Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Peter Schaffrik:
Welcome back to Micro Minutes. My name is Peter Schaffrik and I shall be your host for today. I'm actually very excited, this is a very special edition that we're recording today. It's the first dedicated European edition of Macro Minutes. As you might know, and as we recently announced, we're expanding Macro Minutes, so we have now a dedicated emerging markets section, and we've also got a dedicated European section of which, as I just said, this is the first episode. And I'm really excited to be joined today by two of my colleagues, Cathal Kennedy, our UK economist, and Megum Muhic, he's our gilt strategist also focusing on the UK.
So without further ado, let's get straight into it. Cathal, let's maybe start with you and let's start in the UK. So political risks have really come to the fore in the past week. They seem to be subsiding again, but somehow I can't shake the feeling that this time is a little bit different. So maybe can you share some thoughts? How do you think about it?
Cathal Kennedy:
Yeah. Hi, Peter. Yeah, look, I think it's fair to say that we've kind of become accustomed to political drama in the UK. If you look at it this way, Kier Starmer is the fifth UK Prime Minister in the last 10 years, so two years has become the average lifespan of a UK prime minister. That's less than most Premier League managers these days.
But I think it's fair to say that before this latest episode, discontent was growing within the Labour Party with Kier Starmer's leadership. If you look at the opinion polls, the party's lost almost half its support from the July '24 election. There's been a number of high profile policy U-turns which have used up political capital bow amongst voters and indeed the party's own MPs. And also kind of Starmer's personal popularity ratings are deeply, deeply in negative territory.
So I think kind of recent events, there's been this rumbling, if you like, of a potential leadership challenge for some time now. But like I said, these more recent events-
Peter Schaffrik:
Sorry, Cathal, can I just interrupt you there for a sec? So the leadership challenge, I believe at one point you said, we've seen this before from the Tories, of course, but I believe at one point I overheard you saying that it's much harder for the Labour Party in the first place, isn't it?
Cathal Kennedy:
Yeah. There's a higher hurdle, shall we say. For those of us who can remember the post-Brexit days of the Theresa May government between 2016 and 2019, there seemed to be this constant threat of no confidence votes in her leadership of the Conservative Party.
Now, very simply, there's no similar mechanism within the Labour Party for challenging the leader. Outside the annual party conference, you can't table a motion of no confidence. Instead, where there's no vacancy at the top of the party, the leader has to be challenged by somebody, from usually within the Parliamentary party. Any challenger needs the support of around 20% of MPs, that's about 80, and also probably has to go head to head against the incumbent, because unless they choose not to, their name's on the ballot.
Peter Schaffrik:
Yeah, I see.
Cathal Kennedy:
So I suppose the way I would frame it is, the leadership retains a degree of control over the process, even where they are challenged. But I must say on this occasion, like I said, this has been rumbling for a long time, but on this occasion, given that we seem to be calling into serious question the prime minister's judgment over the decision to appoint Peter Mandelson as ambassador to the US, I think that threat, if you will, that a leadership challenge might be triggered, that those hurdles might be met, it felt much more real this time around, if that makes sense to you.
Peter Schaffrik:
Yeah, no, it totally does. I want to bring in Megum in a second, but what do you reckon now that a lot of the Labour Party grandees came in and support Starmer? Is this topic over now or we going to come back to that?
Cathal Kennedy:
Over, maybe not. Paused, possibly. Most clients we spoke to at the end of last year had already penciled in upcoming local and regional elections in the UK as the next political risk event, shall we say. Given where the party is polling, given the likely losses in elections for UK councils, for assemblies in Scotland and Wales, it kind of looked inevitable that Starmer's leadership would be called into serious question at some point this year. But I think, like I said, most clients we spoke to were already kind of positioned, already kind of prepared for that, shall I say.
Peter Schaffrik:
Yeah, okay. That makes sense. Actually, let's talk about the market then and the implications thereof. Megum, what have we seen in the market? I know obviously political durations are not necessarily new, but how did you read the situation? And what did the market make out of it?
Megum Muhic:
Yeah, so I think, at least so far, the situation looks relatively contained and short-lived. And I guess our base case would be that the worst is at least behind us in the near term. And there are a few supportive factors near term which make us lean that way.
One thing is that Parliament is now going into a recess over the next two weeks. That potentially takes out some momentum from the current narrative. At the same time, gilt supply near term, like in February, is going to be very, very low equivalent to seasonal slow gilt supply periods like those that you typically see in August and December. And as well, doveish leaning from the Bank of England last week, certainly giving a bit of a helping hand here for gilt.
So at least in the near term, we think that maybe the worst is behind us. There's actually a lot of similarities between the current episode in terms of how the market's reacting and the political wobble we saw in November. And that was just pre-budget when Reeves' position was in question. And that was a four trading day episode and similarly led to around 15 base points of gilt bond spread widening, about nine base points steepening of the 5s/30s gilt curve and around two to four base points of asset swap cheapening. So, so far, we're very much following the pattern of the November episode.
Peter Schaffrik:
Oh, that's interesting. For our listeners, we've been long gilts versus bunds at the end of last year. That performed quite well. We shifted it recently into Treasuries, but obviously that didn't go so well. So maybe as a follow-up, Megum, in the here and now, should we continue to run that or what do you reckon? How's that going to go?
Megum Muhic:
Yeah. So in November, the politically induced gilt wobble, at least from the market's perspective, ended up being a good time to buy the dip in gilts. Following that event, gilts performed very strongly, or it was a star outperformer all the way until about mid-January. Asset swaps have performed very strongly. And that wobble at the end of the day from the market's perspective really ended up being a point of sentiment and position clearing and really allowed the market to proceed and price in a much more constructive gilt outlook.
We think beyond the very near term where we see supportive factors, we ultimately think that from the market's perspective, the key question is whether the political developments lead to a change in leadership that causes a shift in the fiscal policy outlook. And from what we've seen so far, we think it's difficult to conclude that that will be the case. And ultimately, this should continue to be supportive of the performance of gilts going forward. So we still like, we have been running gilt US Treasury tighteners and the recent cheapening and position clearing post this wobble, we think it still looks attractive here.
Peter Schaffrik:
Okay. Let me also quickly return back to Cathal, because Megum just mentioned the bank, there was still relatively constructive outlook for the bank. We had the meeting last week in which the market interpreted as a bullish sign. What's your general take, Cathal? What's your reading of the tea leaves here?
Cathal Kennedy:
Yeah, that's very true, Peter. As Megum said, they're the helping hand that situation last week got from a dovish Bank of England.
Now, to be honest with you, the outcome of the meeting was a surprise to us. Going into it, we didn't think that that much had changed since December that might cause a serious sort of shift in the bank's rhetoric or messaging, shall we say. So on the day, the very close vote split, the kind of tone of the minutes and the press conference all lent quite dovish, caused us to pull forward our kind of expectations for the next bank rate cut.
But I think in particular, what stood out to me was, as you know, we're in this kind of new era of MPC communication post-Bernanke. And going into meetings in the olden days, we would have a fair idea of what might happen to the fan chart and the various kind of central projections for growth and inflation and so forth.
But I think on this occasion, what seems to have shifted the position of quite a few in the MPC was the information they had received on wage developments from the bank's agents, and also some analysis that was presented to them on how wages are actually set in the UK, which certainly challenged a lot of our, certainly my prior conceptions around how that process worked. But obviously that was presented to the MPC on the day and we didn't have sight of that in advance.
So I think it explains to some extent why there was a surprise from this meeting, but I think going forward also raises this possibility of there being kind of greater uncertainty around the outcome of these NPR meetings. Because while we now have lots of information after the bank's decision, we can say with a lot of hindsight how they arrived at the position they did going into the meetings, in the absence of the usual rhythm of speeches and what have you , we're working a little bit blind, shall I say, because we don't know what new analysis is being presented.
Peter Schaffrik:
Yeah. Got it. Makes surprises a little bit more likely then, yeah?
Cathal Kennedy:
Exactly. Yeah, yeah, yeah. Now, given we've turned to central banks, Peter, I might just ask you your views on the ECB from here, last week's meeting not exactly the most eventful. It's fair to say the ECB look like they're going to sit on their hands from here, is it?
Peter Schaffrik:
Yeah, I think you're absolutely right. Look, I hate to use those words, but it was probably one of the duller meetings I've listened to in my career. And I fear going forward that might well be the case because they are saying they're in a good place. Everything that they're looking at is neither too hot nor too cold. And the biggest threat that the market sees is that inflation's undershooting, which it clearly does, but they're pushing this away and saying, "This is all okay. We know where it's coming from." And it's coming to a great degree from base effects and one-offs. And when you actually adjust for them, the undershoot is relatively small and that's okay for them.
So I think what they're trying to communicate is that unless you get a big downward surprise in economic activity or inflation or both, they're just going to sit there for quite some time, which obviously takes volatility out of the market. And that's in fact what we're seeing. Volatility at the short end of the Euro curve is coming down and both realized and in implied volatility. Carry trades is still what everyone is going for, what is the best performing trades out there. And I don't think that this is going to go away anytime soon. So as you know, or as people who follow our writings know, we think the ECB is going to stay put for all of '26.
Cathal Kennedy:
Yeah, and just, okay, the one question I constantly see being asked is around the strength of the euro at present. Do you think the ECB is concerned with that or will they brush it off?
Peter Schaffrik:
So far they've been brushing it off. The standard catchphrase, of course, is it's an input variable into their forecasts, it's not a target. And as long as it's not too strong so that it's weighing on economic activity too much or in inflation for that matter, it's not a concern. And actually, when you look at the trade weighted euro, it's not really been strengthening all that much. And as a consequence, I think for the time being, the ECB's not really going to take it into account.
One of the things earlier in '25 that we've seen when we were getting close to 1.20 or a dollar, there were one or two members who voiced a little bit of concern. But A, we're still, I wouldn't say far below that, but we're below that at roundabout 1.18 at the moment. And secondly, it was only a handful of people who were voicing concerns. So I don't necessarily think that the perceived strength of the euro at the moment is a big issue. And I feel confident in our call for the ECB not doing anything.
Megum Muhic:
Actually, I've just got a question on the euro curve. I know its steepness has been a big call of yours and it worked spectacularly over the past year in 2025. But then as we've entered this year's, we've basically gone nowhere. We flattened quite aggressively in the first half of January, and then now we steepen back to the highs. Just wondering if you've got any fresh thoughts here.
Peter Schaffrik:
Yeah. It's not a fresh thought. Thanks, Megum. It's not a fresh thought. It's maybe a reiteration of a thought of why the curve has been steepening because obviously the ECB cut rates and typically, in an environment where rate cuts are coming, the curve is steepening. But that's actually not the main driver of the move that we've seen in '25. It was the other way around because the rate cuts were already almost fully priced at the end of '24 and the front end actually hasn't done all that much. And most of the steepening came from the rise in term premium at the back end of the curve.
And frankly, I'm still concerned that this move is not over for a number of reasons. A, those, again, that follow our writings will have seen this before, when you look at historically how the relationship between the level of yields and curve slope hangs together, we're still far below where we used to be before the zero interest rate period. So we were steeper at similar yield levels back in the day. And I think there's a decent chance that we get back there.
Secondly, the ECB is probably going to QT for years to come, which means that they will hold less bonds that somebody else has to buy and somebody else will probably ask for some kind of a higher premium. So that should steepen the curve.
Then there's probably generally naturally less demand, particularly for ultra-longs, the whole Dutch pension fund reform story that has been around for a while, even if the direct flows didn't come at the beginning of the year.
And last but not least, in the current environment where growth is relatively weak and we see fiscal expansions and generally fiscal constraints, that GDP levels are much higher now than they used to be 20 years ago, there should be higher premium than was the case.
So frankly, I think the story is not over, even though, as you said, like at the beginning of the year, we haven't really seen all that much movement, but I'm reasonably confident that as the year progresses, we will see that story coming back up again, which is also part and parcel of the view why we don't want to get bullish on the market here. So we still have a 3% plus 10-year bond yield forecast in our profile. So yeah, I'm confident that this story is not over.
Well, guys, we're coming up to time, so I think we have to wrap it up here. I think we could continue. Thank you, Megum. Thank you, Cathal for joining me in this very first episode of a European edition of Macro Minutes. Thank you everyone for listening. I hope you enjoyed it. I hope you learned something and I hope you're going to tune in again when we're going to have the next episode in about four weeks time. Thank you.
Speaker 5:
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