Super Bowl or Super Core? - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 310: ‘Super Bowl or Super Core’, 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 February 10th. And as we prepare for Sunday's big game with guacamole and imported beverages, we are thankful that Trump delayed tariffs on Mexico, at least for now.

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, there was a variety of events that led to pretty significant price action in the Treasury market. The most obvious was Friday's release of nonfarm payrolls. Payrolls disappointed at 143,000. That was versus the 175,000 consensus. However, there were a lot of details which suggested that the price response should be bond bearish, and it was. The first detail was that the two-month net revision increased prior payrolls by 100,000 jobs. In addition, there was an unexpected decline in the unemployment rate. The unemployment rate printed at 4.0%, that was down a 10th of a percent from December. Perhaps even more importantly, that drop in the unemployment rate came at the same time that the labor force participation rate increased by a tenth of a percent. So, on net, it was a particularly healthy drop in the unemployment rate.

Another check in the column of bond bearishness came in the form of a higher than expected average hourly earnings print that came in at 0.5 versus the 0.3 expected. Nonetheless, the year-over-year pace was unchanged at 4.1%. We also had the benchmark revisions for the period between April 2023 to March 2024. Here, we saw the BLS took off 589,000 jobs, which was less than the 818,000 prior estimate. Moreover, it was even below the range of consensus estimates for the move, which was -650 to -700,000 jobs. On net, the BLS data effectively reinforced the Fed's decision not to cut rates in January and materially decreases the probability that the Fed chooses to cut in March as well. We still see a reasonable path to two rate cuts this year, but as the data remains firm, any urgency on the part of monetary policymakers becomes less and less as 2025 unfolds.

On the topic of the data's potential influence on the Fed's path of normalization, we did see an unexpected spike in inflation expectations via the University of Michigan survey. Here, we saw one-year inflation expectations increasing a full percentage point to 4.3% versus the prior read at 3.3%. In addition, the medium term, or five to 10 year inflation expectations component, increased a tenth of a percent to 3.3 versus the 3.2 prior. If nothing else, the takeaway from the survey-based measures of inflation expectations is that they remain sticky, and despite the recent relatively benign core-PCE and core-CPI numbers, expectations remain elevated.

The week just passed also contained the refunding announcement. Within the details, we saw 42 billion 10-year notes to be auctioned as well as 25 billion 30s. These auction sizes are unchanged and consistent with the Fed's messaging that auction sizes will remain stable for the next several quarters. It's also notable that the ‘next several quarters’ language was retained, and that sets up stable auction sizes between now and the end of the year. One nuance, however, is that the bulk of the borrowing is going to need to be done in the bill market. So, as there's greater clarity on the magnitude of the deficit and the need for more borrowing, we expect that that will translate into the front end of the market. All of that being said, while it is notable that this quarter's borrowing needs are in excess of 800 billion, the needs for the second quarter were a much more manageable 123 billion. So, if nothing else, this should at least incrementally relieve some of the supply-related angst further out the curve.

Ben Jeffery:

Well, it was payrolls week with all that means for the macro narrative and for the Treasury market, we got a job report that had something for everyone. And what resulted in terms of the move in ten-year yields was a mild bearish retracement, but in this context that after the move towards lower yields that defined the bulk of the week, bearish was nothing if not an in-range affair. 4.50% 10s continues to serve as the focal point for trading at the moment, and as has become increasingly thematic, we have a jobs market that is fine, an inflation outlook that is good enough, and a Fed that is content to hurry up and do nothing. So, after the combination of this week's ISM reads, JOLTS, the Refunding announcement, and NFP, we're frankly remarkably similar to where we started the week.

Ian Lyngen:

And what I'll argue is more interesting is that after yields peaked with 10-year yields at 4.80% in the middle of January, we've seen a fairly steady rally. Now, that rally brought 10-year yields as low as 4.40%, so effectively a 40 basis point rally over the course of three weeks, and the 2s10s curve flatter by 20 basis points. Now, when we think about the new information that the market has been able to absorb during that period, it's important to keep in mind that the inflection point in mid-January was the CPI numbers. And so this served as a reminder that what is driving monetary policy expectations and the market more broadly is the inflation profile and progress towards the Fed's objective. Now, the Fed does benefit from the continued strength in the labor market if for no other reason than it provides them a reasonable amount of flexibility to delay cutting rates until there's greater clarity on the trade war front.

That being said, the first two weeks of Trump's second presidency were anything but boring. We had 25% tariffs announced on Canada and Mexico only to be delayed by a month or so, depending on how negotiations go, as well as an additional 10% tariff on Chinese goods. Now, the Chinese component of it I think is interesting because of the nature of the imports that will be impacted. Now, specifically, when we translate the additional 10% tariff on Chinese goods into core-PCE and core-CPI estimates, we are focused on two primary components: household goods and apparel. Household goods, think appliances and furniture, and apparel, which also includes footwear, are the primary components which we'll see the most direct pass-through of higher tariffs.

Now, to put an estimate on it, we anticipate that the impact will be four-tenths of a percent on core-CPI and three-tenths of a percent on core-PCE, spread out over the course of two or three months. Now, the wild card really comes in the form of intermediate goods. There will be an additional 10% tariff on intermediate imports as well. However, as we know, gains in PPI do not translate one-for-one into CPI gains. In fact, this is the key part of the process where profit compression tends to occur. So, using the 2018 episode as a rough outline of what to expect, we anticipate that at the end of the day, the higher tariffs on China, which are the only ones that survived the week, will have a relatively benign impact on realized inflation this round.

Ben Jeffery:

And from a higher level and in making the rounds with clients recently, the mechanical impact of tariffs on the level of prices is obviously top of mind as investors continue to grapple with when and where is the opportune time to buy dips or, in fact, sell rallies in treasuries.

But we'll argue almost as relevant is this idea that over the span of just 72 hours, the US went from potentially implementing 25% tariffs on its biggest trading partners to, just a couple of days, later not implementing them at all. And it's that inherent uncertainty and overall volatility, particularly in foreign exchange and rates markets, that is going to leave overall risk exposures and duration leans on the more modest side.

After the first Trump administration, this is not a new dynamic, and the fact that the market continues to be beholden to the next tariff headline, whatever that might be, is leading to a degree of fatigue as it relates to trying to calibrate exactly what the new administration's fiscal and tariff policies are going to be, which is a long way of saying we haven't spoken to anyone over the last two weeks who has a great deal of conviction at these levels, given the fact that 40 or 50 basis points of cuts priced, 10-year yields at 4.50% more or less, and an issuance landscape that seems to be status quo is not translating to a great deal of excitement to buy or sell, which, as exemplified by the price action, is leading to a very range-bound market.

Ian Lyngen:

The absence of interest in buying or selling leads to the obvious conclusion that people are simply holding, as the FOMC is as well. The Fed's decision not to cut rates in January we expect will be carried forward to March's meeting as well, and March's meeting will have the benefit of an updated SEP and dot plot to further provide investors with guidance on the Fed's response function to the headlines, at least as they relate to the trade war.

Now, in the week just past, we did hear from the new Treasury secretary, Scott Bessent, and one of the biggest takeaways from his comments is that he appears reasonably biased to maintain the status quo, at least for the time being at the Treasury Department. And this was very consistent with Wednesday's release of the refunding statement in which auction sizes were left unchanged. And despite the recommendation to the contrary from the TBAC, they retained the language indicating that auction sizes will remain the same for at least the next several quarters.

Several, being more than a couple, suggests that the first-time nominal auction size increases will be on the table will be in early 2026. Now, of course, things can change, although I will make the observation that one of the key drivers of the bear-steepening Trump trade was this notion that deficit spending was going to extend or expand unchecked. But for better or worse, there seems to be a renewed push in Washington to improve efficiency, which, while that might have implications for the labor market later this year, it also on the margin benefits the budget outlook, and frankly so do higher tariffs.

Ben Jeffery:

And it's exactly that argument that runs counter to the quote-unquote Trump trade. A pro-growth fiscal impulse funded by larger Treasury borrowing is the exact opposite of what Secretary Bessent is hopeful is a successful effort by the efficiency push to actually introduce for the first time in a long time a degree of fiscal discipline and spending cuts in Washington that will allow the Treasury Department to not lean so aggressively on the market in terms of funding the deficit.

And coming into 2025, thinking about what was certainly an under-priced risk, it was exactly that. Higher term premium, Treasury supply concerns, no landing hopes that were all, at least to a degree, already reflected in 10-year yields at 4.75% or 4.80% has now come back the other way as we have some more disinflationary evidence and policymakers in Washington talking about pushing auction size increases into next year and maybe actually cutting spending. That's a growth and Treasury supply negative impulse that has contributed to the bull flattening of the curve that got 2s10s to its flattest level since late December, as some of the worries about runaway yields in the long end of the curve have abated.

Ian Lyngen:

It's also difficult to have a conversation about monetary policy and the Fed outlook without at least acknowledging the feedback loop between the performance of the equity market and the rates complex. Bessent actually came out and specifically said that Trump is not particularly concerned about the level of Fed funds, but is more concerned about 10-year yields. And to be fair, the impact of 10-year yields on mortgages and borrowing broadly throughout the system is consistent with Trump's focus on 10-year yields. And frankly, it's certainly a level that we spend a great deal of time worried about.

In this context, I think it will be very interesting to see whether or not 4.80% will ultimately serve as the upper bound for 10-year rates during this cycle. The connection with the equity market, and ultimately the overall level of financial conditions, is difficult to understate. The reality is, if we were to break 10-year yields above, let's call it 5.25% or even 5.50%, there would be ramifications for valuations. There would be ramifications for the direction of equities, and that would ultimately flow through into tighter financial conditions.

The fact that the continued solid performance of equities has kept financial conditions easier than they might have otherwise been is actually a net benefit for the Fed because the Fed, at the moment at least, is unable to continue normalizing rates lower because of the uncertainty associated with the trade war. However, the equity market has effectively been doing some of the heavy lifting for the Fed because it has kept financial conditions relatively easy.

Ben Jeffery:

And as long as that continues to be the case, and frankly, even if stocks come under a degree of pressure, as long as it's of the orderly variety and not something that crosses into the characterization of market dysfunction, that's just fine from Powell's perspective. The S&P 500, still well in the green year-to-date, and risk assets more broadly that have held in remarkably well, despite the increase in yields to start the year, all represent market function that is well within the Fed's tolerance bands.

Now, if we do get a more dramatic rethink around tech valuations and stocks are down 10%, 15%, 20% over the course of just several sessions or even a week, then that starts to run the risk of a disorderly tightening in financial conditions that would probably need to warrant a response from the Fed. But volatility around earnings reports, around headlines in the AI space, all of that is very much par for the course and is not sufficient to really shift the broader financial conditions paradigm and, again, keep the Fed comfortable with saying, "The next move is a cut, but that might not be for a little while."

Ian Lyngen:

So, on the topic of AI, Ben, I was thinking that maybe we could come up with our own algorithm. We could call it Shallow Inquiry.

Ben Jeffery:

We've only really just scratched the surface.

Ian Lyngen:

And the screen.

In the week ahead, the Treasury market will have events corresponding to two of the biggest macro concerns at the moment. First will be the inflation series, and second will be the refunding auctions. Expectations for core CPI in January are for a three-tenths of a percent increase. Similarly, core PPI for the same month is also seen increasing three-tenths of a percent. Rounding out the inflation numbers will be import prices for January on Friday anticipated to have increased four-tenths of a percent. Now, translating all this into core PCE estimates will clearly depend on the nuances of CPI and PPI. We'll be watching the super core measure of CPI for any indication that the unexpected acceleration of nominal wages in January translated through into an increase in core services ex-shelter.

On the supply front, on Tuesday, there'll be $58 billion three-year notes auctioned, followed by $42 billion 10 years on Wednesday, and then capped by $25 billion 30 years on Thursday. All else being equal, the relative stabilization of yields over the course of the last several weeks does bode reasonably well for the auction takedown. These are new bonds, so the refunding, not the reopening. And in an environment such as this, we'll assume that that will bring out buyers, but we are operating under the assumption that we have a reasonable auction concession for the event. Now, that auction concession can come in outright terms, but it can also come in the shape of the curve. We remain biased for a 2s10s steepener, 5s-bonds steepener as well in the week ahead, given the supply considerations.

Now, let us not forget that we do see Retail Sales for the month of January on Friday morning, and the consensus there is for no change in headline retail sales. Keep in mind that the retail sales figures are not inflation-adjusted. This implies that for a month in which headline inflation is seen increasing three tenths of a percent, that the real spending figures, which are obviously relevant for GDP estimates, will be biased a bit lower. The market will also be closely watching for any Trump headlines that relate to the trade war, tariffs, or any of the array of potentially market-moving announcements from the president.

That being said, we think that we're entering a period of relative calm, at least until the one-month extension of the tariffs on Canada and Mexico expires. That doesn't mean that there won't be trade negotiations conducted, which will presumably lead to headlines that the market can incorporate, but the big broad sweeping announcements or changes are unlikely to occur, at least not for the next couple of weeks. So, it's with that backdrop that we believe the refunding auctions will be reasonably well-received, and once supply is absorbed, that rates will continue to drift a bit lower. 10-year yields got as low as 4.40%, and while the market has backed up from there, a pushback below 4.40% with an eye on 4.25% in the coming weeks would be very achievable in the event that the realized inflation data for January errs on the side of benign.

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 prepare for 2025's best night of broadcast television, at least for commercials, we'll note that this year there will once again be no advertisement for Macro Horizons. After all, who needs celebrity endorsements and witty slogans when you've got theme music like this?

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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