Roaring Committy - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 277, Roaring Committy, presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery and Vail Hartman to bring your thoughts from the trading desk for the upcoming week of June 10th. And with the FOMC decision and the inflation data poised to define trading for months to come, all we can say is empty lake, empty streets, the bonds of summer are out of reach.

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 Treasury market had the Nonfarm payrolls update for the month of May to contend with, and the data came in notably stronger than expected. Headline printed at 272,000 jobs. And while the unemployment rate did increase modestly, it was accompanied by a decline in the labor force participation rate.

Perhaps the most relevant takeaway was an increase in the pace of average hourly earnings and upward revisions to the prior month. The importance of nominal wage growth in this environment is difficult to overstate because the reality is that there's a high correlation between nominal wages and the super core measure of inflation. And as a result, the update from the BLS put on the table the risk that April's benign inflation print ends up being the anomaly and not what we saw in Q1.

Clearly this has placed the emphasis on the upcoming CPI numbers and also brought yields off of their local lows. The market rallied into the event, sold off after the fact, and has largely managed to maintain a range in terms of the 2s/10s curve. Now, 10-year yields did manage to push below 430%, and so even with the sell-off, benchmark rates remain comfortably below 450%.

We're in a period for the market at the moment where all else being equal, we'd expect that consolidation would emerge as the theme. However, the combination of supply at the beginning of the week ahead as well as CPI, the FOMC and the updated dot plot all will set the tone for trading the Treasury market for the next several weeks, if not the entire summer.

Recall, there is a fair amount of seasonality in the Treasury market, which does favor lower rates as the summer months unfold, but we're at such an important juncture for the Fed that at the end of the day, it does come down to how the data performs and the Fed's perception of whether or not inflation is moderating in line enough with what they need to see to begin the process of cutting rates.

The week just passed also showed disappointments in ISM Manufacturing and the April JOLTS figures. Job openings were revised lower for March and April, which while clearly not directly influential for May, did at least momentarily challenge investors' perception of the ongoing resilience in the jobs market, whether or not that resilience manages to survive the summer remains to be seen. But if nothing else, May's data has given the Fed plenty of cover to continue delaying rate cuts indefinitely until they're satisfied on the inflation side.

Now, despite the fact that the Fed has been emphasizing the employment component of the dual mandate recently, the path toward September rate cut has still largely been a function of moderating inflation. And with several inflation prints still to be realized between now and the middle of September, there's sufficient time to see the development of the long-awaited trend toward easier inflation pressure. At least that's the dynamic that we are assuming kept the Treasury market from correcting even higher in yields on Friday.

Vail Hartman:

For a market that appeared to be anticipating a disappointing takeaway from the BLS update, May's employment situation report caught the market wrong-footed as the 272k headline payrolls gained, topped all forecasts in the Bloomberg survey of economists and decidedly outpaced the 180k consensus. Within the details of the release, the unemployment rate unexpectedly ticked up to 4% for the highest since January 2022. And the fact that the move was associated with a 0.2 percentage point decline in the labor force participation rate made the increase in unemployment all the more troubling. Further, average hourly earnings surprised on the upside at 0.4% month over month, which is a move that places a greater emphasis on the June 12th CPI update, which will cast an influential vote in expectations for the number of rate cuts the SEP signals in 2024. In the wake of the employment update, the odds of a September rate cut have settled at effectively a coin toss, leaving September cut calls highly dependent on the incoming data.

Ian Lyngen:

Another key takeaway from the payrolls report was the revisiting of conversations regarding how immigration has impacted headline payrolls growth. Now this is something that the Fed has mentioned in the past. And when you see an increase in the unemployment rate and a drop in the household survey of employment of 408,000, that divergence becomes a bit more relevant. And at its essence, the market is beginning to question the data.

Now to be fair, we were pricing in a disappointment from May's payrolls release. And so the fact that many were caught wrong-footed has certainly contributed to the interest in diving a little bit deeper into the details of payrolls. All of that being said, the reality is that the Fed will have four more core-CPI prints before the September 18th FOMC decision. So keeping a rate cut in September on the table makes sense and we're reminded that beginning the process of normalizing rates lower was never contingent on employment, but rather was always intended to be a function of inflation coming back in line with the Fed's objective.

Ben Jeffery:

And part of what makes May's jobs numbers so noteworthy from a trading perspective and what we saw in the lead up to Friday's NFP release, was that sentiment and prices had begun to swing more dramatically in favor of greater concern on the state of the consumer, greater concern on potentially the state of hiring, and a little bit more confidence that the disinflationary trend remained intact enough for the Fed to claim that everything is going according to plan.

That in turn translated to the 35 bp rally we saw in 10s after they peaked last week around front-end supply and especially considering the fact that core PCE was relatively benign. Some of the consumption and spending figures we've talked a lot about have shown a modest pullback in terms of consumer's willingness to spend. And then a JOLTS number this past week that showed a still low quits rate and another drop in headline labor demand after some reasonable bearish conviction in Treasuries, everything had started to point and add to the case for lower yields.

Now that got 10-year yields below 430 before NFP was released. And following Friday's sell-off, the market both in terms of yield levels and I would argue investor sentiment, is once again left mid-range without a seriously high conviction opinion on what will come next. For that, we'll need to wait for next week's inflation data and obviously the FOMC meeting, press conference and updated dotplot.

Ian Lyngen:

All else being equal, we would've assumed that the curve flattening trend would persist into the Fed. However, we were also functioning under the impression that we would've had a net bond positive take away from payrolls. So the fact that the curve is solidly in the middle of the prevailing range certainly conforms with the notion that investors remain somewhat sidelined as we await greater clarification from the Fed as well as confirmation that the more benign inflation figures seen in April have rolled through to the month of May as well.

Ben Jeffery:

And on the theme of the market needing more information before it really knows what to do next, it was also telling to see what took place over this past week in the front end of the curve as two-year yields after touching 5% last week, made it all the way back down to 4.75% as the market once again started the process of increasing rate cut pricing over the balance of this year and into 2025.

To look at some fair value estimates around Fed assumptions going forward, for the same reason we thought two-year yields near 5% were too high, we also were of the view that two-year yields at 4.75% were probably a little bit low. And that has to do with what you touched on Ian. And that is this idea that the labor market, even if it's softening, still remains in a good place and the green light for the Fed to cut is not going to materialize until we get a more significant or convincing inflection lower in terms of hiring or greater evidence that inflation is in fact headed back to 2%.

And so using some scenario analysis, two-year yields right around 4.80% or 4.85% seemed to make sense with a Fed path that assumes a rate cut or two sometime this year, and then a gradual lowering of policy rates next year to some slightly restrictive level, somewhere above two-and-a-half percent. Add in some probability that the Fed stays on hold for even longer and some probability that something goes wrong soon enough to inspire a more dramatic dovish reaction and particularly after the jobs report that contained something for everyone, playing the local extremes in the front end of the curve as sentiment becomes very stretched in one direction or another will be one of our operating biases, especially as summer conditions set in.

Ian Lyngen:

It's also worth noting that of the G7, we have now seen two major central banks cut rates, the Bank of Canada and the ECB. Now to some extent, that's going to limit the degree to which the Treasury market can sell off. This isn't to suggest that there can't be a divergence in monetary policy, rather that the divergence between the Fed and the ECB, or the Fed and the Bank of England or the Bank of Canada tends not to persist indefinitely. And therefore, the cuts from the Bank of Canada and the ECB have refocused the market on the notion that rate hikes are very unlikely from the Fed. And to some extent, there's now a shot clock on the time for the Fed's first-rate reduction.

Ben Jeffery:

And after the cuts from the BOC and ECB, another popular client question was, how far ahead of the Fed will the BOC and ECB get in terms of continuing their normalization campaigns? And a crucial factor to consider here that's obviously much more important for central banks outside of the Fed is what more dovishness and markets outside of the US means for local currencies and the strength of the dollar.

Remember, during the hiking cycle, the outperformance of the dollar was becoming a major issues for economies around the world. Europe comes to mind. Obviously, Japan does as well more recently. And that means that looking forward at the path of policy rates, there's going to be a natural limiting factor on how far other central banks can cut until the Fed begins to do so as well in order to avoid risking even more local currency depreciation and thus importing inflation for other geographies while the US is exporting it.

Not purely a treasury market dynamic to be sure, but another factor to consider as foreign investor behavior and the willingness of investors globally to buy the dip will probably determine just how large a backup in 10-year yields we'll be able to see over the rest of this year.

Vail Hartman:

And on the supply front, this week's coupon auction scheduling has been shifted around with the three-year auction on Monday, 10s on Tuesday, the FOMC on Wednesday, and the long bond offering on Thursday. Now recall, these auctions come at the heels of the late May trio of tails at the two, five, and seven year auctions that each saw below average non-dealer bidding.

Now, at this week's three and ten year auctions, investors will have to contend with the event risk posed by Wednesday's CPI data and the FOMC meeting, whereas the long bond auction will be more variably impacted by the price action in the wake of those events. From a broader perspective, we suspect bidding conviction may be dampened at the three and ten-year auctions given the event risks, although it will be telling to see the strength of the demand on the buy-side as rates have repriced to a lower regime as the economic data has largely conformed with the FOMC's objectives in the wake of Q1.

Ian Lyngen:

Setting aside supply considerations, we'll note that the consensus for May's core-CPI number is an increase of three-tenths of a percent. That's the ninth consecutive month in which the market is anticipating a 0.3%. If nothing else, we can say that rounding breeds consistency as much as precision implies accuracy, although neither are true.

Vail Hartman:

So what does that imply for clarity?

Ian Lyngen:

Reply hazy, try again.

In the week ahead, the Treasury market will be focused on Wednesday. Wednesday contains the core CPI numbers, which are expected to increase three-tenths of a percent. Also, the FOMC rate decision, the statement and the press conference, as well as the updated SEP. We are currently in the camp anticipating that the Fed signals 50 basis points worth of rate cuts split between 25 basis points in September, and 25 basis points in December, setting a quarterly cadence for normalization of 25 basis points.

Now we'll offer the caveat that Wednesday's CPI data could materially impact both the market as well as the Fed's impression of what's possible in terms of the departure point for normalization. There's also plenty of supply with which to contend, a fact that all else being equal should bias rates at least incrementally higher in the current environment. While it's tempting to suggest that we might be entering the summer doldrums once we have the Fed and the May CPI numbers in hand, the reality is that we don't expect this to be a low-volatility, simple drift in terms of the price section, although we do look for rates to be lower between now and the end of August.

In part, this is a function of the seasonality in the Treasury market, but at the same time, it is also our interpretation of the balance of risks when it comes to the economic data. In the event that inflation continues to drift a bit lower comparable to what we saw in April, and even if the employment market continues to demonstrate the degree of resilience that we've seen thus far, lowering forward inflation expectations will compress breakevens and put downward pressure on nominal rates.

The wild card for us in this scenario is how the yield curve performs. The market has been content to allow 2s/10s to range between negative 40 and negative 50 basis points, and without clear evidence that the Fed is readying to cut rates, we expect that the cyclical re-steepening of 2s/10s will remain elusive, presumably over the summer months as well until the market and monetary policymakers have amassed sufficient evidence that the price stability assumption has once again been anchored in the US economy. In such an environment, supply and demand considerations around the auctions will be relevant, particularly when we put Treasury issuance in the context of continued deficit spending as the presidential election nears.

It's difficult to completely dismiss some of the political aspects of monetary policymaking this close to the Presidential election, although we do have confidence in Powell's ability to continue with the degree of central banking independence that we've already seen during his time as chair.

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 look forward to two upcoming market holidays, we'll note that two short weeks out of the next four ain't half bad SIFMA.

Ben Jeffery:

Actually, it's exactly half bad.

Ian Lyngen:

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.

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Speaker 4:

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