Speaker 1: Hello and welcome to Macro Minutes. During each episode we will 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 a big welcome back from the holidays, and wishing you all the best in 2023. We've called the January 10th edition of Macro Minutes Can't, Won't, Don't Stop, and while that's a reference to an old school Beastie Boys song, it does seem like an appropriate characterization of current central bank policy. So there is ample debates surrounding near term policy increments and terminal values for various countries. So today, we have myself, Blake, and Peter to opine on these topics, along with Elsa on the US dollar, and Michael Tran on the oil market where prices are down sharply from the peak, and is one of the critical components for inflation dynamics this year.
So to start off today's discussion, I'm going to talk about the situation in Canada. So since our last call in early December, the data in Canada has pushed the market from pricing basically an equal chance of 25 or no change, to almost fully pricing in a 25 basis point rate hike at the next Bank of Canada meeting on January 25th. It is difficult to argue with this pricing given the evolution of the recent data we've seen, and specifically the CPI data where the three month annualized trends in core inflation were stickier than expected. Q4 growth is shaping up to be better than expected based on the October monthly GDP data and the Nowcast estimate for November. And a third, the labor market has posted two strong readings in the past three months.
Now, despite market pricing being very close to 25 basis points, I would say nothing is a lock for the next meeting. The Bank of Canada has shown a pension for surprising the market in the past year. So all possibilities, whether that's 0, 25 or 50, are possibly live options for the next meeting. The upcoming data, specifically the CPI report next week and the business and consumer outlook surveys, they could sway market pricing the either side of 25, but they're unlikely to cause a reaction that would lead to something extreme, i.e. 0 or 50, as far as market pricing.
And I would say the business outlook survey is probably more important than the CPI data and the risk there are probably slanted to an outcome that leads market participants to increase their bets for a 50 basis point move. I mean, I think importantly, regardless of whether the BOC hiked 25 or 50 at the next meeting, or if they did two consecutive 25s, we do think duration can perform pretty well in 2023, especially as the Fed nears the end of its hiking cycle also.
So just to put it in perspective, US bonds, they have posted a positive total return performance in the 3 to 12 months following the completion of every rate tightening cycle we've seen back to the early 1980s. So I think even in a higher for longer scenario for policy rates for Canada, or even possibly the US, I do think duration can perform okay in Canada in 2023. And some final thoughts on the curve and Canada US spreads, the CAD curve we think should stay deeply inverted and any steepening moves should be faded until the rate cutting cycle unfolds, which we don't think will happen in 2023.
And on Canada-US spreads they have adjusted sharply over the past month, but we don't see CAD outperformance continuing from here. With that, I'll turn it over to Blake to tell us about the Fed and the bond market.
Blake: Yeah, thanks Jason. So in the US, I think positioning is pretty clean to start the year, just to the degree that we haven't really seen big thematic trade ideas or positioning, for most of the clients we talked to, it's fairly light. I think perhaps one point of evidence to that facts is that we've got 74% of investors in the J.P. Morgan all client survey saying they're neutral on duration, which, if you look back to 2011 is pretty close to the highest level that we've seen in that survey. So a lot of people kind of coming into this year fairly neutral in the US rate space. To the extent there has been somewhat crowded trades so far this year, it's probably fading 2023 cut-pricing. The pain on those trades over the last week led to some cleaning out of those positions, and again, I think we're back to a place where positioning is fairly clean. Steepener is particularly in forward space also coming back in Vogue, but overall, even there, I think the actual action on some of those positions is still relatively light.
A lot of this kind of light positioning, lack of big ideas, big themes, big conviction is the markets are kind of stuck between a chop between two themes. On the one hand, you've got the Feds pivot from inflation data to labor markets that's occurred over the last month or so, which basically means that these kind of near term hawkish risks aren't really dead despite the softening of inflation data. We've seen the Fed can kind of maintain this hawkish bend, and I think there's still these upside hawks risks that exist as long as labor markets remain tight and the labor market data remains strong, even if we're seeing [inaudible] guide prints inflation data starting to soften.
So you've got that on the one hand. And then on the other hand you've got this theme around expectations for an economic slowdown and cutting cycle later this year. And those two things are kind of playing against each other and I think kind of setting the two sides of these ranges that we're in. Interestingly, fast money I think is kind of tended towards the former, more on kind of the fading of cut-pricing, and really thinking the Fed's going to be more hawkish over the next year, where you've got real money looking more at that kind of cutting cycle and kind of more focused on that steepener side of those two themes.
Far apart, I think the back and forth between these may persist and keep rates somewhere range bound for some time, even if that range is relatively wide. Anytime we see 10s dropping down towards something around 350, you start hearing from many people that they're too rich and I think short interest comes out. But conversely, anytime we try to really back up and you see 10s heading back to 4%, there's a lot of active demand to buy at those kind of higher levels. So that kind of keeps 10s chopping around inside of this what's called 353, 85 type of range.
Part of this is due to the fact that on both of these themes, there's some potential delays before we really get confirmation on either one of them. On the cut side, markets are really only willing to trust Fed guidance out, let's call it three to six months on not cutting, despite their persistence that they're going to hold rates higher. Markets just seem very unwilling to accept anything they have to say about that, and it really may just take time before we really get to a place where that cut-pricing can really more meaningfully fade, despite the fact that we've had market participants, fast money in particular, trying to push against that. It's just going to be a long time before we see enough data to really convince us that the Fed's going to be in a place where they're not cutting rates late this year.
On the other side of it, on the kind of near term hawkishness, even there may be some delays till we really get some confirmation on where that terminal rate is. Markets have been pretty well pinned pricing a terminal below 5%. We still see a five and an eighth term March. But if the Fed does slow down to a 25 basis point pace of hikes at the February meeting, which is the most likely probability price into markets right now, if they do step down to that pace, it could stretch out the arrival of that five and an eighth terminal rate and really push out the timing that markets would have to reconcile with an above 5% terminal rate. It could push that out several months because you really wouldn't arrive at that rate until May at a 25 basis point pay.
So unless they go 50 at the February meeting, it's possible that that gets stretched out longer and how high that terminal rate can go, and market's just kind of refusing to price in anything above 5%. So I'll stop there and pass it along.
Jason: Okay, thanks a lot, Blake. Over to Peter to tell us about the situation in UK or Europe.
Peter: Yep, thank you and first of all, happy new year from my side as well. What I have in mind for today is essentially sort of a talk about three topics. First, the development, the energy markets. Secondly, the implication for inflation and the inflation and numbers that have been released. And then thirdly, the impact on the central banks and the upcoming meetings. I'll finish off by reiterating where we see value in the market. So first of all, energy markets have been a crucial linchpin of the situation for Europe for obvious reasons, and the development since we last recorded this has been a fairly dramatic drop. This dramatic drop comes essentially from three angles. One is that as was previously suggested, the ultimate demand for energy has come down quite significantly, particularly on the continent of Europe. Secondly, therefore, the storage levels of gas in particular are relatively high.
And then thirdly, with a bit of luck, the weather has been relatively mild and therefore the typical season and seasonal patterns have been much weaker than they otherwise have been. And what we currently see is that gas, but also power prices are coming down to levels sometimes where they have been before the outbreak of the war in Ukraine. Now, this is obviously relatively good news for the European economies. And the implication is that inflation has been released much lower than where it was previously expected. It was always expected to come down, but it came down much more. Now, full disclosure, yes we do calculate in the special effects that come from the German subsidies on gas prices for December. And yes, I am fully aware that the core rate of inflation is still increased, and I'll say something about that in a second. But nevertheless, inflation has come down and when you look across Europe, in particularly sort of in places like Spain, it has come down, and where the impact of lower wholesale prices to retail prices is much faster.
We think that will continue, and we have said numerous occasions that inflation will continue to decelerate, and I do think that with a bit of time delay, also core inflation will start to decelerate as well. Whether that's already going to be the case in January when some of these special effects reverse remain to be seen. But over the course of Q1 and H1, I'm absolutely confident that this will happen. So where does it leave us in terms of central banks? Now, what you will have seen is that particularly ECB has been very hawkish. They have talked continuously about the underlying inflation pressures, the tightness of the labor market. Just yesterday, a new report was released where the stress was on wage developments going forward. So we can expect that they will continue to remain on the hawkish side when they speak, and it is likely they're going to hike rates another 50 basis points.
The question is whether they will get to the implied now 350, which would require another 1.5 percentage point increases in the deposit rate. Equally, for the Bank of England, we have seen already a three split vote at the last time round. We think that they will hike 50 basis points in the February meeting, but the question is also whether they're going to decelerate and we think that is likely indeed. So what does that leave us for markets? One of the things that we have pointed out is that we think that the short end of the, particularly the Starling curve, but also the Euro curve offers value.
The Euro curve hasn't really played ball, the Starling curve has. So we still think that this is the case. We still like [inaudible] swap tighteners against the onslaught of issuance that is typical in the beginning of the year in Europe. And also, one of the other elements that I point out, that against this view that the terminal rate is unlikely going to be shifted significantly higher, implied volatility has also come down. We have expected that we have been recommending short straddles and strangles, and I still think that this is a very good idea. So with that, I'll hand back to Jason.
Jason: Okay, great stuff, Peter. Over to Elsa to talk about the swings in the US dollar recently and why it doesn't feel like a typical January.
Elsa: Great, thanks Jason. So from our perspective, it's been an interesting start to the year. There's been a very strong consensus heading into '23 that the US dollar is going to go down, and yet it started against plan and I think a lot of people caught up by the price action last week. Where I think clients are really struggling at the moment is translating some of those rates moves that Peter and Blake and Jason discussed into the effects environment. If for example, the Bank of England is more hawkish than expected, is that really a positive outlook for Starling? Where we'd prefer to focus on is the impact of the withdrawal of central bank liquidity and what that means for countries with high external deficits. If we look at the moment across the universe of both 210 and EM, there are certain countries that have been incredibly reliant on what has been called the generosity of strangers.
So whether that's the UK or in LATAM Chile, Colombia, where the current account deficits are eye watering in many cases, and we think there's good opportunity to play those as shorts against either neutral or long current account surplus currencies on the other side. In G10, one trade we like at the moment is long [inaudible] Starling. In LATAM, we're bias towards short Copi and short Chile, and looking at long Brazil and perhaps long [inaudible] on the other side of it.
In general though, it's a very tricky environment to take directional views on rates and effects, and we're just far more interested in playing those longer term relative value trades. For the week ahead, we've gone with long [inaudible] as we look for that reopening trade gathering steam in China and also being a real beneficiary of that with the thawing in relations, coal, orders coming back through from China, and that playing out with a slightly firmer currency. I'll leave it there and pass it back to Jason.
Jason: Okay, thank you very much. Last up, Michael to enlighten us on the oil market.
Michael Tran: Great, thanks Jason, and good morning everyone. Now, to understand where the oil market is headed, I think we first need to take a step back and just quickly consider what we've learned over the tumultuous year that was 2022. So to kick off, I think really last year, the way to describe it is last year was the year of two oil markets. The first half of the year was one that I describe as fundamentally driven, one that was driven by supply, demand, crack spreads, inventories. Then there was a distinct shift in the second half of the year towards a policy driven market. Now, the biggest drivers in oil pricing over the course of the second half of last year were all really qualitative or policy-driven teams. Everything ranging from OPEC policy, which had changed multiple times, to Biden's historic degree of SPR releases or his potential ban on refined product exports, to the EU embargo on Russian energy price caps, to China's COVID-zero policy.
We had Iranian nuclear negotiations again in the second half of last year, and on and on. The bottom line here is that much of what drove oil pricing in the second half of last year were government and or geopolitical policy rather than just true supply and demand fundamentals of the oil market. And I can tell you that fundamentally driven oil market participants loathes trading policy. So what we saw was policy paralysis that led to positioning paralysis. And this is why liquidity in WTI fell by 40%, or was about 40% below normal levels for much of the second half of last year. And as we all know, low volumes traded equals higher volatility. Now, the positive news here is that we believe that there's a policy de-risking happening. So for example, we're through midterm elections, of course Biden's major SPR releases are likely over, they're actually buying back now. Iranian nuke discussions are clearly dead, price caps on Russian energy are in, China's now trying to reopen.
So we're de-risking the adverse policy scares here. So over the coming months, I anticipate that the focus of the market will move away from the qualitative policy driven noise and back towards the fundamental drivers of the oil market, which should drive oil prices back to an eight handle in the first half of the year, in our opinion, versus trending into in the mid-low $70 barrel mark right now.
I think the major themes this year will be number one, tight global inventory. Number two, the lack of future supply growth, and number three, resilient demand so far despite waiting for a potential recession. Now, I think what's important is while we largely believe that China's reopening will be felt in the second half of this year, we've already seen Chinese import data pick up meaningfully already in December, and India's putting up some of the strongest oil demand numbers on record for them.
That said, the dark cloud of potential weak demand concerns will just continue to weigh on investors, and I would be remiss if I didn't address recession risk and what that means for the oil market. So breaking this down quickly, historically, during meaningful global recessions in the past, like in '08, oil demand contracts for five consecutive quarters falling by 2.2%. Now, given our view that we believe that WTI could average $86 a barrel for the first half of this year, of course backend weighted, by our modeling fair value for recession is about $68 a barrel WTI or so. So I could argue that we think that there is risk asymmetry in this market with the market largely having a significant amount of the recessionary impact already priced in. But with that, why don't I pause there and pass it back to Jason.
Jason: Okay, great. Thank you very much everybody, and thank you everybody for joining this edition of Macro Minutes. I would say, to reiterate one of our messages from late last year, that 2023 could turn out to be as challenging as 2022, but for different reasons as markets transition from higher rates to the next stages of policy cycles, which could show significant cross-country differences and impact relative asset markets. So stay tuned for our publications or reach out to us directly in the interim for any additional insights.
Speaker 7: This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation, and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.