Speaker 1:
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.
Jason:
Hi everybody and welcome to the October 11th edition, the Macro Minutes called a gilt edged crisis. UK Long end yields, they are back close to the highs and US treasuries and risk assets are back under pressure. And it seems like the only traditional safe haven assets that is performing very well is the US dollar. Even gold, which the gold bugs would tell you should be a hedge against inflation or macro uncertainty, is sitting at two year lows.
What is clear right now is that bond yields will be the ultimate swing factor for broader asset markets, and right now it's the UK market that's in the driver's seat. In today's addition to Macro Minutes, we're joined by Peter [inaudible 00:01:03] to discuss UK monetary and fiscal policy and the gilt market. Blake Winn to discuss the US bond market, myself on the Bank of Canada, Canada-US cross market and the relationship between yields and risk assets. And finally, Dan Rico on FX markets. Now over to Peter to kick it off on the all important subject of UK monetary and fiscal policy and the UK bond market.
Peter:
Thank you Jason. So as you pointed out, the UK market seems to be a bit of the epicenter of what's going on and if you take a step back, the last time we had this call, which was just when yields spiked higher, 30 gilt yields reached 5% and the Bank of England had just announced on the day an intervention. Now what happened thereafter is that on the back of the announcement of the intervention, we had a quite significant rally by more than 1% in 30 year assets and thereafter, unfortunately as you just highlighted, bond deals moved higher.
So what happened? Well, what happened is that the actual purchases that the bank had conducted, where let's say a little bit underwhelming, whereas they were announcing that they would potentially buy up to 5 billion per day, they ended up buying in the first string of auctions 5 billion grand total and that was a little bit underwhelming.
As yields continued to rise, what then happened is that the bank announced further interventions. So yesterday for instance, they announced that they would buy up to 10 billion, still ended up buying only a little bit more than 850 million, and also launched a repo program and that really hasn't stopped the market selling off either. And then today, just this morning, they announced that they would include index link bonds in their purchase operation, and that they would also temporarily stop selling their corporate bond holdings.
So we'll now have to see how that is impacting the market. So today we have sort of a little bit more of a positive reaction to the announcement, because they also changed a little bit the price setting mechanism that they would use. Now, however, I would go back to the very first note that we had done after the intervention was announced, the first intervention was announced.
When you go back to the root cause of this all, it obviously stems from a quiet significant widening of the budget balance by the government, particularly the inclusion of what is now that unfunded tax cuts. And what the fiscal authorities have now promised is that the A; will bring forward their presentation of how they're going to balance the books, presumably through a string of spending cuts.
And also the OBR, that's the Office of Budget Responsibilities report on how that would shake out for the government finances going forward. Now what we look forward, we have put out another note where we looked at the most likely path of funding requirements for the government and the requirement of bonds to be absorbed, if the Bank of England was to go ahead with its quantitative tightening program, because as it stands at the moment, at the 31st of October, so that's in around about two to three weeks time, the Bank of England plans still to also issue... Sorry, to also sell some of its government bond holdings.
Now if that's the case, the amount of funding that would be required, particularly on a net basis, is going to be substantially higher than anything that we've seen over the last years, including the period of the global financial crisis and with the UK's credibility a little bit shattered to say the least, we think that is going to be difficult. So therefore I think one of the questions that needs to be answered going forward is A; will the government regain some of its credibility when it presents the figures? We'll only learn that on the 31st when they present them.
And secondly, what is going to be the reaction function of the Bank of England here? And particularly I would stress, can then really go ahead with the quantitative tightening program? I would put a big question mark behind that. So the long story short is that there's lots still influx and the intervention that we've seen so far has failed to calm the market down, and we reckon that probably some more is required in some formal shape. And I guess that's going to be a conversation for another call that we are going to have and I'll hand it back to Jason.
Jason:
Okay, great. Thanks a lot Peter. Next up is Blake to discuss the US bond market, and a situation where yields are edging back to the recent highs.
Blake:
Yeah, hey, thanks Jason. So I think the big focus this week, we've got the FMC minutes release on Wednesday and CPI on Thursday. Those will be the big drivers in the US of course. In the near term we do have quite a bit of sensitivity in US markets to some of the things Peter was discussing. We've seen a pretty high correlation between US rates and what's been going on in UK rates over the last several weeks with volatility. But that being said, I think the US drivers, again minutes and CPI this week.
In my view, I think the minutes are largely going to kind of further on this idea that we kind of heard Evans speak about this weekend. Again, Evans is probably a bit more on the [inaudible 00:06:23] side, but I think his view is probably one that the majority on the committee probably ascribed to is that, as we kind of progress into further restrictive territory, the Feds going to be a bit less dated dependent.
I think they have had this idea in mind for a while as it get to a considerably restrictive level and basically hold rates there, allow those kind of long and variable acts to work for whatever that's worth. I think the path that they've outlined in the dots is something that they see kind of delivering on and then basically sitting. The less data dependent piece, that really means that any kind of further hawkish data, they're not going to be reacting to it in the same way as they did two months or three months ago, when really everything was about front loading and getting the terminal rate as high as possible as quickly as possible.
Now we're into that restrictive territory and that kind of reaction has changed and they're going to let the high overall level of rates do more of the talking, and less kind of the pace of hikes that they're delivering at each individual meeting.
Importantly, I don't see this. I think there's a tendency in the media and people want to call this a pivot. To me, a pivot are always been kind of about bailing on the dots, bailing on what's already priced in and kind of pulling back, because they're worried about growth or labor side. That's not really what this is. To me, this is simply delivering on the path that's outlined in the dots, the path that's more or less priced into the markets right now.
Overall, I think if this is the case, if they kind of preach this kind of or outline this decrease in data dependent, idea that they're going to get to this restrictive level and hold. If that is what we see in the minutes, I think that's overall a bit bullish. There's still persistent short base in the market. I think still a decent crowd hoping for 5% plus terminal and this would kind of throw some cold water on that idea.
What's that mean for the CPI release later this week? Well, obviously with a bit less data dependence, if that is the case, it would take a little bit of the, I think upside risk off of that CPI print. I think a modest beat basically can lock in that 75 basis point hike at the November meeting. I want to highlight, there were nine members of the FMC that saw four and three eights or less terminal rate in the last SEP dots.
So by no means was it a foregone conclusion that we were going 75/50. Again, that is our house call, but it's worth noting that this still seemed to be an open debate on the committee. So 75/50 was by no means locked in, 50/50 was still a possibility that's out there. But if we get a beat on that CPI that could lock in 75/50. If it's a very large beat, I think what's probably more likely is that we price more into December meeting. But what happens is that really comes out of that January, which is currently right around five basis point. So really more of a pull forward than an overall increase in terminal rate. With that, I will pause and pass it on.
Jason:
Okay, great. Thanks a lot Blake. On my end there's three things I want to discuss today. The one Bank of Canada, second Canada-US across market. And third, the link between bond yields and risk assets. So on the first topic last week, [inaudible 00:09:47] was hawkish sticking to the script of the past few months and indicating that more tightening was forthcoming. So unless we get a very favorable CPI print, 50 basis points should be viewed as a floor for the meeting at the end of October. And ultimately the market should be giving some weight to a 75 basis point outcome.
We do think the rate tightening cycle will probably end in December, but the risks are clearly slanted to more rather than less over this horizon and beyond. But in this context we think the curve should remain biased to flattening. And if the Bank of Canada does not signal easing in the near future, curve such as twos-fives could reach minus 80 basis points and twos-tens minus a hundred basis points or more.
On the second topic, Canada-US across market, it's been a hot topic for the investor community the past few weeks. Previously Canada richened very significantly versus the US across the curve. But in the past a week or so, Canada has started to underperform. We have been short, Canada tens versus US tens from minus 67 basis points, and we're currently targeting a move to minus 20 with a stop at minus 55.
There was significant momentum and persistence in the Canada [inaudible 00:11:17] performance trade and it could be the same in the other direction over the coming weeks. And the last topic I want to discuss is the link between bond yields and risk assets. And notably there's been a pretty robust pattern between US yields, credit spreads, the dollar and equities over the past six months.
So the bond market is clearly in the driver's seat and unfortunately I don't think we can reach the situation where equities rally or credit spreads tighten on a sustained basis until the market becomes comfortable with where the Fed will ultimately stop with rate hikes, and the economic consequences of this tightening campaign.
So the Fed is telling us they'll go to 4.6%, possibly, the front end of the curve that's currently on board with that notion, but how long they keep rates high for will probably be the deal breaker for risk [inaudible 00:12:13], along with obviously what happens in the UK, since it is highly influencing the global bond market price action at the moment. Now over to Dan Rico on the FX market.
Dan Rico:
Thank you very much. From the FX market, I think important thing is to note that the market has been trading kind of in a [inaudible 00:12:35] way, where the dollar continues to nominate the overall story, but the market has been kind enough to praise some of the stories that have been working into correcting some of the macro balances in countries, like Mexico for example.
Mexico has been able to out perform the rest of the world, while we have seen a sustained depreciation in currencies like Asia [inaudible 00:13:00], even on the G10 space, most of the DXY components are down. So while the dollar has moved around 24% year today, the biggest question that we getting asked by clients right now is, when is this going to turn? We think that this probably too early yet to call the top on the dollar side and we'd rather be on the more reducing [inaudible 00:13:26] divergent stories trades.
So for that reason we've been pitching very actively to be long met the Mexican Peso versus Sterling, given the divergences on the fundamental stories, the large current account deficit, the triple deficit in the UK. And on the other side from the Mexico side, kind of the improvements on the benefits of the carry, which [inaudible 00:13:50] differential point around over 10%, 11%. So the benefits of the carry in some of [inaudible 00:13:56] have been very good into containing the reason volatility of the dollar and been able to hold very decent [inaudible 00:14:04]. That's all from my side. Thank you.
Jason:
Okay, so thanks for joining this addition of Macro Minutes what happens in the UK and US bond markets should be closely watched, especially if there's continued contagion from gilts to treasuries, in order to determine how broader risk asset markets will behave, there does remain a lot of uncertainty and a clear bullish path for risk assets, will probably not be resolved over the next few weeks and maybe not even over the next few months. So stay tuned for future additions of Macro Minutes to hear from our asset class experts.
Speaker 6:
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