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.
Simon:
Hi, welcome to the June 14th edition of Macro Minutes. The past two weeks have been characterized by increased hawkishness from the BOC and ECB ahead of the Fed and BOE this week. Yields and volatility have spiked again as concerns on inflation, current and expectations, increased on Friday in the US.
Simon:
To help us navigate this landscape, we have a full slate of RBC experts on the agenda today. Blake will discuss tomorrow's Fed meeting, the Fed call more broadly, and implications for treasuries. Amy will look at option market pricing following Friday CPI and University of Michigan sentiment reports. Peter will look back to the ECB and look ahead to the BOE. And Ethel will go through the latest in FX space. Rob will give insights on RBA surprise 50 basis-point hike, and to finish off, I'll discuss recent hawkish BOC developments and the potential for 75 beats from them in July. With that, I'll flip it over to Blake.
Blake:
Hey everyone, thanks for having me. So big story is obviously the media articles yesterday citing a potential for a 75-basis-point hike at tomorrow's FOMC. These were wisely believed to be leaked directly from the FOMC who obviously couldn't speak on the record, given that they're well into the pre-FOMC blackout period. Assuming all these stories were driven by the Fed, the obvious catalysts were the string of recent inflation data. That would include last Friday's big CPI beat, but also in my mind, just as important were the spike in the University of Michigan's five-year forward inflation expectations. We saw that move up from 3 to 3.3%, so a very big jump there. And also, yesterday, before those articles started to circulate, we also saw the New York Feds' inflation survey, which while it didn't spike in the same way that the University of Michigan did, it did gain at very elevated levels.
Blake:
And I think those expectations pieces of it that are forward-looking rather than CPI being backward-looking and also affecting inflation expectations, which have been relatively stable throughout this entire period, I think that's something that definitely probably spooked the Fed a little bit, perhaps even more than the high CPI print. The circulation of these articles about a 75 basis point, which all started to hit yesterday afternoon and did seem like they were part of some kind of coordinated effort or perhaps a string of off-the-record interviews by the Fed or something of that nature, it did lead a lot of the big shops to change their calls for tomorrow to 75 basis points. And it's very tough to deny that that possibility has risen quite a bit and perhaps is the modal outcome at this point for tomorrow's meeting.
Blake:
But I also still don't think that 75 basis points is a completely done deal. I honestly think 50 to 75, something that's going to be discussed around the table. I think there's various FOMC markers that are on both sides of the coin there. They're going to hash it out today and tomorrow at the table. And because of that, there wasn't actually a finalized decision that even would have been available to guide the press. So I really think what was probably more likely is that the Fed wanted some kind of optionality baked into market so they could at least have that conversation and have the option of delivering a 75 without completely upending markets. And they may have done this via the press. Prior to these articles coming out yesterday, I was steadfastly in the 50-basis-point camp.
Blake:
I thought they would move more to utilize forward guidance to push the terminal rate higher. Either they would allow that kind of operating mechanism to provide any further tightening of financial conditions rather than further front loading 75-basis-point, 100-basis-point hikes, things of those nature. But media articles out the blue, 48 hours before an FOMC meeting, is really tough to ignore. Maybe it's just my priors talking here, but I still think 75, 50 basis points could still win out. I think, at this point, it's pretty clear that would be paired with some type of strong setup for 75 in July or even July and September. And it's such a bias towards owning June which, at this point, we have more than an 80% chance of a 75-basis-point hike baked in, but you would also probably want to pair this with something like July, which also has a pretty fair odds of a 75-basis-point hike priced in. That would help to cap some of the downside in the event they do hike 75 basis points in June, given that July's probably also tied to the fate of June.
Blake:
I think the way markets would most likely react to a 75 in June is to seek that increase in July odds of the 75 and even push that perhaps into that 100-basis-point territory, whereas September and beyond, it'd probably be a pull forward out of those months. And I would expect the pricing to reflect that where June and July both go up 75 basis points and beyond, perhaps for July, while September and November and December see some of their odds of 75s or 50s taken out.
Blake:
What does this all mean further out the curve? My expectations for a while, you've heard me on these calls, talk about this give and take, where I think that as we go forward, a more hawkish Fed gets priced in. That comes at the expense of increased expectations for a hard landing or recession. And because of that, I've felt that the upside to tens is relatively capped. Obviously, that's a bit difficult to say after we had such a large move over the last few days in 10, such a large sell off, but it is notable that the curve's been chopping around a bit since yesterday. We had a big flattening coming into yesterday, but on the actual pricing end of that 75 basis points, the curve hasn't really flattened, which has been a bit confounding to me because I thought this would drive much more of this hard-landing recession type of thinking.
Blake:
It's very possible that we're still chopping around and that after this smoke settles, I could see this volatility remaining into Powell's congressional testimony next week. But after we get through these risk events and the smoke starts to settle, I think we do start to get back in this dynamic where the more hawkish Fed expectations being priced in the front end do provide some support for the back end that takes 10s back down towards that 3% level and we start trading in more of a range for the summer. And I'll stop there, unless there's any questions. Thanks.
Simon:
Thanks for those insights, Blake. We'll now move to Amy for a look at the volatility space.
Amy:
Hey, good morning, guys. Thanks for having me on. So look, from the volatility side, clearly, volatility woke up post Friday's CPI print. We now have the VIX standing at 33 spot four. We have the curve steep. The current S&P Wednesday, at the money straddle, was breaking even at 2.9% ahead of the Fed meeting. And look, we're waiting for the Fed with bated breath here, and all different measures of hedging demand and tails are higher as expected.
Amy:
So to just walk you through a couple key metrics, when you look at the one standard deviation tail, the skew, we moved from the first percentile to the ninth over a five-year percentile period. The tails moved from the 12th percentile to the 60th. [inaudible 00:07:42], so the volatility of VIX, moved from 40th to 70th percentile and rates VOL was already high, was in the 96 percentile, but basically moved to an all-time high.
Amy:
And then two key ratios that we watch. One is the S-DEX versus the V-VIX, so looking at if S&P puts are better hedge compared to VIX calls, that's moved close to one-year high, essentially saying VIX calls have become expensive. And then when you look at move versus VIX, essentially a proxy of how rates VOL is behaving relative to equity VOL, that's still on par with each other. The way I would read that is one has not been leading the other. They're actually both moving in lockstep, as opposed to two months ago, where rates VOL was really leading the entire cross-asset volatility sphere.
Amy:
And another key metric we look at is called skew buying power. Essentially, it says, "Look, if on a two-month rolling basis, you sold 10% out of the money put in the S&P, how much upside are you buying?" We've seen this metric go as high as 50 times. It's only at two times. So how do you think about that in an environment where there's a lot of whipsaw and obviously the market has gone down? Essentially what it's saying is, even though we do see demand for hedges, it's first not really in the down 10%, call it, one standard deviation range. It's much more in the tails, and that has been consistently true all year. And second, it means that people are also worried about the up-crash scenario here. And that's why you see that upside VOL expensive enough that your skew buying power is low. And I can tell you, from a positioning perspective, what a lot of people fear that not only is the downside tale, but it is a fact that they are concerned that they have the gross de-risk hedge or whatnot, but if inflection point to an up-crash happens, that they cannot be nimble enough to own that upside. So that's why that bit is there as well.
Amy:
A couple things that we are seeing, from the options market specifically, that our team has highlighted, there's been more hedging on the bond proxy ETFs. We saw that go through yesterday in your related ETFs, like HYG, NLQD. And the other thing is, on moves like this, we've actually seen hedge monetization as well as rolling down. So there are people who are essentially taking money off the table. They've made a lot of money on hedges, especially a day like yesterday, and then some clients are moving to even lower levels from here. So a common question that I get is, "Has volatility peaked?" I'll say two things about this. The first is, while we're nowhere near the peaks that we really saw in March 2020... We had a VIX that hit 80. We haven't had a period of persistently high volatility as we have now, and that has been part of what has made it feel like volatility's very high, even though we're still a sub-40 VIX. And we were much higher levels. It was much [inaudible 00:10:44] during March 2020 than it is now. And that has driven some of what I would say is the poor sentiment relative to the actuality of where skew is.
Amy:
And then the second thing I'd say is I was in Las Vegas a couple weeks ago for the Global Derivatives Conference and almost every panelist and client said the same thing. Essentially, people came into this year prepared for the market to be down 15% or so, and that's why from a derivatives perspective, it felt orderly why you saw hedges placed and taken off and monetized. One tail risk that people mention was essentially people are not ready if there's another full leg down. Those tails haven't been placed. And I think that's why you saw the scramble yesterday that we saw in the derivatives' environment. So, again, it's two wings that are both of concern right now at the upside crash, as well as a further downside crash.
Amy:
And then in terms of inflection points, we continue to see it in China, even though they're talking about COVID re-inflection rates, we see FXI, ASHR, KWEB, all these options being bought. And we continue to see that even in down crashes like yesterday. And then, finally, just a note on crypto, because we hosted the head of Coinbase risk strategies last year, he now runs institutional side of FTX. From his perspective, and obviously this was a little talking of your own book here, but he thinks the Celsius situation is overdone. He thinks timing with regards to Luna Tara was obviously not great, but DeFi regulation, if it is introduced at this time, would also not be good for the old law environment, although ultimately, regulation in the environment would be a net positive. And finally, in terms of contagion to watch the Ave and Block 5 protocols, and I will leave it there. Thank you.
Simon:
That's great. Amy, very useful. Next up is Peter to discuss the ECB and BOE.
Peter:
All right. Thank you, Simon. So, first of all, a look back to the ECB, what the ECB has done was, in part, expected, but, in part, it wasn't. That's why we had such a relatively strong market reaction. So what was expected was that they ended the purchase program that they pre-announced a 25-basis-point rate hike for their next meeting in July. And what wasn't expected, however, was that they also pre-announced a rate hike in September and said that if the situation, as regards inflation, just persists at current levels, a larger move would be required. So, in other words, they put a 50-basis-point rate hike for September not only on the table but made it a default option unless things materially changed to the better, which seemed very unlikely.
Peter:
Now, the response in the market has been twofold, really. First of all, we've shifted front-end rate significantly higher, both in 2022, as well as in 2023. Terminal rate was shifted much higher. The market has been pricing now to 50 to 75 at the peak rate, which is significantly higher to what the ECB has said neutral is, around about 150, but I think it's not going to go away. And then the second outcome was that with the ending of the asset purchase program, spreads have become much more volatile once again, both in the peripheral space, for instance, the Italian bun spread widen quite significantly, but also in the corporate space where the ECB has been a purchaser before and where, for instance, the FX crossover has now priced significantly higher. We were trading two weeks ago around about 420 in the crossover. We're currently pricing 550, so a significant widening here. How do we think, once you trade that, the front end probably don't have a lot of exposure, but if in doubt, I want to be a seller and we are short spreads. And I think that's the position to go.
Peter:
Now, as far as the Bank of England is concerned, which meets on Thursday, the market is currently pricing around about a 50% chance of a 50-basis-point rate hike. And the Bank of England has given us almost no stir whatsoever in which direction it is leaning, just that it's on a hiking path. So 25 basis points is probably still the default, but there must be a significant risk, particularly against the backdrop of the ECB and the backdrop of the fed meeting that they go larger as well. And then the question is, what is the market going to do thereafter because we have priced in quite a lot for this year already? And we have priced in at least two 50-basis-point steps along the way until December at one point. But my hunch is also, if they were to go faster or even if they don't, that the market will just roll forward expectations of more to come. How long is this going to last? Well, we reckon probably for quite a while, until either the inflation data and/or the economic data significantly comes down. We had only a little bit downside recently in some of the UK data. So I reckon the market has still some time to shift front-end rates even higher also in the UK.
Peter:
And then last but not least, on a trading basis, one of the traits that we have outstanding is a five-year spread euros versus Sterling, receiving euros versus Sterling whenever the spread becomes positive. And this has happened once again in the wake of the ECB meeting. It's probably a good opportunity to reload on those. And with that, I'll hand it back to Simon.
Simon:
Thanks very much, Peter. We'll shift now to FX with Elsa.
Elsa:
So picking up on FX, I think a few interesting points to make. First, around the big US dollar picture. As many people have seen, we're at multi-year high levels in the dollar index, and that's prompted a lot of questions on how much further we can go from here. I think a lot depends on what your ultimate outlook is in terms of the bond environment. And Blake outlined at the start why we think that you should get some range trading as the market settles down and begins to price in some risk of recession and you get a bit more flattening of the curve. And if that plays through, then you'd expect the current dollar gains not to reverse but certainly to moderate. If we are wrong and yields continue to rise unstoppably, the current environment with equity weakness and bond weakness is a very good one for the US dollar.
Elsa:
It caught a lot of people off guard in April, but I would refer you back to pieces we've done in total effects just recently in May, as well as charts of the day by Adam Cole, where the current bond equity regime is one where you tend to see the dollar outperform against all other currencies. Outside of that there, there are a number of other very interesting things happening as well. And, in particular, if you look at the Euro, following the ECB, there was a lot of talk whether we're seeing the Euro come under pressure because it's spread widening and so on. In fact, what we've seen post-ECB has been very much just a plain US dollar move. And, in certain process, Euro is actually outperforming. The one cross that we would like to particularly focus on is Euro Sterling or, by extension, Sterling Swiss.
Elsa:
Our trade of the week for this week is short Sterling Swiss. We've got the S&B coming up this week. And while many people tend to ignore Swiss, it is one of the most crowded shorts out there against the US dollar. And while the S&B is certainly going to be slow to join the others in terms of tightening policy, the fact that they're talking about tightening policy and markets are possibly expecting the first hike as soon as this week means that they will almost certainly have to step away from the aggressive currency intervention they have done in the past. So short selling Swiss, a trade we like. The dollar, we expect gains to moderate, certainly not turning into dollar bears, like a lot of the consensus out there, but that outlook very much depends on your bond equity regime. And if you are in the camp where you think yields go higher, then you can expect to see some further dollar gains from here. I'll leave it there and pass it back to Simon.
Simon:
Very interesting views, Elsa. Thank you very much. On to Rob now for a discussion on the RBA's recent 50-basis-point move?
Rob:
Thanks, Simon. So setting the scene here in Australia, the RBA's been a late and somewhat reluctance arrival to the rate hike party, but it's quite quickly set things up recently. So after the initial 25 in May, as you say, they expect unexpectedly hiked by 50 base points last week. I say unexpected, but it's not because the 50 was unjustified. Rather, we actually applaud the move in many ways. It's unexpected because they gave us every indication that they were more inclined to move in 25-basis-point increments in this cycle, rather than the 50s, despite that being increasingly the global norm at the moment. So part of the reason we expected 25 last week was that as the governor himself pointed out, we've got monthly meetings here in Australia, not [inaudible 00:19:43] or so like many other parts of the world. So they don't actually need to use the same increments to achieve the same pace of typing over the course of the year.
Rob:
We also spent some time explaining, the governor that is, in the post-May presser in responses back to a question from our Chief Economist Sulin that they saw 25-basis-point hikes as business as usual and heavily entered that this would be the path that they'd take, but of course, they went 50 basis points, anyway. The key here really is that this latest strong footing for investors and many market commentators, it really just adds to a broader set of communication issues that have been emerging since the second half of last year from the bank. It's been attracting a lot of criticism, both in the press and from investors since that time. I mean, the governor tried to talk down market pricing from the back end of last year and reaffirm the RBA's very dovish... referring to dovish forward guidance, but it's had to take quite a back flip this year, and it's still not quite managing to nail down the communication pieces of many of the other banks globally are managing to do.
Rob:
So it has made things a bit more difficult to read in Australia. And in some of our conversations with investors as well, it has actually discouraged them from being in the Aussie market so, in many ways, punishing the government, for instance, for its fundraising and so on and certainly making things a bit more difficult and illiquid in Australia as well. This is, of course, good because actually today, just a couple of hours ago, the governor had a somewhat unusual interview that he gave to The 7.30 Report, which is the national broadcaster here to speaking to a slightly different crowd to use your... perhaps partly in response to some of this criticism about communication, but also to speak to a broader and different audience to the usual financial markets types.
Rob:
And there are two purposes, I think, to today's interview. The first, getting the message that out there to many other segments of the population to try and explain what they're doing by suddenly moving to rate hikes. And then, as I said, also trying to improve perceptions of communication and some of the criticisms that have been thrown their way over the past six months or so. So where does this leave us? Well, we're still expecting other 50-basis-point moves at the next meeting in July. So it'll be back to back 50. And again, not uncommon globally, just quite a change from where we were just a couple of short months ago. Following that, we're a bit less sure. I still think it would make sense for them to stick to what had been the path of 25 to use those monthly meetings to get us to a sensible place in rates. But it does seem increasingly likely that the odds are that they'll need to do yet more 50s at some point again. So definitely got a 50-basis-point hike penciled in for the July meeting and certainly a rising possibility of more than that later. The market price thing has essentially got a 50-basis-point hike for the next 5 meetings in a row sequentially. So some similar themes to other parts of the world playing out there, although of course, and like I said, we're not yet talking about a 75-basis-point of hikes here just yet.
Rob:
We're also in the [inaudible 00:22:50] market pricing, which terminal rate's now at about four and a quarter up from 4 percent-ish pre USCPI print last week. We're still in the view that it's very high. It's very hard to push back against micro pricing, but we don't think the bank's going to be able to get to that kind of level in terms of terminal rate path, especially as we get the back end of this year and rates are potentially high, we think the consumer here and housing market, in particular, [inaudible 00:23:18] have quite a sharp slow down and basically force the bank's hand to stop hiking well short of market pricing of that 4%-plus terminal rate that's currently taking place. So what do we like? Well, we're still on the US cross-market tightening, targeting those relative terminal rate expectations, where we think the RBA caps out somewhere above 2, but certainly not at the 4%-plus market [inaudible 00:23:47] versus the states.
Rob:
So, basically, we've had this premium, if you like, priced in for Australia for some time. And that premium has lately been wound out a little as Fed pricing has outpaced Aussie. So that's worked our favor on the [inaudible 00:24:02] side of things, but unfortunately, given we've had the trade on in swap, we've had a couple of outside swap spread moves and other bits and pieces of funding markets here go against us on the trade. So, unfortunately, while the core view actually has worked out correctly lately, some of the implementation hasn't. So I guess that really speaks to a bit of nervousness creeping into markets, and the fact that we've got some of these plumbing-type issues and funding and spread markets coming to bite us at this very early stage of the cycle, frankly, the heights cycle, it is a bit worrying. It speaks to markets as very difficult to trade. I think you've got the right view. You need to make sure you input it on correctly and in the best, cleanest possible way.
Rob:
And really, the only certainty remaining here for us is that there's going to be a lot more volatility still to come. So again, that backdrop and against bringing back to fundamental point here, a central bank, which has lost a lot of credibility in the eyes of investors through poor communications, not particularly helpful for these kinds of trades, which we still continue to like from fundamental points of view. That's it for me. Thanks, Simon.
Simon:
Thank you for those points, Rob. Now I'll shift to Canada. A lot has happened the past two weeks, starting off with the June 1st policy decision and the follow-up progress report the next day. As a review, the bank hiked by 50 basis points on June 1st. That was largely expected, but signaled they may need to be more forceful in policy moves going forward given concerns on inflation and inflation expectations and signs that the economy is in excess demand already. This suggests the potential for a 75-basis-point move at the next meeting on July 13th.
Simon:
On terminal pricing, Deputy Governor [inaudible 00:25:42] was asked in the press conference after the progress report about whether the bank would cause a recession and emphasized that inflation was their target, so implying that they would do what they could for growth, but really, inflation was very much the primary focus. Governor Macklem was a bit more nuanced on the subject last week at the press conference for the FSR saying they see a soft landing as achievable, want to bring demand in line with supply, but not choke off the economy, but also suggested the primacy of inflation expectations there.
Simon:
Looking ahead, we think next Wednesday's May CPI report will be very determinant for the 50-basis-point versus 75 discussion. At the July 13th meeting, headline, greater than seven and a half percent and.or another material increase in the core measures would likely see pricing solidified around 75 basis points. We do currently forecast a 50-basis-point hike in July, but as noted, we will be watching the CPI report closely for implications. And also, if the Fed does go 75 basis points tomorrow, then the hurdle is likely lower for a 75-basis-point moved from the bank in July.
Simon:
Looking further out, accelerated near-term hike pricing makes some sense as central banks move towards into their neutral policy rate ranges. But alongside this, we have seen a sharp rise in terminal pricing. So, for example, close to 4% for Canada in the first half of next year. We think it's much more likely a bank goes 75 at the July meeting than they reach 4% for the terminal rate given inflation dynamics expected in the second half of this year and the impact of tightening on a broad economy and as that flows through. So we do think that the terminal pricing is much too high relative to what we'd expect to go through. And with that, that'll conclude the call.
Speaker 8:
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