly not our base case, when the new government takes over in January, in terms of an underpriced bullish risk to the long end of the curve and a counterpoint to the surge in term premium that we've experienced over the past several weeks, it's food for thought if nothing else.

Ian Lyngen:

And it used to be that they called such measures austerity. Now they call it efficiency.

Ben Jeffery:

All about branding.

Ian Lyngen:

In the week ahead, the Treasury market will have a variety of inputs from which to derive trading direction. Perhaps the most relevant will be the core-PCE numbers for the month of October. As it currently stands, the consensus is for a three-tenths of a percent increase in core PCE. And as the Fed's favored measure of realized inflation, it follows intuitively that the market will be closely watching the details of core-PCE and the implications for monetary policy. We'll caution against assuming that an acceleration in line with market expectations will translate into a slower process of normalization as the Fed contemplates the December 18th meeting. Powell has already commented that the path back to the 2% objective for inflation will be bumpy. And to a large extent, we'll argue that that was an effort to excuse away the October data series.

Keep in mind that the Fed will also have the benefit of the November CPI data before it makes its decision on the 18th of December, which will afford the Fed at least a little bit more clarity on the overall direction of price inflation. The week ahead also contains three key auctions. The $69 billion two-year on Monday followed the $70 billion five-year on Tuesday. And then capped with the seven-year at $44 billion. This front-weighted supply, when combined with the policy relevance of the recent developments, suggests that there will continue to be crosscurrents in the very front end of the market. And as we see two-year yields at roughly 4.30%, the debate about what happens when effective Fed funds is cut to effectively the same level on the 18th of December – will funds serve as a ceiling or a new center point for the two-year sector? All else being equal, we struggle to imagine that it doesn't serve as a ceiling, which leaves us biased lower in front end yields and with an eye for a potential bull steepening of the curve.

It certainly isn't wasted on us that the most recent Initial Jobless Claims figures came in at just 213k. Now, this is data that represents Nonfarm Payroll Survey Week and therefore will factor in prominently for investors' estimates of the November NFP data. It is also consistent with the resilience of the labor market narrative, and in this context, we'll be very interested to see Tuesday's release of the FOMC minutes from the most recent meeting. The debate about what it would take to pause in the path of normalization and any concerns about how to incorporate what will likely be a reflationary bias as a result of the incoming administration will be of note. The market will likely focus on any incremental angst on the inflation side linked to Trump's victory. Although at the end of the day, we maintain that the impact of tariffs isn't universally reflationary, nor should tariffs be considered solely from the perspective of inflation as there are also broader implications for global growth as well as profitability.

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 with an eye on the truncated trading week ahead, topping this year's list of giving thanks will be SIFMA. No, seriously. 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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