Plotting the Dots - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 304: “Plotting the Dots” 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 December 16th. And with the final Fed meeting of the year on Wednesday expected to bring the gift of lower policy rates, we are wary of the lump of coal in our stocking that could come in the form of a higher dotplot. Beware of the Grinch that stole steepness.

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 Treasury market got the final piece of data that it was awaiting before fully pricing in a 25 basis point rate cut this month. Core CPI came in up 3/10ths of a percent for the month of November. This matched expectations, and while the average estimate was 0.28, the realities of November's inflation profile proved sufficient for the market to be comfortable that the Fed's going to continue the process of normalization. The inflation report was also consistent with the more benign take on the labor market, insofar as it showed that a restrictive monetary policy stance is continuing to work its way through the US economy. The market also saw rate cuts from the ECB, the Bank of Canada, as well as the Swiss National Bank, which delivered an unexpectedly large 50 basis point rate reduction.

As a theme, global monetary policy rates continue to drift lower. A fact that we expect will continue to bias rates in the front end of the curve lower and contribute to what we will argue is a long overdue cyclical re-steepening of the yield curve. We saw some progress made on that front in Treasuries with the 2s10s curve reaching 14 basis points. Now this occurred in large part as a function of pricing in the final 10- and 30- year auctions for 2024. And as the proverbial auction dust settles, we anticipate that another leg steeper in the yield curve will need to be driven by a drop in two year rates as opposed to an increase in 10s and 30s. Deficit spending supply and the need for positive term premium remain very top of mind as the market contemplates the next several quarters as well. We're reminded of the strong correlation between the shape of the yield curve and positive term premium i.e. the steeper the yield curve, the greater the term premium further out the curve, specifically in the 10-year sector.

Now this correlation holds regardless of whether or not it's a bear steepener or a bull steepener. So the simple mechanics of following through with rate cuts will put downward pressure on the two-year sector, thereby if nothing else, putting a floor in for positive term premium in the year ahead. When we consider the pockets of demand for treasury supply, it is important to put the demand for Treasuries in the context of a global policy rate environment, which has skewed lower the strength of the dollar, and the fact that US Treasuries continue to represent the most liquid fixed income market.

Ben Jeffery:

Well, last week was defined by the payrolls report, which was good enough to be nothing more than the passing of an event risk. And the market frankly treated it as such without a dramatic reaction in terms of 10-year yields that are off the lows, but by no means breaking out to a higher plateau. And that statement is made more noteworthy by the fact that we now have the second of the end of the year's most important data points in hand via the CPI report that showed nothing if not an as-expected increase in core consumer prices during November. And critically as it relates to next week's FOMC meeting, nothing within CPI really calls into question whether or not the Fed is going to bring rates lower by 25 basis points next week. They will. And at the same time, inflation was certainly not soft enough to justify a more dovish tone from Powell and run the risk of a dovish cut on Wednesday.

So in practical terms, this leaves our operating assumption intact that we're going to get a rate cut next week. And Powell’s tone, along with the SEP are going to be most focused on laying the groundwork for a shift slower in terms of the pace of normalization, which means that 2025's operating cut assumption is not going to be every meeting, but more along the lines of every quarter at 25 basis points every three months.

Ian Lyngen:

And that sets up the market well for a January pause. A January pause is also fortuitous timing insofar as it corresponds with Trump returning to the White House. Now, Powell has repeatedly said that monetary policy won't be adjusted based on what could potentially happen with the incoming administration. By the time we get to the March meeting, however, the market and the Fed will have a better sense of Trump's initial moves from the White House. Now we are operating under the assumption that those involve a renewed focus on tariffs, perhaps some meaningful announcements on that side, all of which could then subsequently be factored in to the Fed's thinking about the risk of reflation. Recall that tariffs lead to one-time price adjustments as opposed to a true demand side inflationary push. All else being equal, we'd expect that the Fed would more than likely characterize a one-time increase in prices related to tariffs as a tax on the consumer rather than the type of change that would warrant a monetary policy response.

What's notable is that conversations around a higher neutral rate over the course of the last several weeks have stopped finding their support in the election results and have begun referencing the economic data and the fact that there remain sticky components within the inflation complex. All of this is consistent with the broader risk that things did change as a result of the pandemic and inflation could be structurally higher. Now we are reserving judgment on neutral simply because it's a level that's only evident with the benefit of hindsight. What we can say is that the unemployment rate is well off the lows. And in November it just barely avoided rounding up to match the highest unemployment rate since 2021. All of which suggests that there remains a lingering risk that once momentum in the broader labor market turns, it's very difficult for the Fed to avoid the traditional spike in the unemployment rate.

For obvious reasons that would offset the prevailing Goldilocks economy narrative and as we contemplate the year ahead, the path of least resistance continues to be solid underlying economic growth driven by the consumer unless the labor market deteriorates to the point that consumers lose confidence in their job security and therefore shift their spending patterns. All evidence thus far suggests that such an outcome is a low probability event.

Ben Jeffery:

And in this vein, it's rare that we mention the NFIB survey, but it was telling this week that client conversations centered just as much, if not more, about the measure of small business sentiment than it did on CPI. What we saw within NFIB for November was a surge in the headline index, a fairly dramatic retracement in the uncertainty index and a material increase in plans to hire among the smallest firms in the economy. Now, the intuitive explanation for what in November drove this change is the election outcome and the traditional pro-business sentiment impulse that resulted from the red sweep. And while this opens the door to a bit of moderation in the coming months in terms of what sentiment and hiring plans ultimately play out, the reality is that optimism in the corporate sector and a positive outlook among smaller firms introduces the potential for something of a self-fulfilling prophecy so long as revenues stay solid.

And to your point, Ian, as long as consumption stays robust, if there is an increase in optimism and plans to hire and business is going well enough to follow through on those plans, then it's that reaction function that can generate the feedback loop between an increase in labor demand, a slowing of the pace of the increase in joblessness and ultimately firmer wage gains over the medium and longer term consistent with what we saw within the wage growth data in ADP and average hourly earnings in last week's jobs report. So while we need to consider the stimulative impulse of the fiscal agenda from the incoming administration, it's also worth highlighting that from a sentiment perspective, the election result has had a demonstrable impact on small business sentiment and if small businesses are more optimistic, then small businesses are probably more likely to hire, or at a minimum, be more reluctant to downsize their workforces simply out of concern of what may be coming as it relates to economic performance over the next several quarters.

Now it's just one month's worth of data, and that month did contain the election results. So we'll be eager to see if this represents a new trend or was simply a one-off response to the election and a reversal of what had been a fairly consistent decline in the outlook, both on a headline basis and in terms of hiring plans.

Ian Lyngen:

And given how relevant small businesses have been to this cycle's improvement in the labor market, a shift in sentiment in small businesses is a meaningful contributor to what one might expect for 2025. Also, when layering in the potential changes on the immigration front, the impact of labor availability for small businesses will once again be topical. This suggests that if anything, there could emerge further upward pressure on nominal wages as a fresh round of scarcity develops for front-line service sector workers. Those are the low-wage, low-skill jobs that drove so much of the post-pandemic increase in the labor force.

Ben Jeffery:

But despite all of this, 10-year yields remain comfortably below 4.50%, still within striking distance of 4.25%. And if this week's 10-year auction was any indication, there's still little risk of a buyer's strike in the long end of the curve. Given the context of global fixed income markets, a US 10-year yield north of 4.20% is not such a bad value proposition. The nearly two basis point stop-through of the 10-year auction with bidding statistics that were nothing if not solid runs counter to the concerns that we continue to hear as the new administration prepares to take over in January and that a growing deficit and coupon auction size increases will likely be coming in the later part of 2025. Obviously, we saw a solid sell-off early in the week into the 10-year auction, but these results are hardly pointing to an investor base in the primary market that's unwilling to use the liquidity offered by the Treasury Department to align duration needs.

And while the conversation we've been having thus far has centered around the fact that the consumer remains in a good place, there's optimism on the state of growth and potentially for the Fed to be more hawkish. To a large degree, that's reflected in rates at current levels and as not only domestic buyers, but overseas ones as well look forward into 2025 at the global economic outlook, if the bids that continue to meet backups in yield are any indication, so long as the world's economy continues even on a modestly downward trajectory and the world's central banks remain in easing mode, there will still be buyers of Treasuries at higher yields.

Ian Lyngen:

And to your point, Ben, perhaps the supply-driven concession for the Treasury market in 2025 will come in the form of 10-year yields not falling as far as other major sovereign debt yields do. That would also reinforce the strength of the dollar and therefore provide yet another reason for overseas buyers to be interested in the Treasury market and to help fund what the market generally believes is going to be a very hefty deficit over the course of the next several years. And on the topic of deficits, Ben, how's the holiday shopping going?

Ben Jeffery:

We wouldn't have much to talk about if we didn't have debt.

Ian Lyngen:

There'd be stocks.

In the week ahead the Treasury Market's main event comes in the form of the December 18th FOMC meeting. Expectations are for a 25 basis point rate cut, which would bring the Fed Funds Corridor to 4.25% to 4.50% and the Fed effective rate to 4.33%. We are continuing to operate under the assumption that the effective Fed funds rate will function as a ceiling for nominal 2-year rates, given that it has a strong history of doing so, especially when the Fed is in a rate-cutting mode. Which despite the debate around the precise level of neutral, it seems a safe call to say that the Fed will be cutting rates at some point in 2025. In addition to the Fed's rate decision, investors will also see an updated SEP and of course, the beloved dot plot. Within the dot plot, we are anticipating that there's an increase in the 2025 dot that indicates 75 basis points worth of cuts in 2025 as opposed to the 100 basis points of cuts that was messaged via the September SEP.

We also think that the Fed will add 25 basis points to 2026, implying that we're not ultimately going to get fully back to the Fed's estimate of neutral, which is 2.9, until 2027. We don't see much of an appetite for the Fed to change the long-run dot. If anything, we would suggest that expectations are running too high for the Fed to revise the longer-run dot and unless and until something comes out of the incoming administration that compels the Fed to truly revisit where neutral is. We'd anticipate that the longer-run dot stays at 2.9%. While the Fed has long cautioned the market against trading the dotplot, we expect that the market will once again trade the dotplot. So given that we don't expect the divergence between what the market is calling terminal, which is effectively 4% and what the Fed has called terminal, which is effectively 3%, we expect that the two and three-year sector will outperform on Fed day.

This should reinforce the curve steepening bias that's already in place and set the market up for the final two trading weeks of the year to be biased toward lower front-end yields and a steeper curve. The week ahead also contains the Retail Sales figures for the month of November. Here we see a 0.5% increase, a solid showing, but nothing that would truly redefine the market's understanding of the state of the real economy nor the broader health of the consumer. Friday offers the November core-PCE measure, the Fed's favorite, which is anticipated to increase two-tenths of a percent and be consistent with inflation making steady progress back towards the Fed's objective. On the supply front, we do have a $13 billion 20-year on Tuesday as well as a $22 billion five-year TIPS auction on Thursday, neither of which we expect to materially change the tone of the Treasury market. Instead, we're looking for the outright level of yields to respond to what we expect will be a hawkish cut or at least a rate cut that sets the Fed up to pause in January.

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 Wednesday effectively the last trading day of the year, we look forward to returning in January with a renewed sense of optimism, green shoots, and of course, the case of the missing bathroom scale, because ignorance can be bliss.

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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