Navigating November - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 297, Navigating November, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of October 28th. And as Halloween marks the end of October and NFP kicks off November, the question, ‘trick-or-treat?’ seems particularly appropriate. 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 relevant development came in the form of the price action itself.

The early part of the week was spent in a decidedly bond bearish fashion with 10-year yields pushing as high as 4.25. Now, ostensibly, this was due to a renewed focus on the presidential election and the fact that the race now seems to be a very close call. So to some extent, what the market did is they priced in a higher probability that Trump will retake the White House, and considered the reflationary implications of a renewed push on the tariff front as well as any ramifications from an escalating trade war with a variety of trade partners. That being said, the absence of any meaningful economic data created the perfect backdrop for a sharp response in US rates. So the fact that we did see 4.25 achieved and there was some buying interest that ultimately followed certainly conforms with what we would expect to see in such a trading environment.

The price action also came at a moment when the no-landing narrative has fully taken hold. The variety of data points from the month of September showed that the third quarter ended on strong footing. Now the biggest question at the moment is whether or not September was the anomaly and October will resume a softer trend, or if September marks the new norm, and we will continue to see upward pressure on the super core inflation series, as well as a rebound in the labor market. It also hasn't been wasted on the market that September will be the last clean month worth of economic data before the impact of the hurricanes, and to a lesser extent, some of the recent strikes starts to distort the economic data. That will leave the Fed in a very specific place as it relates to the November rate cut. The presumption will be that any weakness in the October data will be more a function of noise than it will be any new trend.

As a result, we see the path of least resistance for the Fed to continue cutting rates, but at a more pedestrian pace of 25 basis points per meeting. We think that this pace applies to both November and December, and it's not until the beginning of 2025 when we think that there's a reasonable case to be made for the Fed to skip a meeting. Perhaps that's January, perhaps that's later in the year. Ultimately, that comes down to the Fed's read and the trajectory of the real economy. However, for the time being, the market appears content to price in the risk, at least, of a reflationary outcome from the presidential election.

Ben Jeffery:

Well, we came into this week cautiously bearish, but what ultimately ended up playing out was a little bit more than cautious. The 200-day moving average in 10-year yields proved to be nothing more than a line on a chart, and the sell-off in duration that characterized the first part of the week was impressive given the lack of any data of note and the fact that unlike what's been the recent reaction function in the Treasury market, the down trade in treasuries and move towards higher yields wasn't of a flattening variety, but rather a steepening one as 2s/10s accelerated back toward the recent steeps. 10-year yields and outright terms came within striking distance of an opening gap we've been watching around 4.28.

And higher odds, at least from the market's perspective, of a red sweep in November, has reignited the term premium discussion and the compensation that is required for investors to reach further out the yield curve. Now, by no means was it a repricing toward higher rates across the curve, but 10-year yields now comfortably back above 4% and between, call it 4.15 and 4.25 now represents a market that has a reasonable probability priced for Trump to take the White House and Republicans to claim both chambers of commerce. So with less than two weeks to the election, that begs the question of where we go from here, if in fact we have a reasonable amount of politically inspired inflationary premium already reflected in the market.

Ian Lyngen:

And it is interesting to note that the market appears to have come down to one of two scenarios from the election as the operating assumption. Either Trump retakes the White House and there's a red sweep, i.e, both the House of Representatives as well as the Senate going to the Republicans or Harris takes the White House and there's a split Congress. It's notable that those two scenarios have decidedly different reflationary implications, with a Republican sweep being the most bond-bearish. And to a large extent, as you alluded to Ben, it's this risk that has been the primary driver of the recent price action in the Treasury market. So arguably, rates have now priced in a Republican sweep, at least with some reasonable probability. Now, this isn't to say that in the event of a Republican sweep that when the results come in that we won't see a selloff in the Treasury market, but rather the magnitude of the selloff will be less dramatic. Especially in the scenario in which 10-year yields are already in the 4.15 to 4.25 range immediately ahead of the results.

Ben Jeffery:

And in our conversations with clients this week, there was intuitively a lot of comparisons drawn between the 2024 election and the 2016 one. However, unlike 2016, I would argue that whatever comes to pass on November 5th, the surprise potential around Trump winning, given that he's seen as the favorite at this point, is effectively negligible. And frankly, if Harris ends up winning the election, there's probably not a great deal of surprise around that either. Part of this has to do with our evolution of understanding just how accurate polling is, and the other is that unlike in 2016, when Clinton was seen as being the sure thing in terms of taking the executive branch, from the market's perspective at least, it's fair to say that nothing in the political sphere is being viewed as a sure thing. And so rather than serving as the catalyst, as the bearishness that we saw in the aftermath of the 2016 election, our take is that after the election and whenever the results are finalized, which admittedly may take a bit, is that the political outcomes, especially the composition of Congress, will be traded and assumptions around deficits, growth, and inflation refined, but it will probably be more of a passing event risk rather than a moment in time that dramatically reshapes the market's interpretation of the trajectory of the US and global economy.

Ian Lyngen:

And of course, one of the biggest wild cards is in the event of Trump retaking the White House, what the market should ultimately expect in terms of a renewed focus on tariffs and of course, any risk of an escalating trade war between the US and any variety of its trade partners. One risk that has been routinely highlighted is the notion that in the case of a Trump victory, one of the key policy changes will be a wholesale increase on tariffs across the board. It's notable that the market is trading this almost entirely from the perspective of a reflationary risk at the moment.

What the market seems to be discounting is the potential negative impact on global growth from a renewed effort on the trade war front, as well as the fact that US consumers are not in the same place that they were in 2021, 2022, i.e, the ability of producers and retailers to simply pass through any cost increases to the end user should not be considered a foregone conclusion. In fact, as we have seen recently, there's a clear bifurcation among consumers in the US with the bottom quartile of consumers increasingly struggling with higher prices, even though realized inflation has slowed. And of course, an employment landscape that is not as hot as it was two years ago.

Ben Jeffery:

And given the fact that you and I are having this discussion, Ian, not to undermine our own brilliance, but the Fed is aware of this dynamic as well. And so in terms of what that means for Powell and the FOMC and ultimately the shape of the curve, this also reinforces the idea and what we've heard from Fed speakers since the FOMC meeting most recently Mary Daly, that there's no imminent plan to pause rate cuts. And while easing in the near term is not going to be 50 basis points at a time, a 25 basis point cutting cadence is firmly the path of least resistance and will stay the path of least resistance, regardless of what happens at the election. The Fed is not going to alter its rate cutting plans as a function of what might come to pass in terms of policy. And while some tariffs can be implemented without congressional approval, if in fact Congress ends up split, regardless of who's in the White House, there's probably not going to be a massive sea change in terms of economic policy.

So the factors that have been driving the Fed in the front end of the curve for the last year, namely an extension of disinflation and a softening labor market, are going to remain in place well into 2025. And so while we're sympathetic to the fact that maybe what happens on November 5th is worth 10 or 15 basis points in 10-year yields, it's less apparent that the election is as immediately relevant for the Fed and therefore data dependence, not election dependence remains in place as it pertains to front-end valuations. And with two-year yields reaching well above 4% over the past week, we can't help but see some value in the front end of the curve at these levels given where Fed pricing has recalibrated to following NFP and CPI and ahead of next week's payrolls numbers with obviously the inflation figures to follow.

Ian Lyngen:

As a second-order trade as it pertains to the election outcome, we'll be watching to see whether or not there's a sweep in either direction simply because there will be ramifications for the debt ceiling as well as the likelihood that Congress is able to come up with a budget. Assuming that there is some split in Congress, then by the middle of next year, the debt ceiling will once again be topical, as will the potential for a skip payment as well as a downgrade by one or more of the agencies. Now, in such an environment where we're up against the debt ceiling, the Treasury department will presumably be engaged in extraordinary measures and running down the TGA.

This begs the question whether or not the Treasury department would be comfortable increasing Treasury coupon auction sizes, even if, all else being equal, the situation might justify such a move. It's not difficult to envision a debt ceiling debate that delays Treasury auction size increases until later in the year. And in the week ahead, we do have the refunding announcement. And within the refunding announcement we'll be closely following whether or not the Treasury department chooses to retain the several quarters' language as it relates to stable auction sizes.

Ben Jeffery:

And from a higher level, what this means and how it ties into the broader discussion around term premium in the longer end of the curve is that for at least the next quarter, no ‘s’, coupon auction sizes will remain unchanged and after the anxiety around Treasury demand with rising supply that defined the latter half of 2023. It's fair to say that while at some point next year, we expect that Treasury supply increases will once again provide an important bullet point for the bearish argument in the longer end of the curve, the fears around a surge in 10-year yields back to 5% or beyond, solely as a function of higher auction sizes have been in large part allayed by the sponsorship we've seen for treasuries in the primary market this year. Even after the rally back in the low 4% in 10-year yields, there's hardly any evidence that investors are unwilling to participate in Treasury auctions. Sure, it's been primarily a domestic investor theme as foreign sponsorship remains on the lighter side. But as we prepare for Wednesday's refunding announcement and the auctions themselves in the week following, we don't expect that soft sponsorship for supply will be the catalyst that gets us back to a materially higher rate plateau.

Ian Lyngen:

So Ben, essentially what you're saying is that you're waiting for your refund.

Ben Jeffery:

They usually say three to five business days.

Ian Lyngen:

Store credit only.

In the week ahead, the Treasury market will once again have the benefit of a full array of fundamental inputs. The departure point will be Monday afternoon's release of the Treasury's financing estimates, which, recall, tends to set the tone for the refunding announcement on Wednesday. At Wednesday morning's refunding announcement, we're expecting 58 billion 3-year notes to be announced as well as 42 billion 10s and 25 billion 30s. Within the announcement itself, perhaps the most relevant aspect will be whether or not the Treasury department retains the language about stability in auction sizes for the next several quarters. We're assuming that that language stays, but there's certainly the risk that they choose to shift the messaging. The week ahead also contains the first look at third quarters real GDP, where estimates are currently for a 3.0% gain. Embedded within that release will be the three month annualized core PCE numbers.

The September core PCE release itself will be on Thursday morning, and here the market is looking for 0.3% as a month-over-month gain. That is a market acceleration from the 0.1 prior, although broadly speaking, still consistent with the Fed's objective of getting inflation back to 2% over the course of the cycle. Let us not forget that we also have the JOLTS jobs data on Tuesday as well as the official employment situation report from the BLS on Friday. Here, the market is looking for Nonfarm Payrolls to have increased 135,000 in the month of October with the unemployment rate unchanged at 4.1%. We anticipate that payrolls will effectively set the tone of the market until the FOMC meeting. If for no other reason than this will be the first look at the October data and contribute to the discussion around whether or not the strength scene in September was the new norm, or if it was simply a one-off rebound in some of the key data points.

The week ahead also contains three key auctions. On Monday, we have the double header of the two-year on Monday morning at 69 billion, followed by the five-year on Monday afternoon at 70 billion. October's coupon auction supply will be capped by Tuesday's seven-year auction at 44 billion. It's also relevant that Thursday is month end, and given some of the strain that we've seen in the funding market over the quarter end turn in September, investors will surely be watching the October turn for any indication of funding stress. Our base case scenario is that there won't be any undue strains or evidence of reserve scarcity, but given where we are in the cycle, and as the Fed continues to allow its balance sheet to run off in the background, one would be remiss not to at least acknowledge the relevance of funding at this 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 as we don our masks and prepare for the time-honored tradition of accepting candy from strangers, we cannot help the sense that there's some relevant cautionary tale that we're forgetting at this moment.

Oh, well, trick-or-treat.

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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