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 Daw:
Hi everyone, and welcome to this edition of Macro Minutes called Bonds Unhinged. I'm Jason Daw, your host for today's call, which we're recording at 9:00 AM Eastern time on September the 26th. The main story in financial markets has been the bond market and the relentless surge in yields since June. And today, we're going to touch on why yields have been rising and curve steepening. Can the trend continue? And what we need to see for there to be a turnaround.
We'll also explore how bond market dynamics are impacting the FX and equity markets. So for this lively discussion, joined today by Blake Gwinn, Peter Schaffrik, Lori Calvasina, and Adam Cole. To start off today's discussion, I'm going to talk about the Bank of Canada outlook and what's happening in Canada's bond market.
So for the Bank of Canada, the market has overreacted to the last CPI report in our opinion, and it's overpricing the chance of an October rate hike. Pricing in a full rate hike to January does seem like a stretch. Our base case view is the Bank of Canada is on hold until they start slowly cutting rates in Q3 of next year.
At this point in the cycle, the Bank of Canada will give more weight to weaker growth than one to two, higher than expected inflation prints, in our opinion. More specifically, they will have higher confidence that below trend growth that's emerging and easing the labor market pressures will ultimately bring inflation down. They're going to prudently keep optionality at the hike again, but they shouldn't act on that.
On bond yields, the move higher in Canadian yields seems purely a function of the move in the US rates market, which Blake is going to expand on in his comments, and not based on Canada specific reasons. There has been a material reduction in 2024 rate cut pricing that's mirrored the moves in the US market, but the amount of rate cuts baked into 2024 does seem too low based on tail risk possibilities and our base case economic assumptions. Specifically Canada's data surprises, they have been significantly weaker than in the US, and Canada doesn't have the same supply concerns as the US market.
So the idea that the US has dragged Canada yields higher is consistent with the small outperformance of GoCs versus treasuries in the belly to long end since the upward move in rates started back in May, early June. Over the medium term, it's likely that macro forces are going to win out and push yields lower. But for now, positioning is an issue. There's no counterbalance to hedge funds and the machines pushing the short trade as real money's already bought bonds and doesn't seem to be interested or able to add more risk at the moment. So this buyer strike from certain segments of the market, coupled with fast money and momentum players bulling the market at the moment does argue for a cautious approach in adding longs here.
Next up is Blake to give his insights on what's driving bond yields in the US and if that trend can continue.
Blake Gwinn:
Yeah, thanks Jason. So let's just really briefly start with the FMC last week. Fed obviously surprised the hawkish side at their meeting on Wednesday. The economic front, the data that they were inputting into their models was a lot more positive. They left the possibility for one more hike in 2023 on the table, but most importantly, the 2024 median dot went from showing a hundred basis points of cuts in 2024 to showing only 50. All in all, the main message of the change to the forecast and the rate path in 2024 was higher for longer, and markets have adjusted to reflect that fact. All told, since the beginning of September, we priced out about 40 basis points of 2024 cuts, although interestingly, much of that actually occurred in the run-up to the meeting as markets were already setting up for the shift in the dots in the weeks before the meeting.
But since the meeting, near term Fed pricing, and by that I mean both the terminal pricing and the amount of cuts that are priced for 2024, has actually been very stable, which kind of brings us to the sell off. We've had further out the curve over the last few sessions. Tens have sold off more than 40 basis points in September, but a lot of that move in the beginning part of the month was in tandem with the sell off in the front end. As I said, markets prepping for the Fed meeting coalescing around the soft landing view and questioning those 2024 cuts. And as such, curves were largely chopping sideways for most of September. Day of the Fed meeting, when we got the dots, two-tens bear flattened, which is I think what you would expect on this higher for longer theme being priced in.
But after that, curves have started to pretty strongly bear steepen despite a little bit of retracement in that move we've had this morning. As we said before, Fed expectations has largely been stable since the FOMC meeting. Front end has been pretty pegged, which means this move has been all about weakness in the backend.
So what's been driving that weakness in the backend and in turn the bear steepening over the last few sessions? We think it's really less a story about selling and more about a lack of buyers. To that point, I think there are several themes at play. First term premium supply, during the slate of client meetings I was on last week, this question of who's going to buy all the US treasury supply coming over the coming months and quarters? Quarters was a concern that came up at almost every one of those meetings.
Second is the impact of higher for longer on carry and rolldown. As I said before, I think the removal of cuts and a higher terminal pricing is not what's been driving things the last few sessions, but this kind of market acceptance of higher for longer does mean carry and roll for holding [inaudible 00:05:50] is likely going to be more punitive and for a longer period of time. And also then any capital gains you're going to see on those positions as we pivot towards lower yields, is also likely further away.
Also, on top of that, I think potential dip buyers that have a longer term time horizon and can afford to get long yields have already been long. I think they got long 25, 50 basis points ago and that while they may be frustrated, they could have had a better entry if they'd waited for the most recent sell off. There's really not a whole lot else for them to do here. You could stop out, take a loss, and try to reset at better levels, but that's a very risky bet. So I think a lot of those potential dip buyers largely on the sidelines.
Lastly, I would just say technicals. We have breached through a number of support levels and kind of hit some new highs across various parts of the curve and I just think seeing those levels has given a lot of caution. Again, to those would be dip buyers. As I said though, I don't think any of these are really driving actual selling, these are just reasons people aren't buying. As far as what's actually driving the selling flows, I don't think there's really been anything on the fundamental side... Fed speakers, since the FOMC have been pretty blase. Data calendar has been light and long end supply really isn't kicking off for a few weeks now.
So what we have heard is that there's been some convexity related selling. There's some potential flows around this switch on the cheapest to deliver security into the US contract. It's rather technical, but we have heard that as a reason for some selling. But overall, I don't think that this selling flow had to be that large given the lack of buyers to get the kind of move we've seen over the last few days.
For our part, we still believe the Fed has delivered the final hike of the cycle. We see them on hold through Q2 2024 before starting on a gradual cutting cycle. As such, I think the front end could still see some retracement on that pricing out of 2024 cuts that happened into the FOMC meeting. But with the backend still kind of fighting this term premium story and solidly below a lot of these support levels, I see this manifesting near term as a switch from bear steepening into bull steepening. And with that I will pass it back to you.
Jason Daw:
Thanks Blake. Very insightful. So over to Lori now in the equity market to tell us how stocks and sectors have behaved in this yield surge and what the focus on going forward.
Lori Calvasina:
All right. Thanks, Jason. Good morning everybody. So just to kind of put the recent moves in context and the move in yield in particular, if you go back and look at the entire history of sector performance in the equity market post the financial crisis, the playbook is essentially you want to buy financials and energy when bond yields are rising and you want to sell the growth sectors, tech communication services, and consumer discretionary. And that is more or less what's been playing out. If you look at sector performance since early August, we've seen significant underperformance by tech and consumer discretionary, and energy's been on top by a wide margin, along with some more modest outperformance from the financial sector.
And if you looked at last week's FOMC meeting. On Fed days, I always really liked to watch the sectors and how they react. I think it gives me really, probably the best insight into what equity markets are digesting and what we really saw was the tech trade getting hit very hard after Powell started speaking.
So how do we put this into context? I think that this bond yield move is just the latest challenge to a growth trade which has been propping up the S&P 500 all year, and it's frankly a trade that's been looking tired, crowded, and in need of correction even without the surge in bond yields. So what are some of the things we're seeing in our data? First off, valuations for growth relative to value have been at peak. They have started to retreat, but they're still well above the long-term average for growth relative to value. So we still seem to be early days in that unwind.
Secondly, positioning, if you look at the weekly CFTC data on asset manager positioning in NASDAQ futures, the number of contracts had recently broken above the four or five year highs and has started to roll over and that also looks very early days.
The other thing we're seeing on our data is we think the growth trade was really propped up at the beginning of the year by more powerful earnings revision trends than what we saw in the value oriented sectors. And that's really starting to reverse. Growth still has a little bit of an advantage, but it's really starting to narrow. We're also hearing a lot about tax loss selling and the profitable companies where you can book capital gains are also getting caught up in that. So there's just a lot happening in this place and I think that the bond yield issue is just the latest reason to sell a part of the market that's in need of a tactical correction.
Now when we zoom out, the other thing I've been telling people is that we need to keep the sentiment backdrop for equities in mind as well. If we go back to early August, we basically saw that AAII net bullishness hit two standard deviations above its long-term average. So enthusiasm, which in part was driven by chasing the tech and growth trade got too exuberant and we've seen a really rapid decline in that indicator. We're about 3% on the four-week average last week in favor of the bulls.
That's not yet in buy territory, but it's something we've got to keep a close eye on. And I think this is the best star in the sky, if I look back over the past year to help you navigate what's been going on in the equity market. Individual investor sentiment was really in the depth of GFC type lows to start the year in post-SVB. Again, it got peakish and overly exuberant in August, and now it's unwinding. So we need to see when we get back down to that point at which you want to buy the market again, but we're frankly just not there yet.
I think that this sort of tactical pullback in the market has yet to play out. September is typically a bad month for the equity market in recent history. We have a lot of little things starting to hit like the government shutdown, student lending repayments, and gas prices moving up. And there's still a lot of uncertainty about 2024, and corporates frankly are not giving investors a lot of clues yet on how to navigate next year.
Longer term, I do think there's a buying opportunity in here for both growth and the market. One of the things we've been talking about, especially after last week's fed meeting is that when GDP is running cool below 2%, growth stocks typically outperform so that should eventually help the trades settle down and help the market settle down. But we're just not there yet. And with that, I'll pass it over to you Jason.
Jason Daw:
Excellent stuff, Lori. Switching gears to Europe where Peter's going to enlighten us on his views about the bond market.
Peter Schaffrik:
Thank you, Jason. So since we last met, both the ECB and the Bank of England have met. The result in terms of outcome was very different, although probably the ultimate medium term breed across means that both are likely at their peak. I'll speak about those in turn, and then before I wrap up, I'll probably share some insights of why I think our European markets here have contributed to the bond market selloff. So let's look into them in turn.
So first of all, on the ECB, the E C B has surprised us. I think at the day, maybe not so much the market, by raising rates again to 4% in the deposit rate, but the guidance and the steer that was given thereafter seems relatively unambiguous that they have now reached the peak. The market's pricing is reflecting that and we're pricing round about five basis points of further interest rate increases before we are leveling off.
Now the front end of our markets has since been relatively calm as one would expect, but obviously the backend of the market has sold off in tandem with what Blake was saying earlier, and as a result, the curve has steepened a bit. I'll return to that subject in a moment, but I think suffice to say that as far as actual ECB policy is concerned, we probably won't get any further rate increases. And the things to watch out for is two things.
First of all, whether or not the ECB in one of the subsequent meetings is going to tinker with the minimum reserves and that particularly has put some pressure on banks and bank stocks earlier this year. And secondly, whether or not there is an active debate about further QT or an increase in QT being entertained as some of the more hawkish members are pushing for.
Secondly, the Bank of England. The Bank of England has quite surprised the market by not going and they now have probably reached their peak at five and a quarter. And the decision was taken, and a very small margin, five to four of the nine voters, and therefore the market subsequently has left around about 20 basis points in the forwards for another rate increase. We don't think that this will ultimately been delivered because from here onwards the hurdle to get another rate hike through, it's probably even tougher to meet than it was at the previous meeting, and therefore we think that they have probably reached their peak as well. Now the market reaction, however, has been very different. The market was pricing in quite a lot, roundabout 50 basis points or just under 50 basis points and grants total before the meeting and therefore, Sterling the front end has rallied quite substantially in the entire Sterling market with it.
And Sterling and gilts have been the key outperformer in the global bond market selloff. In fact they have been the outlier, but even in outright terms, yields are now lower than they were before the meeting. Whereas, obviously in the US and in the Euro market, they are higher. The curve has steepened, nevertheless. But again, we think from here onwards, there's still some 20 basis points left to squeeze out to the UK front end. And therefore it is reasonable to assume, at least for the next couple of weeks and that the UK will probably remain one of the better performing markets.
So where does it leave us globally and where does that leave the European contribution to the global selloff that Blake was describing earlier so eloquently? One of the things that seems relatively clear when we speak to our clients is that there is a relatively broad, I wouldn't say large in terms of volume, but certainly broad consensus out there that bonds should be bought.
The reason for that seems relatively simple. Central banks seems to have peaked out as I was just elaborating. Inflation is on the way down and the growth indicators over here in Europe look decisively bleak. In fact, we think that the next two quarters, both in the UK, as well as in the Euro area could well be negative. So the logical consequence seemed to be for quite a lot of investors that you have to buy bonds, but then of course the market is not obliging and we think one of the contributors, particularly out of the European sphere, has been investors who have already been positioning on the long side of the market that had to unwind in an environment where the central banks have been pushing the higher for longer agenda, as Blake again was elaborating earlier.
And that probably leaves me with my conclusion because I think the next guidance points that we're getting from both the Bank of England and specifically the ECB, is probably along the same lines as the Fed dots have been indicating. That we won't be getting any rate cuts for quite some time. And of course in both markets we've been pricing in quite a lot of rate cuts in the longer term forwards that can be squeezed out. So it's quite plausible that from the European sphere, we won't get any respite from the bond market selloff in the near term. And with that, I'll hand it back to you, Jason.
Jason Daw:
Thank you Peter. Last but not least is Adam Cole to discuss currency market dynamics under this cloud of the bond yield spike that we've had recently and what to expect going forward.
Adam Cole:
Okay, thanks Jason. So I think the dynamic in FX markets in an environment of rising yields depends, as we've talked about before, very much on the interaction between the two major asset classes.
So what happens to equity prices in an environment of high yield. And I think there are three main scenarios if we were to see yields continue to make new highs in this cycle.
So the first is an environment which has characterized most of the post GFC period, which is where yields rise and equity markets go up. That is what we have traditionally called a risk all environment. Equities rallying and bonds selling off. And it is an environment which is not particularly dollar directional on a sustained basis. What we see in that kind of environment, is typically the underperformance of the safe havens, the Yen and the Swiss Franc and the outperformance of the pro-cyclical currencies like the commodity currencies.
The second environment is more like the environment that held for most of 2022, which is where yields go up and take equities down, where yields function primarily as a discount rate in valuations and both markets sell off together. In contrast, that kind of environment we find is almost wholly dollar directional, whether markets are rising or falling. When you have co-movement of bonds and equities, dollar direction dominates and when its yields higher equities down, the dollar goes up, as it did for most of last year.
And then a final scenario is yields rise, but equities are not particularly directional and that's the kind of environment I think where relatives start to matter and its yields cross market that drive FX and we become much more idiosyncratic. The one thing I think you probably could say in that environment is that the lowest beta market of all is Japan still.
And if yields in the US lead yields globally higher, they'll rise by less in Japan than they will anywhere else. So that that environment would be consistently Yen negative. But otherwise it's a more idiosyncratic, more relative yield story rather than the big thematic asset market led environments that we've seen for much of the last 15 years.
So bottom line for us really is that if we do continue to see yield rising, where we'll look first of all for direction in FX is to asset markets. And if as seems most likely higher bond yields is equity negative again, that would leave us with a core view of the dollar going up still some way outside the consensus amongst sell side analysts that look for the dollar to generally depreciate. With that back to Jason.
Jason Daw:
Okay. So thank you for joining this edition of Macro Minutes. The narrative in financial markets is fluid as always, and right now the trend is your friend, for higher rates and steeper curves. But stay tuned to our publications or reach out to us directly for additional insights into what we think as far as can this trend continue or start to reverse.
Speaker 7:
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