Wasting Away in Consolidationville - The Week Ahead

Ian Lyngen:

This is Macro Horizons episode 239, Wasting Away in Consolidationville 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 September 11th. And as we mourn, the loss of the father of tropical rock will endeavor to keep his memory alive. After all, it's always 5:00 AM on Macro Horizons. Vail crack open a seltzer.

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 most interesting aspect of the economic data came in the form of the surprising drop in initial jobless claims back to the lowest level since late January. This comes as something of a contrast to the increase in the unemployment rate that was seen in the month of August and certainly contributed to the bond bearish price action.

Within the selloff, we'll observe that the opening gap in 10 year yields that comes in at roughly 4.31 has failed to be closed, at least thus far. From a technical perspective, that's a level that should provide some support in the event of another bearish impulse. Our trading bias has been for an ongoing consolidation with 10 year yields between 4% and the upper bound of 4.36%. While eventually this range will break, the obvious events on the macro horizon will be insufficient to make such a break sustainable. As the Fed continues to reestablish the credibility that it lost in 2022, our expectations remain that breakevens will drift lower, real rates will be biased higher, and this will have the traditional impact on risk assets. In this context, we continue to see domestic equities as vulnerable in the near term. This is also consistent with the seasonal patterns that tend to come into play in September and October.

The incoming Fed speak in the week just passed was mixed overall, but the biggest takeaway was that the September meeting will not see a rate hike. Now, this is certainly consensus at this point, but what becomes less obvious is whether or not the Fed will choose to move in November or December. Given that there's no October meeting, the committee will benefit from a series of economic updates which will afford them the ability to see the degree to which prior rate hikes are finally beginning to weigh on both inflation and the employment market. Consumption continues to hold up well all things considered, and in the week ahead we'll be watching the August retail sales numbers as well with a nod to the fact that the consensus is for just a one tenth of a percent gain. Overall, we see no reason to fade the current consolidation that's underway, and we'll note that corporate issuance as well as Treasury issuance remains very topical and will limit the market's ability to rally significantly even in the event of a disappointing combination of CPI and retail sales.

Vail Hartman:

It was a week that offered somewhat mixed signals on the state of the labor market, particularly after the spike in the unemployment rate to 3.8% in August. And that's because we saw initial jobless claims drop for the fourth consecutive week to the lowest level since February and ISM services employment surged to the highest level since November 2021. The culmination of the data served to keep Treasuries in a holding pattern at the top of the cycle range heading into next week's CPI report.

Ian Lyngen:

I think the biggest takeaway from the week just passed was that the Treasury market is unquestionably in a mode of consolidation as we approach the upcoming inflation update as well as a series of auctions in the week ahead. In terms of what this process of consolidation implies for the next leg in US rates, it's unclear. And frankly given how contingent monetary policy is on the economic data at the moment, it follows intuitively that the direction of yields will also be extremely data dependent. That being said, we see a higher probability of 4% 10 year yields as opposed to 4.5%.

Ben Jeffery:

And a big driver of that underlying bullishness is that this latest backup in nominal rates has been very reminiscent of the last time we got 10 year yields back up to 4.30%, given the fact that the selloff has not been a function of higher breakevens, but rather a renewed push higher in real rates. And in the 10 year sector, reals came back to effectively match the cycle highs at 2%. And the last time we saw this happen in the middle part of last month, there was enough angst surrounding the implications from higher inflation adjusted borrowing costs to inspire some modest softness and risk assets, but also drive a lot of client conversations on if the US economy can really withstand real yields this high and contemplate the value of a risk-free inflation protected return of 2% over the next 10 years. Arguably, it's this type of selloff that is a good thing from the Fed's perspective as breakevens that remain well-contained are a vote of confidence in the efficacy of monetary policy and higher real yields will help keep financial conditions tight enough to continue the fight against inflation.

Ian Lyngen:

And an environment in which 10 year real yields are above 2% is certainly not unprecedented. If we look back to the period between the early 2000s and in the runup to the great financial crisis, what we see is that 10 year tips yields were comfortably above 2% for a sustainable period. Drawing that comparison is somewhat dubious because the liquidity and the functioning of the TIPS market during that period was much different than what it is at the current moment. Moreover, QE and the Fed's active use of its balance sheet was not a known quantity the last time that real yields were this high. The realities of monetary policy in the wake of the 2008/2009 episode really have left the market convinced that regardless of the Fed's signaling to the contrary, the balance sheet will always be a backup tool for monetary policymakers.

Ben Jeffery:

And to extrapolate that argument on something we've heard a lot about since the August refunding announcement, I would argue it's also precisely that dynamic that runs counter to the structurally higher term premium argument that has contributed in pushing rates back to the cycle highs. After all with policy in restrictive territory and early signs of the implications of that starting to show up in the labor market, most recently in the August payrolls report, and thinking about the longer term distribution of risk around real growth over the course of the next 5, 7, 10 years, given the fact that Treasuries still operate as something of an insurance product within the global financial system, that suggests that Treasury bonds should be richer and rates should be lower than would otherwise be the case, all else equal. Add to that dynamic that the QE genie can be put back into the bottle and even in an environment with high inflation and lofty deficits, that all points to term premium in the long end of the Treasury curve being a bit lower than "should be the case" if Treasuries were a traditional asset class.

Ian Lyngen:

And Ben, you make a great point about the way Treasuries function as the go-to flight to quality asset. And when we think about the amount of monetary policy tightening that's been executed away from the Fed, the ECB, the Bank of England, the Bank of Canada, even the less dovish tones from the Bank of Japan, all this leaves us with the distinct impression that even in the event that the US economy is able to withstand sustainably higher policy rates for an extended period, we find it very difficult to envision that every major developed economy will be able to do the same, to say nothing of emerging markets and the risks associated with some of the recent dislocations in financial markets there.

Ben Jeffery:

And on the emerging market front, if we're already talking about the risks facing the US, Western Europe, more developed parts of Asia with monetary policy, this tight and interest rates this high, that same dynamic is even more concerning for emerging markets. Think parts of Asia, Africa, the Middle East, places along with the rest of the world that have become accustomed to the cushion of easy monetary policy and low borrowing costs over the better part of the last decade, and who in order to get through the economic shock of COVID conducted a lot of borrowing at very low rates that is now going to need to be refinanced. It's not difficult to envision a situation where some extraneous shock, whether it be geopolitical, economic, or some other as of now unknown influence triggers a round of global volatility that is sparked from a market that right now we're not particularly focused on.

It's this overarching idea that when rates are this high, things are far more prone to go wrong. That also plays a role in our longer term, more constructive take on Treasuries and we've talked a lot about of what we've learned over this past week, but the test of demand for Treasuries will also receive a primary market update as we see the sponsorship that meets threes, tens, and thirties that are set to be auctioned on Monday, Tuesday, and Wednesday of the coming week.

Vail Hartman:

Since the August refunding announcement, that kicked off the first month of growing coupon issuance sizes in more than two years, headline results have been fairly mixed. Though we can extrapolate several constructive takeaways from the takedowns considering that all but one auction has seen above-average bid-to-cover ratios and we've also seen strong non-dealer and indirect participation. Looking to the coming weeks auctions, we expect to see similar demand from these buyer bases, and especially considering that each auction holds the potential to clear at the cycle high levels, and also with the fundamental backdrop of increasing evidence of the effectiveness of the Fed's inflation fighting tools, we're confident in a solid backstop of dip buying demand.

Ben Jeffery:

And along with supply, this coming week is also going to be notable for what's not going to happen and what's not going to happen is any official Fed communication given that we've reached the point where the pre-meeting communication moratorium will be in place. We heard from a lot of Fed speakers over this past week across the dovish and hawkish continuum, both voter and non-voter. And while no hike in September is clear, there's still a willingness if not necessarily desire to deliver another hike either in November or December. And that is surely going to be a function of the incoming data first next week with CPI. But then we also get another month's worth of employment and inflation data before the committee will convene again on November 1st.

Vail Hartman:

On the topic of Fed speak, earlier this week we heard from a more hawkish leaning member on the committee in Fed Governor Waller, who notably earlier this summer said that he called for two more hikes before the end of the year, but has now revealed that there is nothing saying that we need to do anything imminent anytime soon. Given the encouraging NFP and CPI reports that we have received in the interim, what do you guys think the latest data means for the more hawkish leaning members on the committee similar to Waller who may have reached a level of confidence in the trajectory of the data to shift to an on-hold policy stance?

Ian Lyngen:

My takeaway from the recent Fed speak has been that the committee is making it very clear that on September 20th there will not be a rate hike. Now it's unclear whether it's a skip or a pause and more information will be available via the SEP and the updated dot plot. Within the dot plot, we do anticipate that the Fed will retain the signaling that there will be one more rate hike before the end of 2023 and for no other reason than that will provide them sufficient flexibility and perhaps more importantly, prevent market participants from aggressively pricing in rate cuts. So while we're not anticipating a rate hike, it will still be a decidedly tradable event.

Ben Jeffery:

Speaking of tradable events, the NFL is back this weekend, so I'll turn it over to Vail. Vail, any picks?

Vail Hartman:

Yeah. Lions over the Chiefs.

Ian Lyngen:

Yeah, we'll make a strategist out of you yet.

In the week ahead, the market will have both supply and top tier data to contend with. Given the Friday settlement of the auctions, the schedule has been moved forward by a day and on Monday we have $44 bn 3-years, followed by $35 bn 10-years on Tuesday and capped by Wednesday's $20 bn long bond auction. Wednesday morning also sees the release of August CPI where headline expectations are for a six tenths of a percent gain, whereas core-CPI is seen increasing two tenths of a percent. Now our expectations are consistent with the consensus. However, unlike in June and July where core-CPI printed a low 0.2, we are anticipating that the unrounded numbers might be slightly above the consensus. All of that being said, as long as we don't see a 0.4 or 0.5 core-CPI print, the market's collective understanding that monetary policy still works, it works with a lag, and the Fed's attempts to slow the pace of consumer price gains has been effective.

Now, whether or not that ultimately translates into avoiding a Q4 spike in inflation remains to be seen, but as it currently stands, investors are continuing to regain confidence in Powell's monetary policymaking. Assuming no major surprise from CPI or PPI to say nothing of retail sales, we expect that the path of least resistance will remain a sideways grind in rates until we get to the September 20th FOMC rate decision. We're not anticipating a rate hike, but we do think that within the details of the updated SEP, we will see upward revisions to the growth outlook for 2023 as well as another quarter point added to the 2024 projection of Fed funds. This will reduce the amount of signaled rate cuts next year from 100 basis points to 75 basis points.

And we're reminded that if the departure point is in fact 5.75% as the Fed has been indicating, then a drop to 5% won't be truly accommodative. In fact, and this will be framing that it will be important for Powell to effectively communicate, a reduction of that magnitude will simply be going from very restrictive to restrictive. Particularly if as Powell has indicated, the Fed is willing to allow QT to continue in the background as SOMA is allowed to run off. Suffice it to say, Powell's incentives at this point are to make sure that the market doesn't aggressively price in more rate hikes than are currently reflected in Fed fund's futures. And in an effort to accomplish this, the chair will more likely than not note that another rate hike this cycle is still on the table.

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 struggle with the juxtaposition between the current heat wave and the return of pumpkin spice lattes, all we can say is that something has to give. 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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