Inflation's Vote - Macro Horizons

Ian Lyngen:

This is Macro Horizons, Episode 303: “Inflation's Vote” 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 December 9th. And with the November CPI Report at hand, we're reminded that regardless of the Fed's rhetoric, inflation still has a vote on the committee, although probably not a seat at the table. Herman Miller can only do so much.

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 most relevant piece of new information came in the form of the November Payrolls Report. Headline payrolls increased 227,000. That was versus a consensus of 220,000 and October was revised up, but it was only revised up to 36,000. So on net, the headline payrolls came roughly in line with expectations, slight upside surprise. Perhaps more importantly, the BLS added just 56,000 for the net two-month revisions. Said differently, the hurricane impact wasn't completely revised away.

In addition, the change in private NFP disappointed at 194,000 versus the 205,000 consensus. Looking at the combination of the Unemployment Rate and the Labor Force Participation Rate tells an even more troubling story. The labor force participation rate unexpectedly dropped to 62.5 from 62.6 in October and was well below the 62.7% consensus. All else being equal, when labor force participation drops, one would assume that the unemployment rate would move in the same direction.

The fact that the unemployment rate increased to a high 4.2% is all the more troubling. In fact, on an unrounded basis, the unemployment rate came in at 4.246%, so almost a 4.3%. The resulting price action followed intuitively. The market rallied. The frontend of the curve benefited the most and the 2s10s curve steepened. Our biggest takeaway was that there's nothing in this report that will prevent the Fed from cutting 25 basis points on the 18th of December.

Now, of course, we still have the November CPI series to offer incremental direction on Fed expectations, but in the wake of Nonfarm Payrolls, the odds of a quarter point cut in December increased above 90%, all but locking in a rate cut, assuming that there's not too much of an upside surprise in the November inflation figures. We also heard from Powell who stuck to the message of a data-dependent Fed on the path towards normalization with an indirect nod to the fact that at some point at one of the upcoming meetings, the Fed will pause.

We're operating under the assumption that pause comes in January, not in December, but when we get the updated SEP and the beloved dot plot, we'll have much better context for the Fed's plans in 2025. In our pre-NFP survey, we asked the question, "What will the dot plot signal for rate cuts in a year ahead?" The overwhelming majority suggested 75 basis points, which is only a modest increase of the 100 basis points signaled in September. On net, December is shaping up to be a continuation of the Fed's normalization process with little impact thus far from the election results. Clearly, this has a potential to change in January when Trump re-enters the White House, but for the time being, the theme is business as usual for the Fed.

Ben Jeffery:

Well, it was a pivotal week of economic data and frankly, one of the biggest weeks we're going to get before the end of the year, as the stage has been set for the December FOMC meeting, at least from an employment perspective, with headline hiring in November coming in slightly below expectations, a participation rate that declined and was below expectations, and an unemployment rate that increased to 4.2% versus the expectation for 4.1%. All of this tied out with a modest upside surprise in average hourly earnings, and while the minutia of the employment situation report will still be parsed for a clearer picture around the precise landscape of hiring last month between the distortions driven by weather and the compositional components of the data itself, one thing has been made clear by this week's data and that is that the labor market is continuing to soften, the risk of a re-acceleration hiring has moderated for one more month, and that will keep the Fed on track to deliver on their previously communicated messaging, which means a 25 basis point cut in December and ongoing normalization into 2025.

The biggest open question at this stage is what the pace of that normalization is going to look like and how the Fed is thinking about the data in aggregate that we've seen over the past month or so? That is – fine, not great, but not bad either.

Ian Lyngen:

And I think that an important distinction to make in this regard is that fine is good enough for the Fed to keep normalizing rates. We are not quite to the point where there's been enough softening in the labor market that the Fed would begin to get nervous that they're not normalizing quickly enough. That being said, another meaningful uptick in the unemployment rate, some softer numbers for the December payrolls profile could very easily shift the broader conversation from the Fed. The most relevant caveat however, is the fact that Trump takes the White House in January and that will presumably be accompanied by a renewed focus on tariffs, as well as concrete policy changes that the Fed will then have the option of responding to.

Now, one of the debates in the market at the moment is whether or not the terminal rate assumption will be revised higher on December 18th. From our perspective, adding 25 basis points to the 2025 and the 2026 dots is the path of least resistance. Maybe that changes the downward slope of policy expectations to get back to the 2.9 long run target, but we suspect that there is not currently much of an appetite on the FOMC to revisit the long run dot. Instead, we suspect that the Fed chooses to reserve that optionality for 2025 when there's more information in hand as to what the incoming administration plans to do, both in terms of the trade war as well as tax cuts. So said differently, it's still business as usual for the Fed, at least until the new year.

Ben Jeffery:

On the topic of tariffs, we've talked about how the Fed is going to be reluctant to quickly respond to what, in all likelihood, would be a one-off increase in prices and not the ongoing increase in inflation that would result from the implementation of hefty tariffs at the start of the new administration. The one caveat we’ll offer in this regard is that while the Fed is certainly not going to respond to potential policies that will be enacted and will probably still be reluctant to react until the economic implications of those policies show up in the data itself, one observation we've heard around the potential earlier ramifications from tariffs is as it relates to inflation expectations. Remember that the Fed's inflation mandate is not only preserving stable prices, but also the expectation thereof. So particularly if we see continued firming in some of the wage measures, obviously average hourly earnings within NFP, but also the increase in job changer and job stayer wage growth that we saw within ADP this past week.

That sets a backdrop where if workers' wages are continuing to rise and they're faced with the burden of higher costs not as a function of demand-driven inflation, but as a result of tariffs, that then reintroduces some upside potential to inflation expectations. And while not a surefire entrenchment of a wage inflation spiral, an uptick in inflation expectations at a time when growth is going to be coming under pressure as a result of tariffs runs the risk of putting the Fed in a precarious situation where expectations of higher prices are becoming increasingly cemented, all while the economy continues to slow. It's far too early to have a high conviction opinion on what tariffs will ultimately look like and what has just been an early negotiating stance from the incoming Trump administration, but food for thought as the Fed has now, "gained enough confidence in their fight against inflation” and we prepare to evaluate the fallout on the market from the changing of the guard in Washington that will take place in January.

Ian Lyngen:

With that backdrop, it is notable that ten-year breakevens remain elevated, certainly versus where they were prior to the election, which makes the steady decline in outright yields all the more notable. Essentially, it's been a real yield story with inflation expectations continuing to simmer below the surface, but the fact of the matter is that Treasury buyers remain active and as the end of 2024 comes into focus, we anticipate that ten-year yields are going to continue to drift lower, ending with a three-handle, let's call it 3.95%, before reversing course during the first half of 2025. Historically, the first two quarters of the year tend to be a bond bearish period for the Treasury market. There's a lot of seasonality associated with inflation, with forward growth expectations, with green shoots and risk assets, all of which tend to conspire to push yields higher and we don't see any reason to expect that that won't be the case in 2025.

Moreover, as you pointed out, Ben, the change in administration is expected to further stoke inflation expectations, all of which leaves us open to a retest of the 4.25% to 4.50% range in ten-year yields before ultimately, we expect that the second half of 2025 will be more bond-friendly with the bull steepening of the curve becoming thematic. We're forecasting ten-year yields to end 2025 at 3.75%, with two-year yields closer to 3%, let's call it a range of 3.00% to 3.25%. This assumes the typical cyclical re-steepening of the yield curve as far as 75 basis points, if not further by the end of next year. And as policy rates have continued to decline, the carry costs of a 2s10s steepener has become far less punitive. A reality that we expect will remove a disincentive for investors to scale into a core steepening position.

Ben Jeffery:

And while the domestic economic fundamentals dominated the market discussion this week, it wasn't solely US labor market dynamics that drove the price action in Treasuries. We had the headlines out of Korea regarding the political turmoil in Seoul to start the week, that was enough to bring yields off the highs along with the volatility in terms of the French political situation with what that means for the budget in Paris, and another factor outside of simply the US data that is another point of advocacy for lower treasury yields.

Last year, a lot of the questions we received were centered around the core uncertainty of who is it that's going to buy all these Treasuries? And if we've learned anything via the price action over the course of 2024, it's that there still exists a solid amount of demand waiting to take advantage of higher yields in US rates, and that's not only domestic demand, but large overseas players as well have been back to take advantage of relatively elevated yields in the US versus other markets as on the one hand, the Fed continues cutting, but central banks globally also continue on their normalization process as the trajectory of the global economy continues to head downward.

Growth worries in China come to mind. Obviously, Europe and the UK's economic outlook is not quite as firm as it is in the US, and as we've often observed in preparing our annual outlooks over the last several years, there's a lot of potential as of yet, unknown catalysts in the geopolitical and economic realm globally that keeps a stronger bid for Treasuries in place than would otherwise be the case. I would say recent auction performance has been a good barometer of this as well, and particularly as we get ready for the final 10- and 30-year auctions of the year next week, once the CPI Report is in hand, the auction results will be informative as to how willing investors are to step up and buy at these levels.

Ian Lyngen:

There's also the ongoing strength of the US dollar to consider. Even as the Fed remains on track to continue normalizing rates, the US dollar continues to outperform. And all else being equal, in the event that the rest of the world continues to slow while the US economy remains on comparatively strong footing, we would expect that the dollar would benefit in this environment, all of which bodes reasonably well for the underwriting of what is expected to be increased deficit spending over the course of the next several years.

Now, as Bessent is slated to take over the Treasury Department in 2025, and widely considered to be a moderating force as it relates to some of Trump's more dramatic campaign promises, we continue to expect that the first increase in auction sizes won't come to fruition until the second half of 2025 at the earliest. This outlook is also reinforced by the fact that the suspension of the debt ceiling will lapse in the beginning of next year, and the Treasury Department will begin the process of running down the TGA, which will put money into the front of the curve and provide investible cash to move further out, all else being equal.

Ben Jeffery:

And particularly as holiday shopping season wraps up, we're reminded there's a lot of value in liquidity.

Ian Lyngen:

Liquidity? Does that come in pill form?

In the week ahead, the Treasury market has one major data release to contend with, and that's the CPI print for the month of November. Expectations are for headline CPI to increase three-tenths of a percent, and the core CPI print is also seen up three-tenths of a percent. On an unrounded basis, the consensus is 0.27, so a low 0.3, but nonetheless, a 0.3. With the combination of CPI on Wednesday, PPI on Thursday and Import Prices on Friday, the market, as well as the Fed, will have a very good sense of how core PCE, the Fed's favored inflation measure, will perform in November. All else being equal, we expect that a consensus print across the board of the three major inflation reports ahead will provide a background consistent with another 25 basis point rate cut on December 18th.

Now, clearly there's a reasonable amount of surprise potential in the core CPI series, frankly, in either direction. We could see a disappointing 0.2 or an upside surprise at 0.4. The composition of a 0.4 or an upside surprise would be important in considering whether or not it's sufficient to keep the Fed from cutting. We'll be looking at the super core measure, which is CPI core services, excluding shelter. A moderation there, even with a surprise in overall core, could still create a path for the Fed to lower rates.

Let us not forget the auction calendar, which includes $58 billion 3-years on Tuesday, followed by $39 billion 10-years on Wednesday, and then capped with $22 billion 30-years on Thursday. We're expecting a reasonably uneventful auction process. We don't expect any major surprises or trouble in underwriting the final 10-year and 30-year auctions of 2024. It's not until the latter part of 2025 when the need to fund the federal deficit could push Treasury issuance higher. In fact, for the time being, we're more concerned with debt ceiling issues running down the Treasury's general account, which would, for all intents and purposes, create a QE impact as the Fed is expected to continue doing QT, at least through the first two quarters of 2025.

And with the Fed now in its self-imposed window of radio silence ahead of the December 18th meeting, investors won't have the benefit of any official Fed speak that helps refine expectations following the inflation update. However, if recent history is any guide and there is a significant enough surprise in CPI and PPI to warrant refining expectations, we wouldn't be surprised to see the media used once again to clarify the Fed's thinking at the moment.

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 with the season in full swing, remember, it's not a company holiday party – it's a company holiday gathering. So, joke responsibly and save your partying for other company. Get it?

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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