Downshift to Terminal - The Week Ahead

Ian Lyngen:

This is Macro Horizons, episode 205, Downshift to Terminal, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffrey to bring you our thoughts from the trading desk for the upcoming week of January 17th. And as we're optimistic that we'll make it through this Friday the 13th, we'll be safe until mid-October, unless the warlocks get us. George Santos had that listed on his resume too, right?

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 holiday shortened week ahead, the Treasury market received some fundamental input of note. Namely, the December retail sales print, as it presently stands, expectations are for a modest decline of six-tenths of a percent on a month-over-month basis. Now, this is information representing the end of Q4 and should at least on the margin have some implications for Q4 GDP expectations. It's notable that the final quarter of 2022 is generally expected to show solid growth, and this is consistent with the employment data that we've received for the period, and it certainly does allow the Fed ample justification that the real economy can continue to grow despite the tighter monetary policy environment. If anything, a strong Q4 real GDP number will galvanize the Fed's commitment to keep terminal once it's achieved in place throughout 2023 and into next year.

On the topic of monetary policy, the Bank of Japan meets during the week ahead, and expectations there are mixed insofar as the prospects for Koroda to push back further on yield curve control. If the Bank of Japan were to abandon yield curve control in its entirety or increase the ban by another 25 basis points, one should assume that 10-year JGBs should see rates increase in that 25 to 35 basis point range.

The most relevant question for the US Treasury market, however, quickly becomes, how far will 10-year yields increase in sympathy? We'll argue, as evidenced by the most recent increase in the yield curve control ban, that it's not a one for one translation of higher Japanese yields to higher Treasury rates. In fact, we see diminishing bearish returns as it were from any move by the Bank of Japan. So instead of a 10 to 15 basis point sell off in Treasuries, we'd look for a seven to 10 basis point backup in 10-year yields in the event that quota does decide to either abandon or further increase the ban on yield curve control.

Now, the second order trade is then driven by pondering what occurs when the Bank of Japan abandons negative rates. That would provide yet another flattening impulse for the global rate environment. Let us not forget that there's a key currency component at play as well. The yen had a very weak 2022. And as Japanese yields increase, one should expect the yen to stabilize and begin to appreciate against other major currencies, the dollar being the obvious benchmark of relevance in this context.

Hedging costs have been onerous for Japanese investors to buy Treasuries and hedge them back into local currency. Once we see a reduction in the rate divergence between the US and Japan, one would expect hedging costs to be less burdensome and ultimately bring in sideline buyers from Japan, a region that has historically been a major sponsor of US Treasuries. In fact, the most recent MOF data from Japan shows Japanese investors bought a net of 4.3 billion in overseas notes and bonds during the first week of 2023. Now, this represented the largest single week of buying since June of 2022. Nonetheless, the six-week moving average is still negative even if it increased to negative 1.2 billion from the prior pace of negative two billion. Now, keep in mind this data represents the purchase of all sovereign debt by Japanese investors, not just Treasuries, although, historically, Treasuries have made up the lion share of this series.

Ben Jeffery:

Well it was obviously a week the market had been waiting for, and while the information contained within the CPI report was as expected, the outcome in the market was unexpected. Specifically, we saw two-year yields drop decidedly below 4.20. The curves steepen out a bit. And most importantly, as we look ahead to February's Fed meeting, early signs that the committee is going to begin laying the groundwork for a further slowdown in the pace of tightening to deliver a 25 basis point hike on the 1st of February.

Ian Lyngen:

We're decidedly in the 25 basis point camp with a nod to the fact that by downshifting yet again, the Fed makes it incrementally more difficult to reach the terminal projection laid out in a December SEP, which offered an upper bound of 5.25. To achieve 5.25, we now need three meetings at which the Fed feels justified in hiking. Now, there will be a lot of information on offer between now and the May FOMC meeting, so we'll reserve judgment as to whether or not the Fed can actually reach the terminal that they've projected. But for the time being, it's safe to assume that in February and March, we see 25 basis point rate hikes, which then begs the question, how far are two and 10-year yields going to comfortably trade below effective Fed funds? We'll argue that it's too late to assume effective Fed funds will serve as a floor to nominal yields. And for that reason, amongst others, we continue to remain constructive on the longer end of the Treasury market.

Ben Jeffery:

And in some ways, this leg of the tightening cycle is playing out probably as Powell initially envisioned it. Back in December, the question was one of a 75 basis point or 50 basis point move. And now looking forward to February, before we got the CPI data, it was an unknown of a 50 basis point or 25 basis point move. Finally, at what might be the last hike of the cycle in May, it's going to be a 25 basis point or hold debate. So the gradual approach to terminal and the market's response to this week's developments still keeps the hope of a soft landing alive. After all, the payrolls data was nothing, if not, solid. Moderating wage gains, strong headline hiring, and a declining unemployment rate all show that the economy remains in a relatively good place while inflation continued to trend lower into the end of 2022. And we're only just now starting to see the real appreciable impact of the Fed's 75 basis point rate hikes that were delivered in the second half of last year.

So Ian, as you touched on, the question from here is going to be one of data dependence. And while there's no question that in the early days, the economy's dissent is going to look a lot like a soft landing, I think you and I both agree that the ultimate outcome is probably not going to be quite so orderly.

Ian Lyngen:

Well, not only will it not be as orderly, it won't be evident until we're into the second half of the year most likely. And the reality is that both a hard landing and a soft landing were always going to look similar in the beginning of the process. Said differently, we have a great deal of confidence in the Fed's ability to get the unemployment rate from 3.5% to 4.5%, but less confidence in their ability to stop it from going to 5.5% without needing to shift monetary policy. And this brings us to the core debate for 2023, and that will be whether or not Powell is able to retain terminal throughout the year and not resort to rate cuts until 2024.

Ben Jeffery:

There's also another question we fielded this week, which is another nuance on the unknown of just how long the Fed will keep rates on hold and that is, is there the risk we get through the March meeting, and what will be a 25 basis point hike? The SEP shows no dramatic surprise. And then rather than committing to another rate hike in May, the Fed says we may, we may not hike, but there's still further tightening on the table. And rather than an every meeting hiking pace, we returned to what we saw in the 2016 to 2018 hiking cycle, which was 25 basis points once a quarter.

Now, simply holding rates at terminal we think is probably more likely than that scenario, but should the employment market remain strong, and the progress made in bringing inflation lowers start to stall out? Certainly not an unreasonable outcome to consider to simply given the fact that bringing inflation from 7% to 4% was always going to be the easiest part of the journey back toward 2%. It's the demand destruction that's required to get from 4% back to 2% that's really going to be the Fed's biggest challenge.

Ian Lyngen:

And to your point, Ben, the trajectory of inflation at this stage is certainly coming in line with monetary policymakers expectations. But beyond that, the Fed is concerned, not only with the realized inflation data, but also inflation expectations. And it's for this reason that we anticipate there will be an increasing divergence between what the market believes the Fed should do and what the Fed ultimately delivers on. And by this, I simply mean that as inflation expectations, which are highly correlated with energy prices, remain relatively elevated versus, prior to the pandemic, the Fed will have justification and motivation to maintain its hawkish stance. And as we think about 2023, the most reasonable way one should anticipate the Fed will express this hawkishness is via job owning the market away from pricing in rate cuts this year.

Ben, you make a great point that the market isn't trading the pause with any symmetry. In fact, we're all assuming that once the Fed stops hiking, it's truly terminal and the next move is going to be a rate cut. In the event the pace of inflation doesn't conform to the Fed's 2% objective, the Fed could find itself in a situation where it either needs to do more in terms of rate hikes or potentially contemplate selling mortgages out of SOMA.

Ben Jeffery:

And while the bulk of our discussion thus far has focused on the level of Fed funds and where it is the terminal rate will ultimately emerge, let's not forget the Fed is also running down the balance sheet, and this means that, within the process of calibrating the appropriate level of restrictive policy, Powell is also going to need to make some decisions, not only on the MBS holdings, Ian, but also on the ongoing process of the Treasury runoff that kicked off in the middle part of last year. During the conclusion of the last tightening cycle, when we got that final hike in December 2018, the first step the Fed took on the balance sheet was slowing the pace of QT. So rather than effectively reinvesting nothing via add-on at Treasury auctions, the runoff cap was lowered and, in turn, the pace of the rundown slowed. That was, of course, until we got that first fine-tuning rate cut in the summer of 2019, at which point the Fed stopped running down the balance sheet if only given the signaling challenges associated with introducing accommodation via lower rates while also tightening policy via QT.

Based on how this cycle's played out thus far, we see little reason to stray from that roadmap as terminal approaches, which definitely puts a lower pace of QT on the table at some point in the later part of this year. Now, given the outright size of the balance sheet, it's probably likely the Fed is going to want to keep that process running on for as long as possible, but they also probably won't want to be continuing to conduct QT once they need to start cutting rates. So that means the balance sheet will probably stop shrinking at some point in the early part of 2024.

Ian Lyngen:

Not to belabor the point, but the notion of shrinking SOMA more rapidly via the sale of mortgages directly, I think might resonate more with the Fed when we put it in the context of the one key piece of inflation that remains, and that is upward pressure on OER, shelter, and rents.

As the December CPI numbers revealed, we saw downward pressure in a lot of different categories, including auto prices, which had been one of the key drivers as it were of inflation in 2022. The one surprise was that OER printed up 0.8%, which represented an acceleration from the numbers that we saw in November. More importantly, the Fed has made the observation via the FOMC minutes that core services, excluding shelter, have the highest correlation with nominal wages. And with that context, it was notable that this measure increased two-tenths of a percent in December versus 0.15% in November.

So with that backdrop, it becomes less obvious that the details of the data should've justified the market's assumption that the Fed would downshift yet again to 25 basis points in February. What ultimately drove the point home, however, was comments that followed the data from Fed officials. This is very consistent with what we would've expected, i.e. investors receive the data and look to monetary policymakers to help them translate that into the Fed's refined reaction function. On net, at this stage, the market is comfortable assuming 25 basis points on the 1st of February with a nod to the fact that the March rate hike will have the added informational value of two employment reports and two CPI prints.

Ben Jeffery:

And along with two more months of realized economic data, remember, at the March meeting, the Fed will also have to release a new dot plot. And I intentionally use have to there because for a Fed that's looking to maintain flexibility in terms of where it is they want to bring rates, the size of rate cuts, given the fact that we now effectively know that future policy moves are going to be of the quarter point variety, any amendment to terminal projections within the dot plot would quickly lead investors to price May and June rate hikes or price them out based on how the fed's official projections develop over the rest of the first quarter.

It's also worth noting that spread between the 2023 and 2024 dots that we saw in the December SEP at 100 basis points and what might result from softening labor market reads or further deceleration and inflation in terms of a larger widening of that spread and less projected easing next year, the inverse logic also holds. If we start to see inflation firm well above the 2% target, the unemployment rates stay low. There's certainly the potential for the Fed to feel comfortable penciling in a higher terminal rate than that 5.25 level we saw in December or less aggressive cuts in 2024.

Ian Lyngen:

So on net, the March SEP will most likely allow the Fed two signal with a greater degree of confidence where this cycle ends and what the risks are for 2024 and beyond.

Ben Jeffery:

2024 and beyond? It's Friday the 13th, let's not get ahead of ourselves.

Ian Lyngen:

In the week just passed, the Treasury market received a great deal of fundamental information, and it ultimately came to the conclusion that the Fed will be hiking 25 basis points in February as opposed to the 50 basis points that had been floated by some market participants. Now, this transition came following the CPI data, which printed pretty much in line with expectations. Headline CPI declined one-tenth of a percent, while the core figures increased three-tenths of a percent. Now, that follows the prior month’s two-tenths of a percent increase and ostensibly represents an acceleration. However, within the details, what we see is a broadening of the categories that saw prices decline, and arguably more importantly, the year-over-year core CPI figures decelerated to 5.7% from 6.0%. Now, this is directionally consistent with the Fed's 2% inflation target. However, there is still a significant amount of distance to go before the Fed can claim victory on its battle with inflation.

In the week just passed, we also saw notably strong receptions to the $40 billion in three-year notes, the $32 billion in, 10s and $18 billion in 30s. All of these auctions stopped through, and they stopped through despite the strong overall tone in Treasuries. It is notable that in late December, the narrative for January was anticipated to be one of heavy issuance on the corporate side, which would trigger higher Treasury yields in an accommodative move and for hedging reasons to take down the elevated corporate issuance.

Now, in fact, corporate deals have been on the higher side of expectations, but the broader macro environment has been what has ultimately defined price action in Treasuries. We've been on about the notion that 2s/10s can continue to invert back to the negative 85 basis point level that we've seen. The reality is, however, that if the Fed is decelerating its pace of rate hikes, there's a lower probability that it will get to the 5.25 terminal that it's set out in the December SEP. So we're beginning to find ourselves increasingly apprehensive that we could break through negative 85.

That being said, the negative 70 to negative 80 basis point range has become the norm. And until we get the final rate hike of the cycle, and clarity from the Fed in terms of its near and medium term policy intentions, we struggle to see scaling into the bull re-steepener as the path of least resistance. Eventually, the big macro trade of 2023 is always going to be the bull steepener, but it ultimately does come down to a question of timing. And in that context, we think that it is still too soon.

And while it wasn't necessarily new information, there was a variety of incoming Fed speak that helped to further shape monetary policy expectations on the part of investors. The number of comments specifically highlighting a quarter point rate hike, both before and after a CPI, spoke to the validity of that assumption going forward. It's certainly not wasted on us that even prior to the December CPI print. The market had already begun to emphasize the prospects for another downshift to 25 in part due by guidance from monetary policy officials that we expect will ultimately prove to be accurate.

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 track the headlines regarding a second president, that we know of, bringing home classified documents, it strikes us that the work from home revolution can only go so far, although we're certainly sympathetic to Washington being appropriately wary of any revolution.

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.

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