Divergence Emergence - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 261, Divergence Emergence, 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 February 20th. And as the 29th of February comes into focus, we're reminded that it's just a hop, skip, and a jump away. Some might call it a leap… 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 passed, there was truly just one piece of economic data that drove the macro narrative, specifically January's CPI Inflation data. Core-CPI came in slightly above expectations at 0.4%, but within the details, the services ex-shelter component printed at the highest levels since September 2022, which started the conversation about how long the Fed will ultimately need to delay before delivering the cycle's first rate cut and starting the process of normalizing policy rates.

If nothing else, January's data raised the bar for that conversation to start, and it wasn't particularly surprising to hear the wait and see message from the Fed. While the Fed has historically been reluctant to extrapolate too much from a single data point, the January CPI series nonetheless brought into question how that will translate through into core PCE, which presumably will err on the side of being stronger versus the expectations which are for a 0.3%. print to core. Treasuries understandably, and predictably, sold off on the firmer inflation data. 10-year yields made it up to 4.33% give or take, and has stabilized in and around that level. The ability of tens to stay above 4.25% for the foreseeable future is at best questionable. And we do think that as the balance of February unfolds, we will see a modest bid for duration occur and that'll push nominal rates lower.

Now we see it as unlikely that 10-year yields drop below 4% in the near term, but an extended period of consolidation between 4% and 4.25% as the market awaits greater clarity on the data appears to be the path of least resistance. In terms of the shape of the yield curve, 2s/10s flattening continues to resonate if for no other reason than the front end of the curve will remain under pressure as it seems unlikely that the Fed will be cutting any time soon. Ultimately, however, a bull resteepener remains our key strategic outlook for the coming quarters, but we'll caution it still remains too soon to begin scaling into that fundamental trade. Instead, we anticipate that the curve, along with a longer end of the treasury market, will be in a range trade and therefore playing the extremes in terms of the steeps in the flats will be the most prudent course of action.

The week just passed also included disappointing data on the consumption side with retail sales for January surprising on the downside. Now this obviously brought into question whether or not the Fed is at risk of entering a stagflation environment. All else being equal, we don't see that coming to fruition, certainly not based on a single data print. And we are reminded that as the year gets underway, January's data does have a tendency to be choppy and revised.

Vail Hartman:

January's hotter than expected CPI report reinforced the prudence of delaying rate cuts until the data confirms inflation is on a sustainable path to 2%. Core CPI gained 0.4% month over month outpacing the consensus estimate of 0.3% in the largest monthly gains since April 2023. And within the details, we saw core services ex-shelter increase by the most in 16 months at 0.7% versus 0.4% in December. We're hesitant to call the data a true game changer and instead it only extends the timeline for normalization. And this view is consistent with Chicago Fed President Goolsbee's comment that even if inflation comes in a bit higher for a few months, it would still be consistent with the path back to the target.

Ian Lyngen:

It does appear that monetary policymakers are trying to downplay the January inflation data, which is certainly in keeping with the Fed's tendency to focus on longer term trends and discount one-off or potentially one-off data surprises. And even within the January CPI release, we did see a surprisingly strong OER print, which once again brings up the question about what happens if the stabilization that's been seen in the residential housing market finally takes hold, we see a return to home appreciation as opposed to an extended period of stagnant prices, how is that ultimately going to be interpreted by monetary policymakers if they are worried about shelter inflation driving consumer prices in the near to medium term?

If nothing else, our interpretation of the January inflation data is that it has raised the bar for the Fed to be convinced that they've won the battle with inflation and it has extended the period that we expect the Fed will delay cutting rates by at least a few months. And those few months would need to be accompanied by benign inflation data. So we remain decidedly in the June rate cut camp with the caveat that if we have a repeat of January's data between inflation, employment, even with the slightly disappointing retail sales print, it will be very difficult for the Fed to move during the first half of the year.

Ben Jeffery:

And in some ways what we saw within the January inflation report was emblematic of the challenge that the Fed was always going to face in the journey back to 2% inflation, specifically that the relatively straightforward part of getting inflation lower has already taken place and it's going to be the last mile of the move back to 2% core prices that proves the most challenging and will ultimately require the most demand destruction.

So Ian, to your point, to talk about some of the housing components stabilizing or maybe reaccelerating and what that means about real estate sensitivity to higher rates, that simply means that the heavy lifting of the last move back toward the inflation target is going to have to come from some more tempered demand on the consumer side. And that in turn will presumably be a function of some softening in the labor market and a wage growth picture that certainly softer than what we saw within the latest payrolls report.

Now, in an environment when policy rates were not already at 5.50%, this would beg the question of if the Fed was even being restrictive enough to bring inflation lower. But based on, and as you mentioned Vail, the fact that we now have six months of a good softening inflation trend, that demonstrates that policy has moved into restrictive territory. And rather than necessitating more hikes from here, the reaction function going forward is simply going to be delaying cuts further and further given that in real terms, a 5.50% nominal policy rate is much more restrictive than it was in the middle part of last year.

Ian Lyngen:

And in this context, it's important to keep in mind the base effects that are going to be working their way through the year-over-year data during the first half of this year. Now, it's worth noting that in the wake of January CPI, we did receive a number of questions regarding what it would take to actually see the Fed put a rate hike back on the table. Ben, as you noted, our core assumption, pun intended, is that we're going to see the Fed avoid rate cuts rather than go from 5.50% to 5.75% or 6% in fed funds. But that doesn't necessarily mean that monetary policy makers couldn't see the merit in introducing some degree of symmetry at terminal. So we wouldn't be too surprised if the Fed didn't push back in the event that the broader conversation starts to contemplate what it would take for a potential rate hike.

Now, we don't expect the Fed to start that conversation, but that symmetry of risks at 5.50% is certainly consistent with the facts that the Fed could face in the middle of the year. Now again, a rate hike is a low probability event, although it's not a zero probability outcome. It's not impossible to envision a series of core CPI prints accompanied with comparable core PCE moves that mirror what we saw at the beginning of last year, which would of course be troubling for the Fed and realistically get the committee at least talking about perhaps the next move should be higher, not lower.

Ben Jeffery:

And while this is undoubtedly a very low likelihood event, given the market's departure point, such a development would be a game changer for valuations, especially in the very front end of the curve. While we've seen cut pricing this year moderate to more or less in line with what the latest SEP forecasted, there's nonetheless 80 to 90 basis points of cuts priced for the balance of the year with the first cut penciled in from the market's perspective right around June. And so to turn the shape of the very front end of the curve from downward sloping to potentially back upward sloping would hold material ramifications for the outright level of Treasuries across the curve of course, but also the shape of the curve given how consistently market participants have looked for the optimal level to begin scaling into core bull steepening trades.

In a not dissimilar fashion to last year, core bull steepening trades are predicated on the idea that the Fed is preparing to bring rates lower as Powell and others have suggested. And if there's any new economic information or Fed communication that suggests that might not be the case this year, a deeper and aggressive bear flattening of the curve would be the obvious reaction function in the rates market.

Ian Lyngen:

Quickly returning to the conversation about what happens if inflation doesn't moderate from the levels seen in January, there's an outcome that might actually be more likely than the Fed hiking rates, but at the same time more damaging to duration, and that is that by adopting a wait and see attitude, the Fed's actions are interpreted by the market as accepting a higher degree of inflation for an extended period of time, which would necessitate an increase in breakeven rates and push nominal treasury yields higher. That's a bear steepening scenario that would probably be accompanied by more supply related concerns and a return to positive term premium, which could create a bit of a snowball effect that would put 5% 10-year yields back on the table.

Again, not our base case scenario. And we believe that if the Fed is faced with a late cycle surge in realized inflation, that they will behave in a convincing fashion for the market, specifically going out of their way to reiterate that the 2% inflation target remains in place. And if needed, they're willing to hike again.

Ben Jeffery:

And as for the feedback loop and a bit of circular logic that this brings to mind, remember late last year what the conversation centered around as we saw 10-year yields reach 5% and the question remained of whether or not the Fed was actually going to need to hike again this cycle. That was this idea that as market rates increase, particularly real yields, then financial conditions tighten and the market does a share of the fed's work for them.

If the market is tightening, then maybe the Fed doesn't need to be quite as hawkish. But if the Fed's not quite as hawkish, then yields will presumably decline. And that represents the precariousness of Powell's situation at the current point in the cycle where we have good evidence that inflation is declining but not yet enough evidence that inflation has cooled enough to actually begin the process of lowering policy rates.

So all else equal, would the FOMC like to see rates higher? Maybe, on the margin. But one thing is for certain. They certainly can't afford to sound prematurely dovish given what that would do for 10- and 30-year yields. And to bring the conversation back to what you started with, Ian, mortgage rates and the overall level of restriction that market interest rates are inflicting on the real economy.

Ian Lyngen:

To say nothing of the wealth effect and what an increase in rates would do particularly at this stage to the equity market, which remains at or near record highs and as equity volatility has been suppressed, overall financial conditions then benefit from an added easing impulse. Now, we won't make the argument that the Fed would like to see stocks lower, but tighter financial conditions might be a welcome shift from the trajectory of the last two or three months.

Vail Hartman:

And there's been a lot of discussion on the committee about the commencement of the rate normalization phase of the cycle being tied to the committee's confidence that inflation is on a sustainable path to 2%, not the outright achievement of the target. And I think it's important to remember that their confidence need not only be a function of the hard data as survey and market-based measures of inflation expectations will be relevant too. These measures have remained well anchored and I think this will be an important place to watch as potential bumps in the hard inflation data could be deemphasized if these other measures of inflation expectations remain well anchored.

Ian Lyngen:

And I would argue that indirectly in question is how confident is the market that they understand what it will take for the Fed to become more confident in the direction of inflation.

Ben Jeffery:

Crisis of confidence?

Ian Lyngen:

I'm confident.

Vail Hartman:

Go Blue.

Ian Lyngen:

In the holiday shortened week ahead, the Treasury market will have far fewer fundamental inputs to offer trading direction. There's a 20-year auction of $16 billion on Wednesday and a $9 billion 30-year TIPS auction on Thursday. On the data front, we have existing home sales on Thursday, but really nothing that will challenge the prevailing macro narrative.

The one notable event is on Wednesday afternoon where we have the FOMC meeting minutes. The conversation around what it would take to begin cutting rates might be a bit dated in light of the January CPI numbers, but nonetheless, we do expect tradable headlines to result on would stay afternoon.

We'll also be eager to see if the Fed offers any details regarding the conversation about tapering QT. As the RRP continues to drift lower and the Fed has been successful in their efforts to take some of the excess liquidity out of the market, conversations have naturally turned to when the Fed will believe that it has accomplished all that it can in terms of shrinking the balance sheet. That being said, the balance sheet is presently much larger than it was pre pandemic, and so there's an argument to be made that to ensure against a moment of potential reserve scarcity, monetary policymakers will be willing to carry a larger balance sheet than they would otherwise find ideal.

Incoming Fed commentary will also be relevant and there are a few already scheduled speakers on the calendar. We wouldn't be surprised to see some late scheduled media appearances. From a trading perspective, we like the range trade in 10s and 30s. In the 10-year sector, anytime we get at or above that 4.33% level, we'll be watching for dip by an interest in the form of a stabilizing bid. Recall that the February refunding auctions went well with the $42 billion 10-year stopping through nine tenths of a basis point, which bodes well for our understanding that there is duration demand out there simply waiting a period of stability in terms of rate vol.

Our baseline assumption for the next several weeks is that the curve will continue to drift flatter or more inverted in the case of 2s/10s, a return to the prior range certainly resonates especially given the implications for the Fed from the higher than expected core CPI numbers in January. Any incoming Fed commentary will likely contribute to an upward bias on rates in the very front end.

And let us not forget that the final week of February includes the two, five, and seven year auction. So while the week ahead might not see any uptick in front end issuance, the final week of the month does, which further contributes to our bearishness for the front and the curve versus duration.

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. With markets closed on Monday for President's Day, we'll start the countdown to the next market holiday. 38 days to Good Friday. 27 trading days, and 24 and a half trading days if one tends to mail it in on Friday afternoons. But who's counting?

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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