Surprises of October - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 294, Surprises of October, 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 October 7th.

And as the stronger-than-expected rebound in payrolls has redefined the US rates market yet again and uncertainty has become the new norm, we take solace in the knowledge that the one thing we can always count on from the BLS is that the numbers will be revised. As they don't say, revisions make decisions.

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 the Treasury market got an update on the employment landscape, which has for all intents and purposes, materially undermined the probability of a 50 basis point rate cut in November. Headline NFP came in up 254,000 jobs, far outpacing the 150,000 consensus, and the 159,000 jobs added in August. There was net revisions for the prior two months totaling 72,000 jobs and private nonfarm payrolls increased by 223,000 in September. This was nearly double the pace of 114,000 that was seen in August.

Overall, it was a universally stronger than expected print, and it provided further backing for the assumption that the labor market is going to remain resilient into the end of the year. Moreover, there was an unexpected decrease in the unemployment rate, a drop of one tenth of a percent to 4.1%. It's also important to note that this occurred with a labor market participation rate unchanged at 62.7%.

So overall, it was a relatively clean read for the unemployment side, and at 4.1% the Fed's year-end forecast of the unemployment rate of 4.4% provides ample room for softness over the course of the fourth quarter. It's also worth highlighting that the average hourly earnings print came in stronger than expected, up four tenths of a percent during September compared to the three tenths expected. This brought the year-over-year pace of wage gains to 4%.

Now, we will argue that this shouldn't raise the specter of a wage inflation spiral, however, it does show a degree of stickiness in nominal wage gains that will certainly be a consideration when monetary policymakers next meet, even if we don't expect that it will truly define the decision between 25 and 50.

In fact, at the moment, the 25 basis point rate cut decision appears to be the path of least resistance. The one caveat being that on the 1st of November, the Friday before the Fed meeting, the market will see the October payrolls print. And given the volatility of the series, given some of the recent moves, particularly in headline payrolls as well as the unemployment rate, one shouldn't completely dismiss the opportunity that the fourth quarter shows initial weakness on the jobs front, which then puts 50 basis points back on the table.

At this point, however, that's certainly not our base case scenario. We're assuming that we'll get another solid payrolls print in October, and the Fed will lower rates by 25 basis points. The Fed has a long history of looking through a single month's worth of data, and instead focusing on the broader trend, and the broader trend in this context has been softening on the labor front as well as a more contained inflation profile.

When considering the underlying motivations of the Fed at this moment, we know that the Fed is cutting rates because inflation has been contained. The Fed isn't cutting rates because they believe that the real economy needs an easy monetary policy stance. Rather, the Fed's decision to begin normalizing policy rates is a result of their conclusion that price stability has been reestablished for the US economy.

Ben Jeffery:

Well Ian, there's some weeks where frankly we don't have a lot to talk about, but this week is not one of those weeks. An impressively strong payrolls report with upside surprises in headline hiring, a drop in the unemployment rate, stronger than expected wage growth, has once again swung macro sentiment from recessionary angst, and how could the Fed not cut 50 basis points, back toward inflationary concerns and questions about why the Fed needs to cut at all? Sure, it's just a single month's worth of job data, but nonetheless, we saw two-year yields come back within striking distance of 4% in the aftermath of NFP. And as one would expect, the conversation is now back to how likely it is the Fed goes 25 basis points in November and/or December, or if the jobs' market looks like this, maybe they can take a meeting off.

Ian Lyngen:

I think that that's a great final caveat that you added, Ben. If the job market looks like this. Keep in mind we still have another payrolls report released on the 1st of November that will effectively cast the final vote in terms of the true trajectory of the labor market. If we get disappointment in October, then looking back over the prior three or four months, the average payroll gain becomes much less compelling. However, a repeat of September's NFP would definitely take 50 basis points off the table, if not bring into question the prudence of cutting rates at all.

I will note though, that it's important to keep in mind the reason that the Fed is cutting rates is to double down on the soft-landing narrative. It's not to provide the economy with any additional stimulus. Said differently, the Fed is normalizing rates back to neutral. They're not cutting below neutral to encourage growth.

It also goes without saying that any change in monetary policy during the fourth quarter is unlikely to work its way in into the real economy until the second half of next year. The most that the Fed can hope for is that by cutting rates, they ensure the degree of easy financial conditions that are currently in place, that will at least incrementally add to the upward pressure in equity prices and via the wealth effect encourage continued consumption.

The concern, however, has quickly become, particularly in the wake of the payrolls print, that the equity market has rallied too far and that the market has effectively eased for the Fed, thereby risking a fresh round of reflationary jitters. When we consider this from a geopolitical perspective, the tensions in the Middle East have finally escalated to a point where oil prices have started to trend higher, and if nothing else, that risks higher than expected headline inflation during the coming months.

Ben Jeffery:

And while obviously the dual mandate is explicitly focused on core inflation, not headline inflation, what higher energy prices would have a material impact on is inflation expectations. And remember, even though inflation expectations have dropped a bit in terms of the Fed's focus list at the moment, the shift in the Fed's framework over the course of 2021 and 2022's inflationary surge targeted not just realized inflation, but also the expectations thereof.

Survey-based measures like UMich, like the New York Fed's gauge, market-based ones such as break-evens, all of these factors are especially dependent on energy prices. And to discuss this dynamic through a psychological lens, add in the headlines that are sure to circulate around the strength of the jobs' market heading into the fourth quarter, not to mention the realized wage gains themselves, and it's not difficult to make the bull case for inflation expectations after the impressive decline we've seen over the past several quarters.

Now, would the Fed take more rate cuts off the table simply because of a temporary not transitory increase in inflation expectations? Probably not. However, depending on how the geopolitical situation unfolds, depending on what the realized inflation data via next week's CPI print shows, there is the risk of firming inflation expectations that puts the Fed in a bit more of a precarious position after they've expressed such optimism on the progress they've made in bringing inflation expectations and realized consumer price growth lower.

Remember what Powell said at Jackson Hole, to lay the groundwork for the 50-bp cut and that inflation progress has been good enough. We heard from Goolsbee over the past week that inflation is close enough to 2%. And so if that sentiment becomes materially challenged by the data, the Fed could find itself in an uncomfortable situation of maybe starting to ease a bit prematurely.

Ian Lyngen:

There's certainly criticism to be levied that the FOMC's decision to go 50 was a bit aggressive in hindsight, although given the data that was known at the time, 50 basis points as a departure point, if nothing else, it gave them flexibility between now and the end of the year. As you mentioned, Ben, there's a non-zero probability that they take one of the next two meetings off, and the aggregate rate cuts for 2024 only total 75 basis points. Now, obviously that's not our base case. We continue to see the Fed's motivation remaining intact to push policy rates back towards neutral, and a quarter point per meeting seems to be the path of least resistance.

We are somewhat concerned that the re-acceleration of nominal wages, recall that the year-over-year average hourly earnings print came in at 4%, that this risk the Fed revisiting the potential for a wage inflation spiral. Now, we don't see a high probability of such a risk coming to fruition, although it certainly is not wasted on ourselves or the FOMC committee members that there's a high correlation between nominal wage growth and the supercore measure of inflation, i.e. CPI core services ex-shelter.

Now, in the event of a re-acceleration on the wage front, it's very conceivable that the Fed could attempt to refocus market participants on the supercore measure, which has recently come back in line with the levels that the Fed would like to see, but as we contemplate the next several months, there's clearly a risk that that could re-accelerate. That being said, within the composition of core inflation, we know that housing has a particularly strong weighting, so OER and rents, both of which have been trending back toward pre-pandemic levels. Still progress to be made, although the momentum is going in the right direction.

If nothing else, we do take some solace in the fact that we avoided another potential reflationary spike in the form of the dockworkers' strike that hit the ports on the Atlantic and the Gulf Coasts. The strike has been called off and the contract extended to mid-January. So while the decision might effectively just be kicking the can into the beginning of next year, the reality is we will at least make it through the presidential election and the holiday shopping season before it's an issue that's back on the table.

Ben Jeffery:

And it was payrolls that was the biggest driver of this week's price action. That much goes without saying. But given the Fed and the markets increasing focus on the jobs numbers, we would also be remiss not to acknowledge some of the details of the benchmark measure of labor demand that painted a slightly less optimistic picture on the state of demand for workers, admittedly, with a one-month lag.

Specifically, it was what we saw in the quits rate that fell to just 1.9%, which is the lowest level since the pandemic. And looking back before the distortions caused by COVID, effectively the lowest in 10 years as what was an extremely high willingness for workers to resign in pursuit of higher wages, or simply reflection of out-sized confidence in one's ability to find another job has now been replaced by some anxiety or at least much less confidence in job security, and that in turn has led to a lower quits rate.

Taking this data with what we saw in terms of the ADP wage figures that showed job changer wage gains declining once again to just 6.6% on an annualized basis, and even with the strength and average hourly earnings we saw in the employment situation report, there are still enough signals over the medium and longer term of the labor market responding to restrictive monetary policy that after just one strong payrolls print, it would probably be a bit early for the Fed to entirely rethink the trajectory of policy that they laid out at the September meeting, at least from the perspective of the labor side of the dual mandate.

Now, CPI could call that into greater question. There's little doubt about that. But as has been the case throughout this cycle, the Fed has been reluctant to be overly reactive to just one data point, and we don't think this month will be any exception. However, by the time the December meeting rolls around, there's obviously going to be a lot more data in hand; the result of the election, assuming we know the results by the December meeting, and this holds the potential to leave the outlook in a far different place by the end of the year. But for that, we're just going to have to wait and see.

Ian Lyngen:

And over the course of the next few trading sessions, we will have a fair amount of input from monetary policymakers via official Fed commentary. We have several speakers slated to speak early in the week, as well as Wednesday's release of the FOMC minutes. Now, all else being equal, we would look at the FOMC minutes as an especially tradable event. However, in light of the strong September payrolls figures, we expect that the market will discount any particularly dovish takeaway from the minutes as stale information given everything else that's going on in the world.

Supply considerations are also on the radar with the reopening auctions, particularly 10s and 30s likely to provide a reasonable gauge for Treasury demand in the overall macro environment. All else being equal, we're constructive on supply, and expect that the auctions will go fine overall even if more of a concession is warranted, if not outright then on the curve.

Ben Jeffery:

And finally, in a discussion of this week's event, there were also no shortage of conversations around what we saw in quarter end in the funding market, specifically the volatility and repo and increase in SOFR on both Monday and Tuesday with the latter seeing SOFR set at 5.05%, and what that means about the state of liquidity and the distribution of reserves within the financial system.

Money market volatility holds implications for things other than just repo itself, and the concern that reserves are perhaps not as ample as might initially appear, has reignited the conversation around when it is the Fed will slow or stop QT, as well as speculation about what year-end might look like in terms of the street aligning their funding needs. After all, in a perfect world, we wouldn't see 450 billion in RRP usage at the same time that the standing repo facility was tapped, but this week's money market developments reinforces one of our core tenants on the state of the front end at the moment, which is that even on an aggregate level, we're not at any risk of reaching reserve scarcity. Just because the system as a whole is not at risk, does not mean that reserves are abundant in every place that they are needed.

The nature of the US financial system and with no shortage of regional banks that need access to this liquidity means that the Fed has to play to the lowest common denominator. And all else equal, that leaves our repo angst a bit higher than would otherwise be expected heading into the end of the year.

Ian Lyngen:

And as the lowest common denominator I'll note that even I'm starting to get concerned about the repo market into the end of the year.

In the week ahead, the focus in the Treasury market will return to inflation. We have the CPI figures on Thursday where headline CPI is expected to increase one tenth of a percent on the month-over-month for September, and core-CPI is seen up two tenths of a percent. This will be followed by PPI, also seen up one tenth with core-PPI up two tenths to cap the week's most relevant data.

Now, when we consider the monetary policy implications of September's inflation profile, all we really need to see is a 0.2% or a 0.3% core number that ensures that the trend back towards the Fed's 2% inflation target remains intact, at least in a broad sense. In the event of an upside surprise, say, a 0.4% or a 0.5% in the core CPI series, that would bring into question when combined with the recent payrolls release the prudence of cutting rates at all in November. Recall that the primary reason that the Fed is comfortable normalizing policy rates at this moment is because policymakers believe they've been successful in reestablishing price stability. In the event of any evidence to the contrary, the market would very quickly start to contemplate whether or not the FOMC should pause in November.

Treasury supply considerations are also a factor. On Tuesday, we have $58 billion 3-years on offer, followed by $39 billion 10s on Wednesday, and capped with $22 billion 30-years on Thursday. As a general theme, Treasury auctions have gone reasonably well recently, and the fact that the Treasury Department has signaled auction sizes will be stable at least for several quarters, has further supported investors’ willingness to buy duration. The $39 billion 10-year on Wednesday will be the big litmus test, especially in light of the strength in the employment report.

Now, since the Fed has indicated that the direction of travel for policy rates is lower, that it's just the magnitude of rate cuts that are in question at the moment, we suspect that investors will, as a theme, use the liquidity provided by the 10-year auction as an opportunity to buy the market. As is typically the case, we'll be watching for the breakdown between dealer and non-dealer awards at the 10-year auction, and to a lesser extent, at the long-bond on Thursday.

The shape of the yield curve is also once again in focus. We did see an intuitive bear flattening in the wake of the payroll's figures, which while we expect could have some room to extend, won't ultimately get us to the place that the 2s/10s are once again back in inverted territory.

So as the market continues to consolidate in the prevailing range ahead of Thursday's fundamental inflation, ahead of Thursday's essential inflation input, we anticipate that the 2s/10s curve will gradually drift back toward the top of the recent range as the market attempts to price in a more significant concession for the 10-year auction. If not, in outright terms, at least on the curve.

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 scroll through the recent headlines regarding claims to have finally found the Loch Ness Monster, as well as Bigfoot in separate discoveries, it strikes us that maybe Powell's soft landing isn't that crazy after all. We wonder what the unemployment rate is at Area 51. It's probably out of this world.

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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