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 and financial markets, and the global economy. Please listen to the end of this recording for important disclosures.
Speaker 2:
Hi everybody, and welcome to the May 31st edition of Macro Minutes. Since our last call two weeks ago, bond market volatility has eased back to levels witnessed before the Russia-Ukraine tension, bond yields in North America are well off their peak. Equities have recovered sharply, credit spreads have tightened, and the dollar has softened. So basically all the trends over the last two months are starting to reverse somewhat, whether this is a start of a new trend, a consolidation phase, or a pause before the previous trends resume, is a critical question in markets at the moment, and to help us navigate these challenging times, we'll hear from our experts in rates, equities, FX, and credits. So to begin, there's two things that I want to talk about. The first is our mid-year outlook for Canada rates, which we published last Friday and it's called peak rates. So we do think that the worst of the bond market route is in the rearview mirror.
Speaker 2:
At the second quarter should mark the peak in yields. And if yields did go back to the highs, we don't think that'll be sustained. And we think the balance of risks point the yields in the belly to long end grinding modestly lower from here for a number of reasons. First, growth fears are rapidly catching up to inflation fears, and this is providing more balance to the fixed-income market. Second, bond stock correlations are shifting. So in days where equities are up, yields are not necessarily higher, and when equities are lower, bond yields are lower, regaining their traditional relationship with stocks in risk-off periods. And third, there's been a convergence in yields across the yield curve, that's both in Canada and the US. And this typically occurs at end of policy cycles but it's happened much earlier this time, which means that the belly to long end is really going to be determined by what happens with terminal value pricing. And I don't think that gets repriced on meaningfully higher from here given that growth fears are starting to catch up to inflation.
Speaker 2:
And finally, excessively bear sentiment and consensus is starting to be unwound, and there's some buyers of duration and carry-trade players that are coming back into the market. So based on kind of our core macro and policy views, the trade ideas that we recommend on a cross-market basis, we like receiving Canada two-year versus paying the US, at the longer end, receiving Canada five-year, five-year versus paying the US. We like six months forward [inaudible 00:02:49] the flatteners. We like being long duration so 10-year cash, and we like real return bond 2026, 20/50 breakeven steepness. The second topic I want to talk about is the Bank of Canada meeting this week. So the current macro landscape, whether it's growth, labor market, inflation does support further near-term aggressive tightening from the Bank of Canada to reach a neutral level as quickly as possible.
Speaker 2:
So they delivered a 50-basis point back in April, and with price pressures still remaining acute, another 50-basis points on June 1st does seem kind of guaranteed at the moment, which is expected by us consensus and market pricing. So any hawkish or double surprises, that's good to relate to nuances expressed in the policy statement or the economic progress report on June the 2nd. And right now, the balance of risks, they're probably slightly in favor of a more hawkish outcome instead of a dovish one, given that growth is pretty strong and inflation pressures seem to be broadening. So after June the 1st, we do expect another 50-basis point hike in July, which would bring the policy rate to the low end of the Bank of Canada's neutral range estimate. And then we see them down-shifting to 25-basis point moves in September, October with the policy rate ending the cycle at two and a half percent.
Speaker 2:
And I would say the risks right now to rates ending below or above two and a half percent is finally balanced but maybe a little bit more in favor of more rather than less tightening, but as we progress through the summer, if the growth slowdown becomes more intense, then the risk would start slanting the downside. So now with that, I'm going to turn it over to Adam on the FX market. So we've had a bounce in Euro/Dollar. It's barely off the 20-year lows. Sell-side analysts, they're as bullish as they've been over the last decade. So what does the second half of the year look like Adam?
Speaker 3:
Thanks, Jason. So that's the background exactly, the seemingly strange confluence of events where Euro/Dollar is only three or four cents off of the 20-year low, yet the sell-side analyst community is incredibly bullish on the outlook and bearish on the dollar on the other side of that. And this is not a new phenomenon, of course. For five years now, the sell-side community has been skewed very heavily to a bearish dollar view and a bullish Euro view. And for the majority of that period, that view has been wrong. What has changed through time is that we keep circulating through different reasoning on why the bearish dollar view holds. So for a while, it was the reemergence of the US twin deficits. For a while. It was the end of US exceptionalism and simple cyclical reasons.
Speaker 3:
And to get an idea of what the thinking is, now, we had a chat with a few of our buy-side clients, and it seems the principal driver behind this consensus view that is skewed so much towards bearish dollar and bullish Euro is much of that is based on the idea that there is some disproportionate importance of the ECB moving through the zero bound on rates, some kind of [inaudible 00:06:16] that gets a disproportionately large FX move for the move through the zero bound. I'm intuitively quite kind of plausible but statistically, it's kind of hard to find any evidence that's the case.
Speaker 3:
So we've got several examples, of course, of central banks moving through the zero bound, most instructively, the ECB in the other direction, when it first cut rates into negative territory. And then we have the Swedish Riksbank doing the same and doing the reversal. So going from negative back to zero and positive and several others. And going back and looking at the historical experience, we can find very little evidence that there is anything disproportionately important about the move through the zero bound. Technically, the beta of currency moves to interest rate differentials is stable. There is no evidence that the beta becomes particularly large around the zero bound. And for that reason, we are not convinced that the first 50-basis point moved from the ECB that takes us from minus the half to zero on the depot rate is any more important than a 50-basis point move at any other point in the rate cycle.
Speaker 3:
And for that reason, we still find ourselves pushing back slightly against this negative-dollar, positive-Euro consensus. These [inaudible 00:07:45] normalization story, it's hard to believe it's not fully priced now. We have 25-basis points move discounted for the July meeting more than 50 discounted for the September meeting. And if anything, forward rate probably overpriced ECB move. So if we take that alongside a view that there's nothing special about the move through zero, then it has to say that I think there is a big risk that just as many of the other reasons we've circulated through against this bearish dollar background, just as many of them have disappeared quietly as they fail to work.
Speaker 3:
I think there really is a risk if that is the case again, but we started with analysts clustering around the negative-dollar consensus and continuing to circulate through reasons that fit the view rather than fitting the view to the market background. And for that reason, we are, as we have been doing for most of this year, somewhat pushing it back against the very bullish Euro consensus, very bearish dollar consensus, and sticking with our view that we will get a brief test of parity at some point in the second half of the year. Back to you, Jason.
Speaker 2:
Okay, great. Thanks, Adam. Next up is Lori to shed some light on whether the recent balance in equities can be sustained.
Speaker 4:
So look, I just wanted to talk a little bit about the rally we saw in the S&P 500 last week. And what we really did see was after sort of traveling down from the January highs, we hit about an 18.7% drawdown. Now, we put out a piece a couple weeks ago that we basically called Stocks at a Crossroads. And I think a number of the things that we highlighted in there really help us understand why the market rallied back so fiercely last week. And I would just say first off, the market demonstrated pretty clearly that it's not ready to price in a recession yet. And we've used the growth scare framework throughout early 2022 to describe this moment in the market that we're in. Basically, those are drawdowns similar to 2010, 2011, 2015, 2016, and late 2018, those all ranged from 14 to 20%, and the 2011 and 2018 drawdowns came in at about 19.4 and 19.8%.
Speaker 4:
So with the move that we saw on the May 19th low, we came within spinning distance of those 2011, 2018 moves but we're still firmly in growth scare territory. If we had priced in a full 20% drawdown of something matching the kind of late 2018 drawdown, we would've hit 38.50. And I think it's very interesting that several times in May, we've seen in the S&P on an intraday basis approach that level but it held. And I think in terms of what really kind of allowed the market last week to move away from recession pricing, I do think retail earnings came in a little bit more balanced after the initial Walmart and Target numbers. And we really did not see any kind of clear evidence of a breakdown in the consumer broadly last week despite sort of problems at the low end, problems with execution in terms of companies that were more exposed to the low end, and we also had a shift in tone from the Fed, which I think equity markets had really been clamoring for.
Speaker 4:
The other thing that we talked about in that piece Stocks at a Crossroads was really that valuations had stopped being a problem. And what we saw very briefly in mid-May was that when you look at a trailing PE, a current year PE, and a forward PE in the market, all three for the first time in quite some time broke down below their long-term average. And what we saw in the data was that valuations were not a reason to buy the market, but they stopped being a problem. And it really did signal, I think, to many investors that it was time to start bargain hunting. And then the third thing I would just focus on in terms of why we rallied back so fiercely is that sentiment indicators on the equity side got very, very close to washed out.
Speaker 4:
If you look at retail AAII net bull/bears have been sort of a screaming buy for the market for the last few months. We've seen net bullishness down in the -30% area and -10% is usually a buy signal. And where we've been trading has really been the worst levels we've seen since financial crisis lows. And actually what we saw has been worse than what we thought at the lows of the pandemic. Now, the problem we had in equity markets is that we hadn't really seen enough of a collapse in terms of institutional investor sentiment. We really needed that to catch down to gauge that institutional investor sentiment. We watched the weekly CFTC data and US equity futures positioning among asset managers. And that really has really... If you look at Dow and Russell 2000 contracts has been down around great financial crisis lows.
Speaker 4:
So we really do think we had seen capitulation there. And the S&P 500 contracts have gotten very close to past lows. There's a little bit above 2015, 2016 lows but have really come close to most of the other lows that we've seen over the past decade or so. So we do think that institutional investor sentiment has really kind of been hovering around the bottom. Now, I'll just wrap up by talking a little bit about what we're seeing in our positioning work. One of the things I've been emphasizing to clients over the past week has been that if you look at defensive sector positioning against secular growth, so that's combining healthcare, consumer staples, and utilities against tech communication services and consumer discretionary, defensive sector overvaluation has basically returned to the most extreme levels. We tend to see that often in a sort of a company major market loads in the S&P 500.
Speaker 4:
So really the sort of smell test for buying defensive sectors at this point has really dissipated. The other thing we've noticed in our positioning work has really been if you look at hedge fund filings, those 13 Fs did come out. And I do think that was a big deal for the hedge fund community. Two things we noticed there, staples hedge fund positioning was back to three Q of 2016 highs when the low-ball yield defensive trade peaked following the industrial earnings' recession of 2015, 2016. So we really think that was a good indicator that defensive positioning had gotten over at [inaudible 00:13:36]. And then secondly, we got a real sense of how deep the carnage has been in top hedge fund holdings. If you look at the performance relative to the S&P of the most popular hedge fund stocks or the valuation levels, we're really kind of back to the 2017,2019 type range, not necessarily at the lows on the valuation side that we saw in that range but really we do see pretty clear evidence in those charts that the pandemic fraud is out of the most popular hedge fund names.
Speaker 4:
And the final thought I'll give you is just from our cash equity trading desk. Over the weekend, our tech traders did note at the end of last week, they've started very small pockets of mutual fund longer-duration TIMT buyers emerging. The big question here is whether or not this will be sustainable. There's essentially been a buyer strike the last few months because of poor liquidity and volatility, but it was very noteworthy that we were starting to see longer-term investors step into the tech space last week. And that's it for me, Jason. I'll pass it on to the next speaker.
Speaker 2:
Okay, great. Thanks, Lori. Over to Adam Jones. On credit, spreads have tightened a little bit consistent with what we've seen in the equity market, can this be sustained? What's kind of the views in credit space?
Speaker 5:
Yeah. Good morning. Yeah, Very strong week in credit. I think things that jumped out to us, first of all, Munees were one of the stronger assets overall on the week. Last week, there was some Munee closed-end funds up close to 10% on the week outperforming equities, which is obviously very atypical. And in many ways, the Munee turn was kind of something that led the charging credit. US... We saw a decent move. I think we're like 20 or so tied to an LQD. The overall Corp OAS rallied from 150 to 134. I would say, though, against that backdrop, we did not see massive participation from real money. The concerns have been new issue. It was a very light week on the new issue side. We know there are large cash balances set there in the real money community.
Speaker 5:
The question is, do they care to deploy them or are they holding onto them in anticipation of further outflows? New issue is basically going to be the litmus test. This week, we might not see that much of that because you got London out Thursday and Friday and so it could be a lighter week on the new issue side, which short term could well prove to be supportive. Further to that, other concerns in the background, there've been many stories about loan deals where banks have got hooked and have been trying to move them in the background. And we saw the Peloton deal finally clear. And there's definitely a focus on that. And it'd be nice to see some of that move. It really feels like the high-yield market is somewhat more tenuous than IG though.
Speaker 5:
And most of our trading or most of my trading is in IG where I think that short-term things can trade a little bit better. I'd also note last week we did see decent inflows into ETFs, which is also encouraging MUB, LQD, the high-yield ETFs, the crossover ETFs all had decent inflows on the week. And so broad, let's say short term, we feel reasonably optimistic but the real test is probably going to come next week when hopefully we see more on the new issue side and we'd need to see that... Basically, you want to see the books oversubscribed and trading well on the break. Anything other than that, I think will just reignite concerns.
Speaker 2:
Okay, great. Thanks a lot, Adam. Last up, George Davis to shed some weight on the technical picture.
Speaker 6:
Thank you, Jason. So I think the overarching theme that we've been focused on in the cross-asset technical space over the last couple of weeks can be defined in one word, and that's correction. And I think there's three main touch-points to focus on there. Foremost, we've generally looked at US yields as being the so-called canary in the coal mine in that respect. And last week, we did see confirmation of a head-and-shoulders [inaudible 00:17:32] when the 10-year broke below the 285 level. Now the rallying bonds is basically stalled out right around the 271 level. So that's going to serve as very important yield support going forward for the mark, and topside that neckline that served the head-and-shoulders-topping pattern basically comes in at 292 today. So the 292 level is going to serve as very important yield resistance.
Speaker 6:
And so I think what we're setting up for right now is a bit of a consolidation between two 270 and 3% for the time being with more of a bias to the downside in yields, just given the confirmation of that topping pattern last week. Now, that has been a positive factor, I think, for US equities. When we look at the S&P, the selloff basically stalled right around 38.2% retracement of the post-COVID rally at 38-15, and more importantly last week, the break above 39-66 triggered a bullish short-term trend reversal. And that was amplified on Friday when we closed above the most recent high at 40-91. So that basically suggests we're in a shorter-term corrective phase for equity. It does open up 41-95 in the 42-25 area next on the top side. But the one thing that we've been cautioning clients is that if you look at the downtrend that we've been in since early January, the resistance trend line that basically delineates that down just above the 4,500 level.
Speaker 6:
And so that basically suggests we still have quite a bit of work to be done before this corrective phase has come to an end. And so we tend to look at the bounce that we're seeing right now as more of a bear market rally for the time being. And we'll have to close above that 4,500 level to confirm a change in tone in the market. And then lastly, when we look at the impact on the dollar lower US yields rally in equities that's boosted risk sentiment.
Speaker 6:
And so we've seen some of the steam taken out of the rally in the US dollar. When we look at the Bloomberg Dollar Index, for example, the next support levels that we're watching as part of this corrective phase come in at 12-15 and 12-08. The broader trend is still upwards so we would view these corrections as an opportunity to scale into some long positions at better levels. And on the top slide, we're watching the 12-36 level. We're going to have to see a return back above 12.36 in the Bloomberg dollar index to basically neutralize the corrective phase and suggested [inaudible 00:20:00] over. So that's the main theme that we're going to be watching over the next couple of weeks in terms of monitoring the markets to see if these corrections remain intact, or if the cross-asset backdrop changes. After you, Jason.
Speaker 2:
Okay, great. So that concludes the May 31st edition of Macro Minute. You've heard from everybody about the kind of reversal in some of these trends we're seeing in markets and kind of what we're thinking going forward.
Speaker 7:
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