Fourth Quarter Kickoff - The Week Ahead

Ian Lyngen:

This is Macro Horizons' episode 242, fourth quarter kickoff, 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 October 2nd.

With the new iPhone running hot, Taylor Swift apparently a huge fan of Kansas City (not the Fed), and 10-year yields closer to 5% than to 4%, it's been an exciting end to the third quarter, and it's clear that the fourth quarter will decide the game.

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 passed, the Treasury market selloff continued, and we saw 10-year yields reach new cycle highs. The price action was initially accompanied by a selloff in equities, but as stocks continue to stabilize and the curve re-steepen, there's a growing sense that we're in the midst of a sustainable repricing to a higher rates plateau. While we're certainly sympathetic to the idea that the US economy might ultimately be able to withstand higher monetary policy rates, the notion that a 5% 10-year yield will be easily absorbed throughout the system is a bit more difficult to get behind. To be fair, it's not as if 10-year yields have never been above 5%. It's just been quite some time, and the implications for borrowing costs on the household level are becoming more and more acute.

With mortgage rates sustainably above 7%, activity in the housing market, certainly for potential buyers relying on financing, has effectively come to a standstill. We saw that evident in the new home sales figures as well as existing homes last week and housing starts during the prior week. Taking a step back, this is very consistent with the objectives of monetary policy at the moment. When we look at what's been driving the bulk of the upside on the inflation front, one of the key components has been OER and rent, and this is clearly related to home prices. Moderating gains in home prices, focusing on stability as opposed to the significant increases seen during the beginning of the pandemic will ultimately continue the deceleration that is already evident in the core inflation series. That being said, there are ramifications for the wealth effect even if the stabilization in the equity market provides something of an offset.

The underwriting process for the recent Treasury issuance has been relatively uneventful, which suggests that there is demand for Treasuries at these levels and that concerns of a wholesale buyer strike were somewhat overblown. That being said, term premium in the 10-year sector is now back to positive for the first time since June 2001. The ACM model put 10-year term premium at roughly three basis points. When we look back to the last period in which term premium was consistently positive, that would be March to June of 2021, it got as high as 35 basis points. It is notable, however, that it quickly compressed from 35 basis points to negative 60 basis points over the course of six weeks. Said differently, term premium might be back in the Treasury market, but it could be only for a limited engagement.

Vail Hartman:

It wasn't a week that contained any new crucial economic data, and still we saw a fair degree of bearishness in the long end as 30-year yields traded above 460 and 10s above 450.

Ben Jeffery:

This in turn drove the primary conversation that we had with clients this week, which was when does the selling stop? I'm being intentionally ambiguous there because, Vail, you're exactly right, it was a very bearish week for Treasuries, but the bearishness wasn't limited to bonds as stocks have also come under a fair amount of pressure in response to not only higher real rates, but also a building sense of angst around the state of the consumer, what higher oil prices might mean for the risk of stagflation and the fact that all the Fedspeak we've heard over the course of the past week has left the door for another rate hike firmly open and not even begun to entertain the idea of rate cuts. There's also the risk of a government shutdown, of course.

Ian Lyngen:

The one thing that I would add on the rate hike front combined with the government shutdown potential is, if we do actually see the government go into shutdown mode and the economic data flow dries up, it's unlikely that the Fed will hike 25 basis points in November. Now, in the past, government shutdowns have led to distortions in the economic data that have made it difficult for at least a couple of months for the market and the Fed to have a true sense of how the real economy is performing. Therefore, a government shutdown could also lessen the probability of a December rate hike.

When we look at the futures market, what we see is that the market is currently pricing in higher odds of a December than a November rate hike, although even December is still at roughly 25%. If the government shutdown is more than a three or four-day event, what we anticipate will happen is that the Fed will roll forward a potential quarter point hike into the first quarter of next year as opposed to taking it completely off the table based on the uncertainty of not having economic data.

Ben Jeffery:

But in any case, the Fed has been successful at shifting the market's conversation from whether or not we'll get a 75 basis point rate hike to a 50 basis point rate hike to a 25 basis point rate hike to now the uncertainty around the cadence of maybe another quarter point, maybe not. Instead, what investors are focused on is how far into 2024 Powell will be able to maintain terminal, and that holds implications for valuations in the front-end of the curve even as the down trade in 10s and 30s has been more of a term premium story than anything else.

In the debate around when the selloff will end, while most agree that rates this high and policy this restrictive, as an environment in which something is bound to go wrong, remember the regional banking crisis, there's a collective unwillingness to call the top in yields in the long end of the curve simply given the fact that the longer the soft landing narrative can persist, the more term premium will be incorporated into the longer end of the curve and the higher long end yields will drift.

That's a different story in the two-year sector, which is far more beholden to Fed policy expectations, and now, after an undoubtedly dramatic tightening cycle, we have some reasonable amount of conviction that terminal is within 25 basis points and the path forward from terminal will be lower yields. That means further bearishness in the two-year sector certainly is an impossible, but it will be limited relative to the rally potential in the event something goes wrong.

Ian Lyngen:

When we think about this in the context of term premium, this week, we just saw the first positive term premium print for the 10-year sector since June of 2021. Now, keep in mind, in 2021, term premium was only positive for about three months and the range was between zero and 35 basis points. That means that, as we push further into positive term premium territory for the 10-year sector, potential dip buyers could look at the historical performance of term premium and identify this as a very attractive opportunity to get engaged.

Also, let us not forget that that period between March and June of 2021 when term premium reached 35 basis points was immediately followed by a correction lower in term premium down to negative 60 basis points by mid-July. Our takeaway is that, while seeking term premium might be a compelling reason to stay on the sidelines while the Fed ends its rate hiking cycle, historically, any shift into a decidedly positive term premium environment does trigger significant investor demand, and that's something that will be on our radar during the balance of 2023.

Ben Jeffery:

The primary reason that we are of the mind that term premium can't stay positive for long has to do with the fact that, despite all that has changed in the world over the course of the last decade, Treasuries remain the benchmark safe haven asset and exhibit something of an insurance product quality that is somewhat unique among financial assets. As one thinks about the distribution of risk around the forward path of the labor market, the forward path of growth both in the US, but also globally, that means that the term premium that, quote, unquote, should be incorporated in Treasuries is lower than it would be for, say, corporate debt, and that's even before taking into consideration the fact that monetary policy is well into restrictive territory. There's no shortage of geopolitical risks out there, and some of the signals around the tightness of the labor market and the health of the consumer are starting to flash maybe not quite red yet, but at least yellow.

Ian Lyngen:

There's also the fact that this is a real yield story as much as it is anything else. Sure, nominal 10-year yields got to that pivotal 450 level, but we also saw 10-year TIPS yields or real yields push above 220 and, when we look historically, the correlation between the performance of the real economy risk assets and significantly higher real rates is difficult to argue. In part, this is a key contributor to the underlying dynamic that has pushed global equities lower over the recent sessions.

Ben Jeffery:

While earning season for the third quarter doesn't get underway for another couple of weeks, we've already started to hear some angst around the more consumer-sensitive parts of the stock market and the risk that earnings are going to demonstrate on one hand the impact of higher rates, but, on the other, personal savings on the household front that are now all but depleted after the pandemic, along with credit card delinquencies that are on the rise and student loan payments that are going to be restarting. From a corporate perspective, softer revenues combined with higher interest rates are ultimately going to necessitate costs be cut somewhere else in order to preserve profitability.

Ian Lyngen:

Profitability has been compressed over the course of 2023, and what will be notable is the inflection in the equity market as analysts respond to big layoff announcements. As it currently stands, firms aren't actually being rewarded in the stock market for laying off employees. Eventually, that pendulum will swing the other direction, and that will be an inflection where business leaders take a much harder look at their labor force, and such a dynamic is very consistent with what we have seen historically. As we've referenced in the past, anytime the unemployment rate is more than three-tenths of a percent off the cycle low, history suggests that we will see a spike over the course of the next six to eight months, and that spike hasn't typically been 50 or 75 basis points. Rather, it's been 200 or 300 basis points, which suggests that Fed's year-end forecast for the unemployment rate at 3.8%, unchanged from August level, is the least likely outcome particularly if monetary policy still works.

Ben Jeffery:

Talking about real rates, the labor market, the efficacy of monetary policy, there's also the real growth component of all of this as well and the susceptibility of real yields at these levels to any shock that runs counter to the notion that the economy is going to glide to a soft landing and be able to avoid a true recession. What I mean by true recession is not negative real growth. That's simply a function of higher inflation like we saw last year, but, instead, a consumption-led slowdown that's a result of softer wage gains, a weaker labor market and individuals being forced to pull back as a result of the developments of the economy.

Vail Hartman:

Transitioning to the topic of Fedspeak, this week, we heard from Minneapolis Fed President Kashkari, who is also the most hawkish-leaning member on the committee, and it was notable that even he said the FOMC may have to do less with monetary policy as a result of the potential downside to growth from the UAW strikes and a potential government shutdown.

Ian Lyngen:

Vail, you're right, there was actually a very interesting comment from a member of the committee that has historically led the hawkish side, although, at this stage, it really is primarily a conversation about that final quarter point hike to 575. It would be a different framing if Kashkari would have suggested cutting rates earlier in 2024. While it wasn't an incrementally dovish sentiment, the reality is higher for longer will continue to drive market expectations for monetary policy.

Ben Jeffery:

We've made it this far in the conversation without talking about energy prices, and the modest pullback we've seen in crude to still very high levels, no doubt, but nonetheless, the fact that oil stopped rallying this week was enough to inspire some meaningful compression and breakevens and steepen the breakevens curve given the heightened sensitivity of front-end TIPS to energy prices. There's some geopolitics at play as well here with some optimism on thawing tensions between Saudi Arabia and Israel, potentially implying some improvement on the supply front and, as we've talked about a lot, softer consumer demand and industrial demand is also a negative for oil prices if, in fact, growth is going to be slowing.

Now, obviously, our best guess on what happens on the production side would not be a particularly good one. The path of energy prices and the potential for ongoing divergence between headline and core inflation is simply going to serve as another cross current and source of volatility for the Fed and markets as we approach the final hike of this cycle, or maybe not.

Ian Lyngen:

Well, if nothing else, it sounds like the concerns in the energy sector could be a slippery slope, and we're worried about spillover.

Vail Hartman:

Don't be crude.

Ian Lyngen:

In the week ahead, the macro landscape will offer a lot more questions than answers. First off, the question regarding whether or not the government shuts down and the extent to which it remains closed will remain top of mind for many investors. Now, in the event that the government is able to reopen on Monday, October 2nd, then, attention will very quickly shift to Friday's non-farm payrolls data where expectations are for a decrease in the unemployment rate to 3.7% and a modest increase in headline payrolls of 150,000.

Let's assume that the federal government is unable to cobble together a compromise to keep the doors open. In that case, the question becomes will it be an extended government shutdown or will it be a short-lived three or four-day event? Should any potential shutdown last more than two or three weeks, then that would, for all intents and purposes, take a November rate hike off the table because the Fed would be effectively flying blind on the data front.

It is notable that the key data releases that would be impacted by a shutdown include NFP, CPI, PPI and the marquee releases. They do not include the private data, however, for example, ADP, so that suggests that the market could be taking a greater degree of its trading direction from ADP than it has in a very long time. It's also worth observing that, historically, a government shutdown has been a bond bullish event. During the 2018-2019 episode, it was worth roughly 15 basis points lower in 10-year yields during that period.

What could also result from an extended shutdown would be that the data not only for September and October would be distorted, but the rebound from some of the series would make November's data less than compelling, which really implies that the market could lack the benefit of current economic data at a point when the Fed has emphasized that monetary policy is data-dependent into the end of the year.

Now, such an outcome wouldn't mean that the last quarter point that the Fed suggested in 2023 wouldn't come to fruition. Rather, it would simply be rolled forward to the first quarter of next year. This doesn't seem to be a scenario that the market is currently focused on. However, at the end of the day, it's very clear that it all comes down to Congress' willingness to come to some agreement on the budget. If nothing else, then simply a stopgap that would buy a few more weeks of negotiation.

We're also watching the price action itself very closely for any indication of what appears to be a pretty significant breakout that's underway, has triggered not only meaningful technical levels, but also potentially brought in, otherwise, sideline buyers. Thus far, we see no evidence of anyone willing to stand in front of the move.

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. As we contemplate a government shutdown, we cannot help but recall that, during the last shutdown, the failure to pay TSA workers was the ultimate inflection point. Perhaps, random searches of any member of Congress traveling commercial are in order. Who knows, they could turn up a few extra dollars or gold bars to avoid a work stoppage.

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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