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For the Birds - The Week Ahead

FICC Podcasts Nos Balados 22 novembre 2023
FICC Podcasts Nos Balados 22 novembre 2023
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Ian Lyngen, Ben Jeffery, and Vail Hartman bring you their thoughts on the U.S. Rates market for the upcoming week of November 27th, 2023, and respond to questions submitted by listeners and clients.


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About Macro Horizons
BMO Strategists discuss the week ahead in the U.S. rates market delivering relevant and insightful commentary to help investors navigate the ever-changing global market landscape.

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Ian Lyngen:

This is Macro Horizons episode 250, For The Birds, 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 27th.

As open AI becomes closed AI and team strategy struggles with our own dearth of I, we're reminded that intelligence takes many forms, all of which have proven very elusive to us.

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 treasury market had another data point on the supply front worth contemplating, specifically a strong reception to the 20-year auction. Now recall that the struggles seen at the 30-year refunding reiterated concerns that the amount of supply that's hitting the market will become increasingly difficult for the market to digest. One of the concerns that we've had over the last two refunding cycles has been the search for the incremental bond buyer and how that plays out in the primary market, i.e. at the auctions themselves.

What we have seen thus far with a few exceptions is that the supply and demand dynamics remain relevant, particularly in terms of the shape of the curve, but ultimately the outright level of yields are a function of growth and inflation expectations, while the front end of the curve remains closely linked to the monetary policy outlook. As the Fed's first rate cuts approach on the horizon, we anticipate that the two-year sector will eventually become unmoored from the 5% level and drift lower over the course of 2024. The key aspect of this outlook, however, comes in the form of when that shift begins. And given how committed Powell remains to reestablishing price stability in the US economy, we anticipate that the Chair will err on the side of being restrictive for longer than the market currently expects.

Now, the signaling around that could come in one of a variety of different ways, not least of which on our radar is the SEP and the dot plot for 2024. It goes without saying that the 2023 dot will be lowered to match the current effective fed funds at 5.33%. The operative question quickly becomes what do they do with the 50 basis points of cuts signaled for next year? We can see a reasonable path that that is reduced to 25 basis points. It's also conceivable that it remains a 50 basis point rate cut message. All else being equal, we do think that between now and the end of the year, the most tradable policy event does come in the form of the Fed's updated forecast. So this is an area to watch closely if nothing else.

All else be equal, we expect to go into that event biased for a hawkish pause and one that translates into weakness in the front end and either extends or rekindles any inversion trend depending on the departure point. Now, in the interim, we do have enough updates on the fundamental and policy side that we could conceivably find ourselves going into the December meeting in an even lower rate environment in the event that 10 year yields managed to push back below 4.40% and into the 4% to 4.25% range.

Vail Hartman:

It was never a week that was going to contain any paradigm shifting new fundamental information and with rate cuts still priced into early 2024, the trajectory of the economic data and the consistency of the Fed messaging informs our skepticism that no rate cuts will be delivered in the near term. And this week, 2024 voter Richmond Fed President Barkin reinforced this bias by saying that although inflation does seem to be settling, he sees inflation being stubborn and that makes the case for him for being higher for longer.

Ian Lyngen:

And that certainly does resonate when we look at the price action, the fact of the matter is that the yield curve remains comfortably inverted, and that's largely a function of the fact that the two-year sector is anchored to 5% plus or minus 20 basis points given on the prevailing trajectory of economic momentum at any given moment. The more interesting dynamic can be seen further out in the curve as previously sidelined duration demand continues to emerge. The 20-year auction was especially telling this week insofar as it offered a modest stop through, but perhaps more importantly, it didn't tail the way that the new 30-year bond tailed now recall that there were some clearing issues or concerns thereof that occurred around the 30-year supply event. So getting back to some version of normal offered investors solace that there might not be the degree of supply indigestion that people had been fearing.

Ben Jeffery:

And to bring the conversation back as recently as just a few weeks ago, remember that the primary discussion in the market was who was going to buy all this Treasury issuance? What does it mean that term premium had surged back to its highest level in many years? And how was the Treasury Department going to continue to fund the deficit given that there was thought to be no marginal buyer of treasuries in an environment with rising supply? Fast-forward to the wake of first the refunding announcement and then a softer than expected NFP print, capped off with a lower than expected CPI report, and those represented three very important reasons why an investor might start to be interested in the long end of the treasury curve if in fact the labor market is softening, if in fact inflation is continuing to trend lower. And now that we know the Treasury Department is at least cognizant of the influence that their borrowing is having on the shape of the curve.

So in this context, after term premium in the 10-year sector reached nearly 50 basis points in late October, now that we've seen the ACM model drop back below zero, there's certainly the case to be made that that premium ultimately proved to be a good buying opportunity.

Ian Lyngen:

I'll also add that positive term premium won't remain elusive indefinitely, but what made the most recent surge in term premium so notable was that it came at the end of a hiking cycle in a bond bearish fashion. We do see a bull steeper emerging in 2024, and that will reintroduce positive term premium because after all the conversation regarding the trajectory of the real economy will presumably be much different when the Fed starts to normalize rates back towards neutral.

Ben Jeffery:

And this dynamic was also evident in the way the curve moved this week. And what I'm talking about here is the fact that unlike what had been bull steepening and bear flattening, what we saw to start this shortened week was actually a bull flattening that accelerated in the wake of that stronger 20-year auction and demonstrates the fact that even though, Vail, as you touched on earlier, we still have cuts priced into the early part of next year, investors are not yet willing to drive the cyclical bull steepening of the curve simply given the fact that while, yes, inflation is cooling and the jobs market is softening in outright level terms, neither of those variables are to a point that would justify a more significant dovish pivot. And that means the front end of the curve and the two-year sector in particular isn't especially attractive if in fact Powell's going to be able to keep rates on hold through the entirety of the first half of next year, if not necessarily beyond.

And so in looking at curve shape that has left flattening or steepening, really a derivative of a directional reaction to the performance of outright duration, given the front end of the curve probably out to the two-year sector is going to remain fairly anchored. Even if any selloff back beyond 5% in 2s, for example, will now probably be viewed as a buying opportunity, clearly there's a greater willingness to start to extend further out the curve and that pushed 2s/10s back to its most inverted level since the September FOMC. A very telling shift in terms of the market's reaction function at this point in the cycle.

Ian Lyngen:

It's also worth noting that while conceptually we're comfortable with the notion, as you point out Ben, that the curve has devolved into a directional trade at this stage in the cycle, we've shifted to a different stage insofar as a steeper curve in this environment is unlikely to be a supply issue or a term premium story. And instead, will manifest itself in either a wholesale risk on move, i.e. significant rally in risk assets that conforms with a soft or no landing scenario. Or, it will come as a knee-jerk response to higher than expected realized inflation.

Now, this is a nuance that is worth exploring because we can see isolated episodes of bear steepening in such an environment. But, to get a wholesale re-steepening of the curve back to flat, would be predicated on one assumption that we don't think will come to fruition. And that is, that the Fed is unwilling to respond to higher realized inflation at this stage in the cycle.

Now to be fair, our baseline assumption is that we're at terminal and the Fed will express any further hawkishness by delaying rate cuts. However, that doesn't mean that if core CPI starts printing at .4, .5, .6 on a routine basis that the Fed won't put hikes back on the table and ultimately deliver them. The primary path to a sustainable bear steepener from here is if for some reason the Fed is limited in their ability to fight inflation. We don't see this on the immediate horizon, and we do think inflation continues to conform with the Fed's objective. But it's not inconceivable that we see a significant spike in the unemployment rate while inflation remains sticky. And that could be a recipe for a sustainable steepener.

The question is, would that be bullish or bearish? And our baseline assumption is that would most likely be viewed as the trigger to the traditional bull re-steepening the curve as more rate cuts are priced in response to the downside in the jobs market.

Ben Jeffery:

Ian, I'm glad you touched on risk asset performance along with what we've seen in terms of moves in the treasury market, given what we heard just three weeks ago from Powell in terms of the emphasis on the financial conditions tightening. That resulted from, on the one hand, equities coming under pressure into the early part of November. And on the other 10-year nominal rates touching 5%, 10 year real rates moving to 2.40% more or less, and what that meant for the overall level of restriction that the market was delivering for the Fed. Fast-forward to today, 10 year rates are 60 basis points lower, give or take, the S&P 500s up 8% since the Fed meeting. And looking at the Financial Conditions Index, we're now 80 basis points looser than we were just before the November FOMC and back to the easiest level we've been since the September FOMC when the committee narrowed the spread between the 2023 and 2024 dots more than the market was expecting and accelerated the selloff in treasuries that ultimately got us to the levels that we are thinking will represent the cycle highs.

So this begs the question, if financial conditions are 80 basis points easier and some of the progress the Fed felt had been made into early November has been undone, does that mean the messaging needs to be more explicit on a willingness to hike again? If not necessarily in December, maybe in January, maybe in March?

Ian Lyngen:

And I think that is precisely the messaging that the Fed is going to favor. The Fed has a very strong incentive to keep a potential rate hike on the table as long as possible, if for no other reason then it will prevent the market from more aggressively pricing in rate cuts. And we're reminded that as we reach this point in the cycle, we do see a tendency of the futures market to price in the prevailing monetary policy stance, which at the moment is being on hold for the foreseeable future, which tends to be five or six months. And then start pricing in the next logical shift, which will be towards rate cuts. And we anticipate that with the passage of time, the window of stable policy rates will be extended further and further into 2024. And that's one of the reasons that we anticipate that the cyclical steepening of the curve will be delayed during this cycle. Because while the market would like to see that price action occur sooner, the reality remains that Powell is fighting to reestablish price stability after a period that saw decades high realized inflation. So why wouldn't the market anticipate a decades extreme hawkish response on the part of monetary policymakers?

Ben Jeffery:

And while we have a market holiday, another week's worth of data, and then ultimately an NFP and CPI report before the December FOMC. Ian, what do you make of the argument that there's the risk the Fed goes back to the September playbook in terms of the dot plot, and even while leaving rates unchanged opts to shift the official forecasts more hawkishly and take yet another rate cut out of the forecast for 2024? Now, obviously in terms of actual predicting power, the dot plot is dubious at best to put it politely. But nonetheless, as we've seen this year, the market is certainly willing to trade off the new information and especially from the relatively bullish departure point that will presumably be going into early December from. Does this introduce some asymmetry in terms of a potential reaction function, either in outright terms or the shape of the curve?

Ian Lyngen:

So I think that without question, the most tradable aspect of the December FOMC meeting will be the updated dot plot, and I do think that there's a reasonable path for the Fed to go from signaling 50 basis points worth of rate cuts to signaling 25 basis points worth of rate cuts in 2024. And as you point out, Ben, whether that actually comes to fruition or not is a moot point because it's a tool that the Fed can use to signal their intention to avoid rate cuts as long as possible. And from a messaging perspective, that would be very consistent with everything that we've been hearing from the Fed thus far.

And recall that in the September SEP, we saw the Fed really double down on the no landing narrative. The unemployment rate is seen peaking at 4.1%, which given the fact that it's at 3.9 at the moment, seems highly unlikely, to put it mildly. So there is room within the SEP for a few updates that reinforce no landing expectations and simultaneously push back against the market's aggressive pricing end of rate cuts in 2024.

Ben Jeffery:

And on the topic of aggressive, really am looking forward to those political conversations around the Thanksgiving dinner table. I, for one, will never agree that our star is higher on the other side of the pandemic.

Ian Lyngen:

Well, actually, there's a very compelling argument to be made that because of the structural changes that occurred as a result of the pandemic, that our star is actually lower.

Vail Hartman:

Who's our star?

Ian Lyngen:

You're our star Vail.

Vail Hartman:

Thankful for you.

Ian Lyngen:

In the week ahead the most notable change will be that it is a full five-day work week, a transition that's always difficult in the wake of Thanksgiving. In addition, given the timing of month end, the auction schedule will be front loaded. We have $54 billion 2-years on Monday morning, followed by $55 billion 5-years on Monday afternoon. Nominal coupon supply is then capped with $39 billion 7-years on Tuesday.

It's a week of second tier economic data at best. Although we do see the ISM manufacturing print as well as revisions to the third quarter GDP numbers. What will be more interesting and potentially influential for the overall direction of rates and risk assets will be the headlines associated with spending during the beginning of the holiday shopping season. Given the relevance of the state of the consumer and spending's contribution to the overall growth profile, a strong start to the holiday shopping season will be essential to preserving the perception that the real economy is on solid footing as the fourth quarter unfolds.

Shifting our focus a little further into December, we'll be tracking the employment anecdotes to see if there is any obvious skew as to how the November non-farm payrolls numbers play out. Recall the unexpected increase in the unemployment rate to 3.9% was also accompanied by a decline in the household survey of 348,000 jobs. This divergence between the establishment survey and the household survey tends to occur as the labor market reaches an inflection point. The inflection point in this scenario is toward the downside. We do think that the jobs market is somewhat overdue for a correction toward the weak side. So as employment proxies continue to come in, we anticipate that we will see somewhat choppy price action as we approach the December FOMC meeting.

Recall that Friday, December 1st will be the last opportunity for the Fed to offer guidance before the Fed enters its pre-meeting period of radio silence. The timing of the November CPI release, which comes on the Tuesday before the Fed's meeting, complicates the messaging. Although given the fact that core-CPI in October printed at just 0.2% on a month-over-month basis, the bar is very high for the November number to put a rate hike back on the table in December. Therefore, all else being equal, we think that December almost by definition at this stage will be a Santa pause.

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 Thanksgiving dinner preparations underway, we are reminded to glutton early, glutton often, and of course glutton with gusto.

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:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Ian Lyngen, CFA Directeur général et chef, Stratégie de taux des titres en dollars US
Ben Jeffery Spécialiste en stratégie, taux américains, titres à revenu fixe
Vail Hartman Analyst, U.S. Rates Strategy

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