Wake Bonds Up, When November Ends - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 298: Wake Bonds Up, When November Ends, 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 4th. And as we close the books on October, we'd like to wish everyone at Canadian banks a happy Fiscal New Year. 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 spent much of the week under pressure with yields higher and the curve fluctuating within a range as market participants remain largely sidelined in anticipation of the upcoming presidential election. Friday's employment report marked the most relevant economic data release of the week. And here we saw that during the month of October, NFP increased by just 12,000 jobs. That was well below the 100,000 consensus and just at the bottom of the range of estimates, which was negative 10 to positive 180,000. In addition, we saw that September was revised lower. Now September reads at positive 223,000 jobs compared to an initial estimate of positive 254.

Moreover, the net two-month revision was negative 112,000. Private non-farm payrolls actually dropped in outright terms – negative 28,000. That's compared to a consensus for a positive 70,000. The unemployment rate, however, was unchanged at least on a rounded basis, whereas unrounded, it came in at 4.145 compared to the 4.051 in September. Average hourly earnings increased four tenths of a percent, bringing the year-over-year pace to 4%. What was perhaps the most telling aspect of the report was the category of ‘Workers Unable to Work Due to Bad Weather’. That printed at positive 512,000. That compares to the average of roughly 55,000 per month in October.

So, clearly, the hurricanes had an impact on headline payrolls. In fact, the BLS went on to acknowledge this, saying, "It is likely that the payrolls employment estimate in some industries was affected by the hurricanes. However, it is not possible to quantify the net effect over the month change in the national employment hours and earnings estimates, because the establishment survey is not designed to isolate effects from extreme weather events. There is no discernible effect on the national unemployment rate from the household survey." And so, on one hand, the BLS has clearly told us that the headline figures are being distorted by the hurricane. But at the same time, because of the nature of the household survey versus the establishment survey, the BLS is at least incrementally more confident in the household figures. And more importantly, that unemployment rate at 4.1%.

All of this is very consistent with the notion that the Fed is, for all intents and purposes, going to be flying blind over the course of the next couple meetings as it takes a while for the hurricane impact to work its way through the economic data. This is not only going to be the case for the labor market statistics, but the hurricanes will also impact the consumption figures, as well as presumably the inflation numbers. As we saw in the ISM manufacturing print, we had the highest ‘Prices Paid’ component in five months, an unexpectedly strong move well above 50. And to a great extent, we have to assume that this is also going to be an impact of what we saw from the hurricanes and some of the supply chain disruptions created by the recent strikes in a variety of different industries.

So, overall, we're entering a very challenging period for the economic data with a backdrop of the presidential election and all of the uncertainties associated with both the timing of knowing the outcome, as well as the outcome itself.

Ben Jeffery:

Well, we got the refunding announcement, the JOLTS figures, and most importantly this past week, October's NFP numbers that came in at just 12,000 jobs added last month, with the unemployment rate unchanged and wage growth modestly higher than expected. But the most common question we fielded following the release of the numbers and as the market responded to the latest update on the labor market was, is this the story of a hurricane?

Ian Lyngen:

To be fair, the BLS did acknowledge that the hurricanes had an impact on headline payrolls. However, they did note that there was no discernible impact on the Unemployment Rate, which while technically unchanged at 4.1% on an unrounded basis, actually increased to 4.145% from 4.051%. So, the unemployment rate went from a low 4.1 to a high 4.1. Now, this has made all the more relevant when we think about the Sahm rule and the implications for a forward spike in unemployment rate as the cycle continues. It follows intuitively that the Treasury market rallied in the wake of the disappointing payrolls numbers, with the two-year sector driving the bulk of the price action as the curve re-steepened.

That being said, the Treasury market particularly further out the curve has managed to retain a great deal of the pre-election weakness that has been priced in. As we watch the polls and the consensus seems to be drifting towards a Trump victory, and even possibly a complete red sweep, it's not surprising to see some of the bearishness in 10s and 30s retained, because to a large extent, the market appears content to trade a Trump victory simply from the perspective of a reflationary impulse. Now, that follows intuitively in comparison to a Harris victory. But we are reminded that an increase in tariffs, a further decoupling of the US from its major global trade partners, doesn't necessarily translate into higher realized inflation. US households are not in the same position that they were in 2021 and 2022, and therefore it is not a foregone conclusion that end-users will be able to absorb any higher prices that producers attempt to foist upon them.

Ben Jeffery:

And it's this dynamic that's the other side of the traditional "Trump trade" that should be bearish for the long end of the curve in steepening fashion as higher term and inflation premium make its way into the back end. And that is, as we saw in 2017 and 2018, there's a material negative growth implication from higher prices as well. That, to your point, Ian, is going to be especially apparent at the current point in the cycle, given the fact that the labor market and household balance sheets are not as resilient as they have been over the past several years. So, while, yes, all else equal, higher prices should flow through to higher yields, what we're left considering is if higher prices translate through to a dimmer consumption landscape, then maybe a Trump victory won't necessarily be so bearish after all. This is not to say that in the knee-jerk to the election outcome, whenever that may ultimately be revealed, won't be toward higher yields if in fact we do see Trump win or a GOP sweep.

But over the medium and longer term, it's going to be less about politics and policies themselves, and more about the economic implications of those policies that's going to dictate the path of rates and the shape of the curve. As it relates to the FOMC, it's also worth mentioning, on the one hand, the timing of any potential new policies is probably not going to be until Q2 or early Q3 at the earliest. So, not really showing up in the data until much later in 2025. Again, at the earliest. And so, for a Fed that has put a heavy emphasis on data dependence, if the data that they're depending on does not start to react until later into 2025 or early 2026, then the driver of the 50 basis point cut that we've already seen and the 25 basis point one we're almost certainly to see next week will remain in place.

On the other hand is that unlike during 2021 and 2022, if we start to see prices move higher solely as a function of supply side dynamics around policy out of Washington, the Fed is not going to be as quick to respond to that type of inflation as it would the type of higher consumer prices that are a function of a true demand-driven price increases. It's a nuance of inflationary pressures, but one that's worth acknowledging, especially as we approach the election and the FOMC meeting, and investors attempt to calibrate the market's reaction function to the coming information.

Ian Lyngen:

And it's also worth keeping in mind in this context that we did see a 1.9% Quits rate from the JOLTS data. And the disappointing headline payrolls, while clearly impacted by the hurricanes, was associated with the general sense that perhaps it wasn't the July, August and now October employment data that was the anomaly, but rather it was the strength in September that was the one-off. Recall, it was very surprising to see how quickly sentiment shifted based on the September data series. Now that we have the first look at the marquee data for October, I suspect that the debate will quickly become whether or not investors should be more heavily discounting September.

Now, putting this in the context of the forward path for the labor market and what that could potentially mean for consumption. In the event that we continue to see mixed to softer employment data, one should be looking toward the consumption figures as a barometer for the overall health of the real economy. Now, this inflection could occur just at the point where the holiday shopping season tests the resilience of households at the moment.

Ben Jeffery:

And to shift gears slightly, it wasn't just the fundamentals of the performance of the economy that we received updates on this week, but we also got November's refunding announcement, which as expected, left next week's auction sizes unchanged for 3s, 10s and 30s, with another quarter of unchanged coupon auctions moderating the bearish supply impulse to the long end of the curve, at least for the time being. More importantly than what we're going to see over the next quarter was the fact that the Treasury department retained the phrase that it views itself as well-positioned for the next several quarters, emphasis S, to continue to fund the deficit.

And within the TBAC minutes, we also saw that generally speaking, the dealer community doesn't see further auction size increases taking place until late 2025 or 2026. So, really what that means is that at present, the market's operating assumption is that August is probably the soonest we'll start to see auctions grow again, with the caveat that an election between now and then, and any potential fiscal changes, could pull that timeline forward to May, depending on what the new government has in store in terms of fiscal plans. Notably as it relates to the debt ceiling within the financing estimates we got on Monday afternoon, the Treasury department caveated its cash balance forecast at just over 800 billion, as dependent on an agreement or a suspension of the debt ceiling by the end of Q1.

Now, if history is any guide, we are skeptical that the debt ceiling is going to come and go with little issue this time around. And so, as it relates to Q1's borrowing needs and the forecasts from the Treasury, we're of the opinion that those should be taken with a meaningful grain of salt as we wait for the current debt limit to expire on January 1st. But in any case, without any signal of an impending increase to auctions further out the curve, we suspect that the bond vigilante crowd will remain on the sidelines for at least another quarter, if not quarters.

Ian Lyngen:

And one of the questions that we receive quite frequently given the focus that's been put on the fiscal side of the equation is whether or not the US Treasury market is overdue for a Gilt market style event, i.e., the spike in rates that we saw on budgetary concerns. Our take is that the US Treasury market is not vulnerable, certainly not at this moment, to a comparable episode. And the logic here is relatively straightforward. There was a moment in which we actually ran up against running out of support from the traditional buyers for US treasuries. Recall in September and October of 2023, we had seen the banks pull back because of the regional banking crisis. We had seen overseas sponsorship for Treasuries at markedly lower levels. And as a theme, buyers had become much more rate-sensitive. In fact, we'll argue that we ran up against the buyer of last resort, and the buyer of last resort at that moment was the hedge fund community and the sophisticated money managers.

And that's when we saw a demand for higher, at least positive, term premium, as well as an atypical late cycle bear steepening of the curve. What happened? The equity market responded negatively, risk assets more broadly corrected lower, and the Fed as well as the Treasury department very quickly changed their tunes and the Treasury market rallied. Now, this isn't to suggest that every auction in 2025 is going to demonstrate strong demand, but rather the cross-currents both in the domestic as well as the global economy, suggest that there will be plenty of demand to buy duration in what remains the reserve currency, at least for the next few years.

Ben Jeffery:

And one of the questions we get on that argument is whether the feedback loop between risk assets, the level of yields, and the Fed is still in place, or has the world changed enough as a function of QE, as the function of deglobalization, that those traditional cross-market drivers have started to break down. While the status of the global economy and financial markets is surely not the same as it was in say 2017 and 2018, or even in the early days following the pandemic, the simple fact that the dollar remains and will almost certainly remain, the reserve currency for the foreseeable future, should keep that feedback loop in place.

To say nothing of the realities of the global economic cycle and what's seeming to be a slowly turning labor market in the US, growth worries in Europe, China, that's already rolling out in impressive stimulus measures, and what that means for safe haven assets and specifically dollar-denominated ones. It doesn't mean that 10-year yields are going back to 1% anytime soon, but it should serve as a backstop of demand to take advantage of any sell-off in treasuries as we get them over the course of the next several months and quarters.

Ian Lyngen:

And on the topic of risk-off, it's nice to have survived another season of taking candy from strangers.

In the week ahead, the Treasury market will have a wide variety of influences to offer trading direction. However, there will only be one that really matters, and that is the presidential election results. Now, there's a great deal of uncertainty regarding potential outcomes, although we'll argue that the market has settled on one of two outcomes, one outcome being a Trump victory combined with a Republican sweep of Congress, i.e, both the Senate and the House of Representatives going to the Republicans. And the alternative scenario being a Harris victory with the Senate going to the Republicans and the House of Representatives going to the Democrats.

Both outcomes have decidedly different implications for the Treasury market. In the event of a red sweep, one should assume that that will be a bear steepener, upward pressure on longer-dated yields, certainly in outright terms, which will push the 2s10s curve even steeper. The biggest question that remains is to what extent has that already been priced in with 10-year yields in a range of 4.20% to 4.30%, which is where we're assuming that the market will remain until there's greater clarity on the election side. Now in the other scenario, the Harris win with the divided Congress, we would expect that to be much more bond bullish in the very near term with rates across the curve being pushed lower.

Now, it's probably not a 20 or 25 basis point rally across the curve, but it certainly should prevent any further sell-off. Returning to the first scenario, a Trump victory, we would suspect that that probably gets 10-year yields above 4.40%, at least momentarily. And then it becomes an issue of whether or not the backup in rates at this point in the cycle is sufficient to pull in sidelined buyers or if investors will remain more inclined to wait until the proverbial dust settles. Part of this will be a function of whether or not we know the full composition of Congress and the degree to which the market is comfortable with the stated results of the election, i.e., whether or not the general perception is that the results can be successfully challenged.

There's also a question of how long it will take before the election is actually declared. Recall that it was four days in 2020. And prior to that, with the exception of the first George W. Bush victory, which it took roughly 36 days before the results were official, it tends to be the night of or the day after the election when we're confident in the outcome and the results. Let us not forget that we also have the FOMC meeting on Thursday. The Fed is expected to cut rates by 25 basis points. And there's no updated SEP, so one would expect that the guidance contained within the statement to be consistent with the messaging that the process of normalization is underway. The incremental data will be informative as to the Fed's pace of future rate cuts, but the direction of travel is clear.

Obviously, Powell's press conference will be closely followed for any indication about the committee's current thinking as it relates to the December 18th meeting. We also have the refunding auction, which entails 58 billion 3-years on Monday, followed by 42 billion 10-years on Tuesday, and then capped by 25 billion 30-years on Wednesday. The schedule has been skewed a day earlier, simply to accommodate for the FOMC decision on Thursday afternoon. On net, we remain in the curve steepening camp. We think that a steeper curve can be achieved in both a bullish and a bearish scenario, the bearish being more likely in the event of a Trump victory and a Red Sweep, whereas a Harris victory would simply represent the passing of an event risk and allow investors to refocus on the Fed's path of normalizing policy rates.

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 market continues to work through the details of the noisy employment report, it strikes us that the ‘L’ might be missing from the BLS update this month. 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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