Jason Daw:
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 Macro Minutes. Today is the 5th of March, 2024. My name is Peter Shepard, and I shall be your host today.
For most of this year, it has been about how much rate cuts have been priced and how fast they will happen. It appears that over the last few weeks, markets have finally found a level that is at least temporarily deemed to be fair value or thereabouts. In the US, we are now priced for just under three rate cuts for the rest of this year, which might be a bit on the low side, but still within the realms of what the SAPs appear to be guiding us.
For the ECB which meets this week, we are pricing a bit more than three rate cuts, which we are forecasting at roundabout 90 basis points cumulative by December. For the Bank of Canada, which also meets this week, the market is implying a similar amount and thus, slightly more than the US, with around 85 basis points cumulative cuts by the end of this year.
Longer end yields also seem to have [inaudible 00:01:24] for now, at least in the near term with about 430 in the US and 250 in 10-year bonds being a formidable obstacle and have come down over the last few trading sessions. Movement in the FX markets are rather limited and it seems to be the absolute, rather than the relative movement between markets. That seems to be the market's obsession at the moment.
Where does this all lead? The question of this episode is, Are we there yet? Whether that repricing that started at the end of 2023 has run its course. To make sense of this all, I'm joined once again by a strong cast of RBC experts who will help us navigate their respective markets.
We'll kick off with Blake Gwinn to talk about the US and the Fed, followed by Jason Daw, to illuminate us on the Bank of Canada. As I mentioned earlier, it meets this week. Gordon Scott will share his thoughts on the ECB meeting on Thursday, and to round us off, we're joined by Elsa Lignos to share her thoughts on the FX market and whether there are any interesting movements in store after all. So Blake, please take it away.
Blake Gwinn:
So the macro and fed narrative in the US, I think has mostly been on hold the last week and we've seen market pricing for 2024 cuts, more or less chopping around a midpoint between three and four cuts for 2024.
I think what we're seeing is that the strong January data that we got, particularly on the inflation side, has largely caused a bit of a deer in headlight moment for markets, and the fed, for that matter. I think that's because we're not really sure whether that strong January data was really a one-off, just a noise on the broader downward trend to 2% inflation, or if it is representing some potential signs of slowing or a re-acceleration of the data. Further complicating things, we have seen a bit of a seasonal pattern in the economic narrative the last few years. Basically, big beats in February and March turning to big misses in April.
Now, I know it's a fool's errand to try and forecast where data surprises are going. It's difficult enough to forecast where data itself may be, but to forecast where surprises are going, even more difficult and probably more problematic, but that pattern is at least enough to make me a little bit weary of the pickup and the no landing narrative we've seen to begin this year.
For the fed's part, they don't really seem to have been disrupted from their modal forecasts. We've had a heavy calendar of fed speakers over the last few weeks and I think they've generally reaffirmed that their prior inflation views are more or less still intact and most of them have, I think, acknowledged that the path towards 2% was always going to have some bumps along the way. That being said, I mean, the acknowledgement of upside risks to inflation has seemed to be ticking up over the last few weeks and starting to reappear in a lot of those speeches. So again, just a lot of uncertainty as to which path the economy's currently headed down.
To this point, I think there was a lot of focus on last week's PCE report after the CPI and PPI beats that we had. I think many were looking for a similarly strong PCE number to further propel that pricing out of cuts, but the anxiety that we had around that print very quickly died down. PCE came in as expected and we really did not get that confirmation in either direction. I think one of the reasons people had been looking so heavily at that is that the Fed does look much more at PCE than CPI, we do know that, and there had been some thought I think that if the PCE had also come in strongly that we might see some revision in the Fed's dot plot at the upcoming FOMC meeting in a few weeks. To be fair, that is a very thin line. It would only take two FOMC participants that had submitted at the median level in December. Only two of those members would have to upgrade their dots in order to pull the whole median higher. So, I think that's the thought process that people were thinking looking at that PCE number.
For our part, I think at this point, given what we've seen on the inflation side, on the data side, and heard from the Fed, I think those dots are going to continue to show three cuts as the median rather than moving to two. But again, that line is somewhat thin. Overall, I think markets and the Fed are left waiting here for the February data to give us a little bit more confidence that either January was a bit of noise, a one-off, or confirm that those no landing risks are truly rising.
We do get one more inflation print before that FOMC announcement, although it does come very late in the process, I believe they're already meeting. So the Fed really won't have a chance to move market expectations after seeing that inflation print.
To that point, our Fed forecasts are still for our first cut in June and we have cuts still forecast for every meeting after that. I think we do lean the idea that this no-landing positive economic narrative we've had over the last month is probably nearing a peak and that the pendulum's probably due to swing a bit more back towards neutral. That being said, the risks are certainly there on the other side. We wrote a piece several weeks ago that just highlighted a number of the reasons why Fed hikes may be having less of an impact on the economy and why we think the economy might be on fairly solid footing from here. So those upside risk also certainly present. Again, we are not that different from the Fed and the rest of the market and being stuck between these two mines.
To that point, we did recommend a steepening in 2024, 2026 fed pricing last week. I think that that could perform well either in a pullback on that theme as we price some of those cuts back into 2024, or it could do well on the re-acceleration theme if we do see market expectations for the terminal rate or even neutral rate for the Fed increasing, which would push up that 2025, 2026 pricing. So with that, I will turn it back to you.
Peter Schaffrik:
So still for a June cut. Jason, over to you. Is that also the view for the Bank of Canada still?
Jason Daw:
I think with the Bank of Canada this week, the good news and bad news is that there shouldn't be any fireworks at the meeting on March the 6th, in so far as the policy rates should be unchanged. The main risk is whether they will provide any hints about near term cuts, and we think the messaging though should remain broadly unchanged but if there's any room for a surprise, it would be on the Dover side, given this is where the Bank of Canada has been moving, albeit in baby steps. So they have been expressing increased confidence that policy is restrictive enough to get inflation back to 2% and they have downgraded the risk of any further tightening, but they have been clear that more time is needed. I think paraphrasing what Powell told us in January and applying that to the Bank of Canada, they have confidence and their confidence has increased, but they need more confidence before they can start to cut rates.
Now, our long held forecast since July of last year was for the easing cycle to start around midyear 2024, so we have it penciled in for June, and for there to be four cuts this year. But we've also said that the risks are slanted to later and less cuts rather than earlier and more. So when you look at current market pricing of between three, three and a half cuts this year, it is hard to argue with from our perspective. So it is probably relatively close to fair value with the risks being less rather than more.
One other thing on the policy side I wanted to mention and the next thing to keep an eye on is the March 21st speech by Toni Gravelle on balance sheet normalization. We do continue to expect an earlier end or a revamp of QT compared to what consensus thinks or what the Bank of Canada has told us previously, as far as where they view the steady state links balances. So the March 21st speech is an opportunity to sow the seeds for an earlier end to QT, or introducing other policy tools that could be deployed to dampen the risks of pressure in the funding markets. So with that, I'll turn it back over to you, Peter.
Peter Schaffrik:
With that, I'll hand over to Gordon to speak about the ECB meeting that takes place later this week.
Gordon Scott:
This week the main focus in Europe will be on the ECB meeting on Thursday. We, like market pricing and the analyst consensus, expect the ECB to keep rates unchanged. With an unchanged decision, all but a lock, there'll be three key points that we're going to be looking out for at this week's meeting. Firstly, we'll be looking out for any messaging from ECP President Lagarde, over the timing of future interest rate cuts. Increasingly, we've noted size that both the hawks and the doves in the governing council appear to be converging upon a June start to rate cuts. On the hawkish end of the spectrum, we've heard from Simkus and Kazimir are both leaning towards June. Then also on the dovish end of the spectrum, from Greek Central Bank, Governor Yannis Stournaras. Our own call also remains for the ECB to begin its cutting cycle in June and we see 25 base point cuts in September and December after that. However, for this month's meeting, we expect ECB Present Lagarde to refrain from giving any firm commitments and expect to try and maintain as much optionality as possible, particularly as the ECB continues to monitor the incoming wage data.
The second key area that we'll be looking for at this month's meeting will be any changes to the ECB staff forecast. Both the ECB's near term growth and inflation projections are likely to have to be lowered. We expect, for example, headline inflation for 2024 to be lowered by around 0.3 percentage points. Further out though, we expect fewer changes to the ECBs projections. That reflects tentative signs of an uptick in economic activity, as well as the fact that the ECB's new staff forecast will be conditioned upon a lower path for interest rates than in the December projections. That in turn will put upward pressure and growth in inflation in the second half of the forecast horizon.
The third key point that we're going to be looking out for at this month's meeting will be any discussion about the ECBs Monetary Policy Framework review. There have been a number of reports in the press suggesting that the ECB is close to completing its monetary policy framework review, which focuses on how policy is actually implemented, as well as the long-term size of the ECBs balance sheet. We think that this week's meeting is likely too early to get any announcements, but some reports in the press have suggested that it could come as early as next week's non-monetary policy meeting. With that I'll hand back to Peter.
Peter Schaffrik:
We'll probably leave the fixed income market for the time being and go to Elsa to speak about the FX market.
Elsa Lignos:
So FX, as Peter mentioned at the start, it's not been the most exciting asset class since the start of the year. The last month in particular had seen ranges particularly tight and net movement particularly small. But what that has meant is that clients are looking more and more at carry trades and thinking about how to invest in high yielders in an environment of generally low volatility.
Some of you who follow our work will know that we have a carry barometer that uses options prices as a measure of the trade-off between carry and volatility, rather than simple car to vol ratios. The basic arithmetic runs as follows. We take the three month carry across the currency pair and think about what it would cost to buy a put option on the high yielder versus the lower yielder. The amount of premium and the implied vol in the pair determine the strike price of the option. So the closer the strike price is to being at the money, the better the trade-off. Lower vol and wider yield spreads both have the effect of making the option closer to at the money. If all ever became so low and the rate spread so wide that an investor could buy in the money option, that would effectively be free money, the perfect carry trade. Of course that never happens in reality, but we have come very close on occasions and that gives you some sense for how popular carry trades are at any point in time.
Updating our carry barometer to look at things as they stand now. What's really interesting in the last few months is the shift that we've seen, whereas a year ago or six months ago, we had several potential low yielding currencies to use as funding currencies. Now increasingly, we're finding that the Swiss franc and the Japanese yen are popping up more and more at the top of the efficient funding currencies. For the Swiss franc in particular, it's a really interesting shift in approach because if you look at the Swiss franc for all of 2023, it was a steady out performer. In fact, long Swiss Yen was one of our favorite trades. For us, it all came to an end in December of last year when the S&P effectively stepped back from its policy of selling FX and buying Swiss franc, and too much more nuanced outlook. Some might even say a currency outlook that supports some Swiss franc weakness.
On the yen side, it's also pretty interesting because we've been mindful that positioning is pretty long dollar yen or short yen, and that there is some scope for a pull back as we get closer to the March or April Bank of Japan meeting. But yet, if you look at pricing for those meetings, we're around 40% price now for the first Bank of Japan hike to come in March, around cumulatively 70% price for that to come by April. Markets pretty much certain that it will have come by the middle of this year. So yes, there is some potential for a little bit of a pullback in the yen if people anticipate this shift in policy from the Bank of Japan leading to a real material change in the outlook for the Japanese yen, but we think that would likely be very short-lived because for us as always, the key driver for the longer term direction of dollar yen is what's going on on the US side of things and the cost of hedging, which is driven by front end US rates rather than Bank of Japan rates. As long as that's the case, we expect that any dips in dollar yen are likely to be quickly brought into, and that's even more so the case in an environment of low volatility and generally popular carry trades.
For investors though that don't want to take the absolute risk of funding themselves with a safe haven like the Swiss Frank or the Japanese yen, there are still some alternatives out there. It's not quite as efficient as funding with the very lowest of the low yielders, but Aussie, for example, doesn't screen too badly for funding some commodity currencies. The likes of South African rand or Chilean peso, or in some cases, Euro screens not too bad for the likes of Brazil cope and pen. Turning to the Asia complex, Taiwan dollar is still a very popular funding currency for the high yielders like IDR and INR, and we expect that to remain the case.
So bottom line, I think the low volatility environment in FX is hard to fight at the moment. As a result, carry trades become increasingly popular. We'd rather not default to short dollars long the high yielder, it's certainly not the most efficient way of funding carry trades. The other options out there are quite, you do have the likes of Swiss franc, Japanese yen, that are much lower yielding, but you run the risk of shorting a haven and we all know how carry trades eventually end. They typically at some point blow up, or you can look for those slightly more nuanced options where you're paying a little bit more yield to short the funding currency, but at the same time, you're protecting yourself a little bit more by using a risk proxy as a funder. I'll leave it there and hand it over back to you, Peter.
Peter Schaffrik:
That was very insightful as always. That shall conclude today's edition. Thank you everyone, who participated. Thank you everyone, who listened and hope that you join us again next time.
Speaker 7:
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