The Madness of March - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 265, the Madness of March, 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 March 18th. And with the NCAA basketball tournament beginning and despite our complete lack of talent or physical presence, we cannot help but lament not going pro. Still waiting for that podcast deal. Spotify.

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, there were several developments of note on the macro front, the most obvious being the slightly higher-than-expected core-CPI print. Core-CPI for the month of February increased 0.358%. That rounded to a 0.4% versus the consensus of a 0.3%. Recall that January's upside surprise in core-CPI was also 0.4% versus 0.3% anticipated. However, February's inflation data had a somewhat different character. Not only was it a notably low 0.4%, but it was also accompanied by a slowing in the pace of core-services ex-shelter, which suggests that the benign wage gain seen in February translated through to at least marginally less upward pressure on core services. All that being said, one of the key takeaways from CPI was that it provided neither a definitive hawkish bias for the Fed, nor a definitively dovish one. So said differently, the report contained something for both the bond bears and the bond bulls.

The week just passed also contained an update of PPI, which only reinforced the idea that February's inflation data has demonstrated some degree of stickiness, if not as dramatic as what we saw in January. One of the other more surprising aspects of the data profile was the flat control group within the retail sales series. The market tends to focus on this subset of retail sales as it has the highest correlation with the consumption numbers within GDP. So we've now seen a negative control group for January and a flat control group for February. If nothing else, this suggests that the consumer is starting to feel some of the pressure from higher real borrowing costs as the Fed has maintained its restrictive policy for the last several quarters.

The net of these influences on the treasury market led rates higher as a theme and the curve somewhat flatter. Although the weakness in the front end stalled out in the latter part of the week, as the market's focus shifted overseas to developments with the Bank of Japan and the potential for the BOJ to shift away from negative policy rates. The prospects for a Bank of Japan rate hike have improved, certainly some of the developments on the wage front out of Tokyo reinforce the notion that the BOJ will soon join the rest of the world in positive policy rate territory.

Vail Hartman:

January and February's firmer than expected realized inflation data has presented a material challenge to the disinflation narrative that defined the second half of 2023. And as such, investors in US rates have been left largely indifferent whether the June 12th FOMC will mark the departure point for rate cuts this cycle. This week's FOMC meeting and accompanying policy statement, SEP, and Powell's press conference will play an instrumental role in refining forward monetary policy expectations.

Ian Lyngen:

Vail, I think you make a great point that there is a great deal of uncertainty associated with the next several months from a macro perspective. Now, obviously we came into the beginning of the year as a market looking at March as a potential departure point for the first rate cut. Clearly, that has not come to fruition and frankly, there's a low probability that we see a move in May, which has appropriately focused the market on the end of the second quarter; i.e., the June 12th FOMC rate decision.

It's important to keep in mind that not only do we get an updated SEP in June as well, but we'll also have three new CPI prints in hand; i.e., data for March, April, and May. These reports could very easily demonstrate a resumption of the downward trajectory in realized inflation that really defined this second half of last year, and frankly paved the way for the Fed to consider cutting rates in June.

Ben Jeffery:

And that dynamic would reinforce this idea that investors were on the lookout for in the CPI report, which is that January's data both as it related to the job market and the inflation data, was something of a temporary, or transitory, reversal of the broader trend that was set out during the latter part of last year. Obviously, February's jobs report showed meaningful downward revisions in terms of headline hiring, a higher unemployment, and that took some of the upside edge off what we saw in January, and when taken with the labor demand data kept the longer term trend of softening labor market dynamics intact.

Now, coming into CPI this past week, there was no doubt that the market was on the lookout for a similar dynamic as it related to CPI. Remember, the January CPI data served as the catalyst to get rates back toward the top of the range, and so, in a similar fashion to what we saw in NFP, the idea was that February's data would keep with the broader disinflationary trend and make January something of a one-off.

Now, we didn't get that and CPI while a bit higher than expected was definitely not as soft as NFP was. But Ian, I think exactly as you touch on, a stronger January and middling February as it related to core CPI, is not going to be sufficient to get the Fed to completely set aside the plan that they brought into this year, which was eventually bringing rates lower, given the several quarters long trend that we've seen in realized inflation and jobs. And that means that assuming the next several months worth of inflation data don't show a new trend, that's still a reasonable operating assumption, at least for the time being.

Ian Lyngen:

And let us not forget that we saw a disappointment in retail sales as well. So we now have the higher unemployment rate revealed from the prior week's payrolls report, combined with softer consumption and a disappointment on average hourly earnings. All of this points to some degree of softening in the broader outlook, even if there are demonstrated pockets of stickier inflation for the time being. So combining this all for a near term skew on the market really does leave one in a position of being responsive to any nuances from monetary policy makers, especially given that there's no meaningful economic data in the run-up to the Fed.

Ben Jeffery:

And on the topic of the market that's sort of settled into a wait and see mode ahead of the FOMC, it was very telling to see the price response we got on Thursday. Specifically after the PPI data and the retail sales report, along with jobless claims, and that the market sold off dramatically, 10-year yields were higher by almost 10 basis points, and if one had laid out a bearish reaction to higher than expected PPI data, the intuitive curve response would have probably been a flattener.

But instead, what we actually saw was an impressive bear steepening of the curve that was then undone a bit on Friday. But nonetheless, the bear steepening, not flattening, reaction we saw to higher than expected inflation data speaks to this idea that now with two year yields back above that 4.70% level and the uncertainty on what will come to pass in the dot plot, what Powell will sound like on Wednesday, there's enough implicit value in the two year sector back at these levels that it's going to be difficult to see a meaningful amount of bearishness extend from here, at least until we have more fundamental information from the Fed.

So said differently, the market sold off, but the price action in the front end became increasingly stubborn as we moved back toward 2024's year to date highs in two year yields, and that cleared the way for the 10- and 30-year sector to lead the way toward higher yields. Which given that it's still extremely unlikely the Fed is going to be willing to hike again, makes sense as we contemplate the fair value of the two year sector.

Ian Lyngen:

Another complicating factor on Thursday was the series of reports suggesting that the Bank of Japan is readying to hike rates on Tuesday. When we think about the BOJ's reluctance to move out of negative rates until this late point in the global cycle, it does beg the question whether or not they're effectively fighting last year's battle with inflation. But regardless, there have been enough developments in Tokyo that suggests that a move out of negative rates territory will be on the agenda, if not for March, then in the following meeting.

And Ben, as you highlight, translating this into higher two year yields was a lot more difficult for the treasury market then pushing longer dated rates higher simply as a reflection of the notion that the rest of the world is continuing to slowly work their way back to some version of normal policy that could be maintained for the foreseeable future. All of that being said, we still expect that the ECB and the Bank of England will accompany the Fed and start cutting rates sooner rather than later.

Ben Jeffery:

And let's not forget there was another driver of the price action in the long end of the curve this week, which was Treasury supply. 10- and 30-year auctions that were generally well received?

Vail Hartman:

Well, between the 10- and 30-year auctions, we did see a bit of a contrasting result, although the 10 year auction did come within closer proximity to CPI. The 10-year auction tailed by 1.1 basis point with softer bidding statistics, and that came after a solid intraday concession on the back of the inflation data. And then on Wednesday we had the 30-year auction that stopped through an impressive 2.2 basis points with elevated non-dealer participation and indirect bidding statistics.

Ian Lyngen:

It is notable that the supply and demand dynamic in the treasury market continues to be topical even though the Treasury Department has made it clear that they have no intention of increasing nominal coupon auction sizes anytime soon. Still, there are plenty of conversations about widening deficit spending and what that could mean as a fiscal impulse, specifically, will it be inflationary, and perhaps more importantly, will the results of November's election meaningfully change the trajectory of deficit spending. Our take is that it's very difficult to find a deficit hawk in Washington at the moment, and so regardless of who ends up in the White House, and frankly, the composition of Congress, it's difficult to envision anyone truly attempting to champion austerity in this environment.

Ben Jeffery:

While the February refunding announcement pushed Treasury issuance to something of a backseat after it drove so much of the market discourse in the middle part of last year, it's not just the path of policy rates that's going to be in focus on Wednesday, but also the messaging the Fed delivers around the balance sheet and what their plans are in terms of tapering QT. A slower pace of QT is going to mean more SOMA reinvestment and more SOMA reinvestment will help take some of the pressure off the need for larger Treasury supply. Although, given the size of the deficit, that's probably just on the margin.

Vail Hartman:

So there remains an elevated degree of uncertainty around the exact timing and pace of the QT tapering process. And to help answer these questions, on Wednesday, investors will be looking for clues around how low RRP balances can decline before policymakers deem it appropriate to begin slowing QT, and possibly even if the runoff can continue after the RRP is depleted. Taken further, investors will also be on the lookout for any insights around the threshold for reserve balances and how large of a buffer policymakers would like to maintain above the level that is deemed as ample.

Ben Jeffery:

So QT and what is suggested about the path of policy definitely are top of mind, but it also won't take much in terms of specific changes to the dots to move median dot plot projections or what the committee's official outlook will be as it relates to inflation.

Vail Hartman:

So it's important to remember that in December when we saw the 50 basis point downward revision to the 2024 fed funds dot, it was a close call because only two dots made the difference between implying 50 and 75 basis points of cuts in the year ahead. So on Wednesday, because only two dots need to move above the current 2024 median of 4.625%, it's not difficult to imagine a path towards 50 basis points of cuts being implied by the end of the year.

And revisions to the 2024 dot aren't the only risk we need to be watchful of within the SEP, as policymakers’ core-PCE projections for 2024 will also be in focus. Recall in December, the estimate was 2.4% and in January core-PCE YOY ticked down to 2.8%. So using this departure point in January, core-PCE would need to average a monthly gain of 0.18%, or rounded a ‘low’ 0.2%, so in this context, it's notable that January's core-PCE gain of 0.4% and what's expected to be a 0.3% in February is solidly above the trend that would be needed to reach 2.4% YOY in December. So considering the two months of inflation data we've received so far in 2024, and because it was above the trend that we had seen in the late part of last year when the Fed had made its 2024 year end projection, it's also not unreasonable to assume we see the 2024 core-PCE projection nudged higher.

Ian Lyngen:

I think it almost goes without saying if they move the core-PCE number higher, they're probably also going to move the Fed funds estimate to signal 50 rather than 75. Embedded in the Fed's decision is whether or not two data points are enough to extrapolate a trend.

Ben Jeffery:

So I guess we'll just have to wait an FOMC.

Vail Hartman:

Ah, never gets old.

Ian Lyngen:

At least not to us.

The week ahead truly contains one event of any relevance from the macro perspective, and that comes on Wednesday afternoon. We have the FOMC rate decision and generally speaking, no one expects that the Fed will cut policy rates at this meeting, however, there is a very active debate as to the degree to which Powell will be willing to signal an increased dovishness or simply retain the ongoing hawkishness that has been in place by delaying the prospects for any rate cut.

Now, we remain in the June rate cut camp, with the caveat that we and the Fed will need to see how inflation performs over the course of the next three months. The March, April, and May CPI reports will be in hand by the time the FOMC meets on the 12th of June. That will, if nothing else, create an opportune departure point for starting the process of normalizing rates lower in the event that inflation behaves.

We're focused on either the June or the July meetings as the first rate cut because of the optics of cutting in September, which is effectively right ahead of the presidential election. And while there is technically nothing to prevent the Fed from cutting in September, it's very atypical for the Fed to start a new campaign, either hiking or cutting, immediately ahead of the presidential election. The timing of the election and the stickiness of the inflation data early this year certainly complicates the calculus for the Fed in its effort to start the process of normalizing rates, but certainly doesn't offset the fact that the Fed will, at some point, start the process of lowering policy rates.

The most tradable event specifically will come in the form of the 2024 dot; i.e., does the Fed choose to signal 75 or 50 basis points of rate cuts during the balance of the year as their baseline assumption? There's enough uncertainty around this debate that having a strong bias at this point could simply prove folly. If asked to put a probability on it, we'd say that there's probably a 70% chance that we see 75, and a 30% chance that we see 50 basis points worth of cuts signal. There's also some supply in the week ahead. There's $13 billion 20-years on Tuesday afternoon, and then that's followed by $16 billion 10-year TIPS on Thursday. That being said, the week ahead is primarily about the Fed, Powell's press conference, and the beloved dot plot.

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 the Ides of March pass, we cannot help but feel as though we narrowly escaped. Fail, what's that?

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:

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