Ex-Shelter from the Storm - The Week Ahead

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Ian Lyngen:

This is Macro Horizons, Episode 222, Ex-Shelter From The Storm, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring you our thoughts on the trading desk for the upcoming week of May 15th. And with April's CPI report offering no convincing skew for June's Fed meeting, we're reminded of the most often utilized tools in the strategist arsenal, the dartboard, the coin flip, the magic eight-ball, and of course, the newest edition atypical inference.

Vail Hartman:

Wait, that's not what AI stands for.

Ben Jeffery:

Really?

Ian Lyngen:

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 US rates market received a wide variety of fresh fundamental information to help guide price action, and what resulted was a bull steepening. To be fair, the bull steepening hasn't represented the big cyclical breakout that we've been expecting as twos tens remains close to if not precisely on negative 50 basis points. Nonetheless, we continue to see the path for the yield curve turning positive by the end of the year, and as we've seen fives bonds already lead the proverbial charge, we expect that that spread will move north of 100 basis points by the first half of next year.

The week just passed gave us the all important April CPI print, which showed core CPI as expected up four tenths and headline CPI similarly matching the consensus at up four tenths of a percent. Now within the details however, what we did see were rents and OER decelerate, some downward pressure in auto prices and of course, the all important core services Ex, OER and Shelter component increased just one tenth of a percent in a marked deceleration from recent reports. Now as a result, the market took this information to conclude that the Fed had in fact reached terminal at 5.25 and then the debate began in earnest as to when the first-rate cut would occur and how significant such a move would be.

We remain in the camp that the Fed will do everything that it can to avoid cutting rates between now and the end of the year. They have signaled on a number of occasions that an atypically long period at terminal is warranted given the upside surprises in inflation that characterize the bulk of 2022.

Now in the context of the average seven months at terminal, we'd expect that the bar would be very high for the Fed to contemplate a December rate hike instead erring on the side of pushing the first rate hike into Q1, let's call it March. When we look at the Fed fund's futures curve, what we see is roughly 100 basis points worth of rate cuts priced in for February of next year. So that would imply a much more dovish Fed than Powell has been signaling.

Now to the market's defense the Fed only rarely gives forward guidance as to precisely when it will deliver rate cuts. Although it is notable that the March SEP communicated to the market that next year there will be a recalibration lower of policy rates, albeit still in restrictive territory. And I think that that's ultimately going to be the most interesting messaging challenge for the Fed. If they have underestimated the impact of the credit tightening associated with the regional banking turmoil, then it would follow intuitively that rates would need to be recalibrated slightly or perhaps even meaningfully lower to achieve the desired amount of tightness in overall financial conditions.

Now in the event that we see a significant sell off in the equity market that leads to a spike in equity volatility, the associated tightening of financial conditions would also potentially warrant some type of adjustment for the Fed. For better or worse, the equity market continues to bring forward the prospects for a rate cut and assumes that the Fed put is struck a lot closer to current levels than we ultimately believe that it is.

Vail Hartman:

With April's CPI and PPI data in hand, the market is widely confident the committee has reached a terminal rate for the cycle and we are now pricing in roughly 75 basis points of rate cuts by year-end and more than 100 by February 2024.

Ian Lyngen:

That does offer interesting context for where we are as a market and it's certainly not atypical for the futures market to indicate investors are anticipating the next logical shift in monetary policy. The Fed did an admirable job of signaling that once terminal is achieved, that the next move will ultimately be a rate cut.

Now, they chose to do this intentionally as evidenced by the fact they didn't introduce any symmetry of risk around a pause. And so we, along with the market, are operating under the assumption that 5.25 will be the upper bound for monetary policy during this cycle and as a result we're not looking for another rate hike in June. That being said, the biggest challenge for the Fed this year will be retaining 5.25 longer than is typical following a hiking cycle. On average it's about seven months from the last hike to the first cut. That means in practical terms that the December meeting is I'm air quoting here "in play."

Ben Jeffery:

And it was the inflation data that unquestionably drove the bulk of this week's bull steepening. After all, we saw the Fed's favorite sub-component of CPI in core services, excluding rents and OER, rise at just 0.11% month over month. A very encouraging detail for the sub-component of inflation that Powell has told us is most closely linked to wage gains and this in turn pulled some hike pricing out of June, Ian as you touched on, and an even more dramatic inversion of the Fed fund's futures curve beyond July.

However, it wasn't only inflation that dictated the price action as anxiety surrounding the regional banking sector once again flared up and offered what's becoming the textbook way to trade a banking crisis in the rates market, which is an extension of the bull steepening. So partially fueled by inflation, but also a fair amount of banking angst in there as well.

Ian Lyngen:

It's notable that the go-to trade in response to elevated banking sector angst has been a bull steepener as opposed to a bull flattener. And the reason that I make this observation is because the Fed has gone well out of its way to draw the distinction between macro prudential tools and monetary policy tools. The former being used to ensure banking system stability while the latter is designed to address inflation expectations as well as the employment market.

Ben Jeffery:

And thus far, at least on the employment market front, there seems to be little urgency to cut rates. After all, we got the unemployment rate dropping back to 3.4% in April with the participation rate unchanged. So that's a true decline in the unemployment rate and further extends Powell's timeline that he will ultimately be forced to cut rates.

Ian Lyngen:

And to the market's defense, the reality is that if the situation in the banking sector gets dire enough, the associated tightening of credit standards and therefore tightening of overall financial conditions will warrant monetary policy action even if the Fed believes that the current level of financial conditions represent the appropriate degree of tightness. In the event that we see a spike in equity volatility or a meaningful increase in credit spreads, that will push financial conditions deeper into restrictive territory, potentially warranting a response on the monetary policy side. But at the end of the day, it really comes down to whether or not the Fed has appropriately estimated the rate hike equivalent of the credit tightening that is sure to follow the banking stress that we've already seen.

Vail Hartman:

The Fed's quarterly senior loan officer survey failed to generate a meaningful price response as it didn't demonstrate quite as much credit tightening as the market was anticipating.

Ben Jeffery:

It's a great point, Vail, and along with CPI, obviously the senior loan officer survey on Monday was definitely an event risk that many in the market were going to be closely scrutinizing for any more concrete, not just anecdotal evidence of a pullback in lending from banks around the country as a result of what's been seen over the past couple months. But instead what we saw is that the survey, and it is worth acknowledging that it is just that, a survey, showed that credit conditions in the first quarter did not tighten as dramatically as was the initial concern.

Ian Lyngen:

To be fair, the majority of respondents to the survey saw the credit conditions overall as basically unchanged, which was consistent with what we saw during the prior quarter. Although on the margin the survey did reveal some incremental concern. That being said, I think the more fascinating aspect of the senior loan officer survey was the fact that demand fell rather sharply.

Now this follows intuitively. There was so much uncertainty during the first quarter that if a firm was considering a significant expansion or investment in property plant and equipment or capital raising effort for any other reason, those plans logically would've been put on hold if that was an option. Anecdotally, the vast majority of capital markets activity was a result of deals that were already in the pipeline and there was very little appetite to bring a new transaction until there was sufficient distance from the mid-March episode.

Ben Jeffery:

And so, for better or worse and definitely consistent with the Fed speak that we've heard so far this week, the ultimate unknown in terms of how many rate hikes is the regional banking crisis worth is still left unanswered. And this isn't a question we're going to have a great deal of clarity on for probably the next several months, if not the next several quarters as the Fed is increasingly shifting to a mode of data dependence and ultimately that means the direction of the market is becoming increasingly data dependent as well.

We have NFP, we have CPI, and we're heading into the next few weeks, which at least in terms of economic data are relatively sparse before the setup for May's payrolls report. We do get retail sales, a few pieces of housing data, 20-year supply and tips supply next week, but more likely than not, it's going to be up to more tactical, technical and cross asset considerations to drive the short term price action in Treasuries. And given what we've seen recently, there's two levels of note to flag that we've been watching. The first is 4% 2-year yields and the second is 3.50 10-year yields or said differently, the magnetism of negative 50 basis points in twos tens that is becoming increasingly relevant as investors continue to ponder when is the right time to put on a 2s/10s steepener.

Ian Lyngen:

That is the big question for the year. This year was always going to be about timing the cyclical re-steepening of the yield curve. Now we were encouraged and continue to be encouraged by the fives bonds spread, which has pushed back north of 40 basis points this week and reinforces the idea that as investors look to the next stage of the cycle, we're far more likely to see the Fed err on the side of needing to cut rates further once that process gets started. Again, we think that rate cuts will be delayed into 2024, all else being equal, with a nod to the fact that the market is aggressively pricing in a rate cutting campaign that far exceeds what has been signaled by the Fed via the most recent SEP.

Ben Jeffery:

And we've made it this far in the conversation without talking about this week's Treasury supply. It was the refunding week and there were some takeaways for what we saw in terms of auction sponsorship.

Vail Hartman:

The relatively contained 0.8 bp tail for tens was especially telling, considering it cleared out effectively the yield lows for the day and following the dramatic rally after the CPI data.

Ben Jeffery:

What about the bidder stats? Anything jumping out there?

Vail Hartman:

Well, for tens, they were effectively in line with recent averages, but looking at the three-year auction that stopped through three basis points, the supply was met with a lot stronger sponsorship and that was particularly informative given it comes in line with the steepening trend we've seen in Treasuries and the idea that the market is not expecting any more rate hikes this cycle.

Ian Lyngen:

Said differently, front end rates just got too attractive that bidders couldn't stay away and I think that's very consistent as you point out Vail with where we are in the cycle. If one thinks of three year yields as nothing more than a 36-month moving average of monetary policy expectations, it goes without saying that over the course of the next three years, the Fed is going to be doing a lot more cutting than they are hiking.

Ben Jeffery:

And also within the details of that threes auction, what was most notable was an elevated indirect take down. Not something that's immediately knowable until we get the auction allocation data in a few weeks, but as a rough back of the envelope approximation, indirect bidding has tended to track more or less in line with foreign sponsorship. And so, if in fact overseas investors were behind the strength of the bid that we saw at the three-year auction, this is another vote of confidence for Treasuries as an asset class simply given the fact that domestic buyers are becoming interested but so are foreign ones.

Now additionally, this week we also learned some information to the contrary of this notion, and that was that two more large Japanese life insurers revealed their investment plans for their new fiscal year, and notably it included reducing their holdings of currency hedged Treasuries in favor of more purchasing of US corporate debt and also local JGBs.

Ian Lyngen:

It'd be interested to see what comes out of Tokyo insofar as the allocation to mortgages. Recall that for all intents and purposes, the mortgage market has been on pause since the middle of March. We have seen the SVB portfolio make its way into the market and the distribution has all things considered gone reasonably well. Certainly the FDIC has to be happy with the way the market is absorbing the parts of the portfolio that are being divested, and it remains to be seen in the event that the regional banking stress increases how the market will respond to the potential for more bonds to hit the street.

Vail Hartman:

This week, president Biden and House Speaker McCarthy also met to discuss the debt ceiling and anxiety is still high.

Ben Jeffery:

It certainly is high Vail, and judging by the number of conversations we continue to have about the likelihood of a default, the market as a whole is clearly worried that the quickly approaching x-date will actually result in a delayed payment from the Treasury department. Still something we see as extraordinarily unlikely, but the reality is that the clock is running out for the Republicans and the Democrats to reach some sort of consensus around a compromise to either raise or suspend the debt limit.

Early June maturity bills continue to trade at a steep discount to surrounding maturities and we actually saw the two-month auction on Thursday stop through by 38 basis points. So there's still demand for bills after the auction size cuts we've experienced, but that demand is not for maturity days around the potential for a late payment.

We've mentioned it before, but it's worth reiterating that June 15th is going to be a pivotal day as it relates to the actual x-date, given the fact that there will be coupon payments to be made, but also quarterly corporate tax receipts received by the Treasury department. And so in the event Yellen can make it through that week without running out of funds, that should buy the government a few more weeks of runway before another potential late bill payment would be a real risk.

Ian Lyngen:

The one aspect of this entire thing that I have the most confidence in is Congress' ability and desire to wait until the absolute last minute to cobble together some type of deal. The moving target aspect of the x-date however means that determining the 11th hour becomes much more difficult for lawmakers and as a result there is a non-zero probability that a payment is missed.

What will be more interesting in the event of a missed payment is to see any remedies that the Treasury department chooses to impose upon itself as a result, i.e. can we get Congressional approval to pay accrued interest on the bills that end up being paid late? Would the Treasury department assign a penalty fee for missing the payment? A normal lender would need to do that, in this case, however, we worry about the moral hazard associated with simply charging the Treasury department a penalty because future Congresses might look at that as simply the cost of doing business, thereby taking away the stigma associated with a missed payment and if nothing else, that would further undermine the dollar's stature as the reserve currency.

Vail Hartman:

So why are we trying to seal up the debt? Don't we want people to buy it?

Ben Jeffery:

I before E, except after C.

Ian Lyngen:

And sometimes Y.

In the week ahead fundamental information will be comparatively limited but not completely absent. On Tuesday we see the retail sales report for the month of April. Expectations there are for a three tenths of a percent increase in nominal sales. It's important to keep in mind that this is not an inflation adjusted number. So just using April's CPI of up four tenths as a back of the envelope estimate of what real might be, our conclusion is that a consensus print would suggest that real consumption began the second quarter in negative territory.

Now, that's not particularly troubling for the Fed. After all, Powell has emphasized that the current tightening campaign will result in economic pain somewhere in the system. Presumably the chair means even beyond what we've already seen in the regional banking sector. On the supply front, Wednesday offers 15 billion 20-year notes, and then on Thursday we see 15 billion 10-year tips.

Gauging appetite for Treasuries as an asset class as a function of the take-down of inflation protected tips creates a unique challenge. It goes without saying that despite some of the debt ceiling concerns, the dollar remains a reserve currency and the liquidity provided by the 10-year tips auction has historically been taken advantage of by investors whose mandate simply dictates that they need exposure to the sector.

Let us not forget that on Friday, May 19th Powell speaks in the morning and given the economic data, the update on the inflation front, and any headlines associated with the debt ceiling debate, market participants will be particularly attuned to what the chair has to say. Our baseline expectation is that Powell will reiterate the messaging that followed the FOMC meeting, which emphasized that monetary policy has unquestionably shifted into the mode of being far more data dependent than it was this time last year.

And in light of April's CPI and non-farm payrolls report, it will be a potentially tradable event to hear Powell's interpretation of the overall health of the US economy. Let us not forget that we will see a variety of housing sector updates. Existing home sales in April are forecast to have declined 4.3% on a month-over-month basis. While this might be a logical outcome based on the Fed's efforts to counteract housing inflation, the reality is that for the vast majority of the country, home equity represents the most significant store of wealth. Does that ultimately translate into downward pressure on consumption as 2023 plays out? That appears to be at least part of what the Fed is wagering.

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 a reminder to anyone that might have forgotten Sunday is Mother's Day. Recall, every Mother's favorite color is platinum.

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 Podcast 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:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com\macro horizons\legal.