Jason:
Hi everyone. And welcome to the May 3rd edition of Macro Minutes, which is ironically episode five in our series and is aptly called Central Bank Strikes Back. The movie was released in 1980 and that time period has parallels to now. Bond markets and inflation uncertainty is behaving very similar to that period when Volcker started raising rates at all costs to control inflation.
Jason:
For monetary policy, high and volatile inflation is the dark side of the force, and low and stable inflation is the light side. And nobody wants to go back to the 1970s, early '80s' style of inflation. And as such, the battle is on.
Jason:
Some policy makers have taken aggressive action already to fight inflation, such as the Bank of Canada taking the unusual step of raising rates 50 basis points a few weeks ago, which is expected to be followed up by Fed hiking 50 basis points this week. And overnight the RBA hiked more than the market expected.
Jason:
And for the first time since 2010, markets are pricing more action from the Bank of England and even for the ECB to tighten in the second half of this year. So against this backdrop of faster and more aggressive policy tightening, we have a full slate of experts on the call today to help us navigate the fixed income currency and credit markets.
Jason:
Tom's going to tell us about what the Fed is going to do on interest rates this week and going forward. Blake's going to talk about the impact of the Fed on the treasury market. Peter's going to tell us essential banks in the UK and Europe are going to be able or willing to match what's priced into markets.
Jason:
I'm going to talk about bond mark volatility. Sue Lynn will recap the RBA and the outlook going forward. Daria will discuss recent EMF effect selloff and central bank policy developments. And Adam from Credit Trading will help shed light on why credit spreads are widening and if that can continue. So to begin, I'll pass it over to Tom on the Fed.
Tom:
Thanks, Jason and good morning, everyone. Look, from our perspective obviously a 50 basis point hike is going to happen at tomorrow's announcement. There's been a lot of discussion about how Powell has continued to out hawk himself. I think you have to understand why that is and why it's reasonable to expect that he could do that very thing again tomorrow.
Tom:
He's trying to build in this wave of tightening. And from this point onward, the moment he relents is the moment that you could actually potentially see an easing in financial conditions, which is exactly what he does not want to happen. How could he out hawk himself? Look he's clearly going to lend credence to the idea of something along the lines of additional multiple 50 basis point hikes that away does.
Tom:
I wouldn't be the least bit surprised if he even lends a little bit of credence to the notion of even a potential 75. Again, I don't think that's necessarily the direction that he wants to go, but he cannot relent on the hawkish rhetoric because he'll undo a lot of what has already been done, which is to say they want a tightening of financial conditions.
Tom:
And I think that's a really important idea to take into tomorrow's meeting. I think that one of the things that we've been talking about, we just wrote about this last week, is I think at some point Powell is going to have to start to flag what he's really looking for on inflation. No one really knows because here's one of the things that you have to keep in mind.
Tom:
If you think about last year when he was on a mission to get to max employment and he did even with inflationary pressures building around him. If now this year he's on a mission to get to target, then funds are not going to hold a three handle, funds are going to hold a four or five handle. And that's the reality.
Tom:
And look, you're speaking to someone who has a inflation falling probably by more than a lot of other folks expect or slowing, rather. I don't even have inflation getting close to 2%. I think we need some clarity on what his comfort level is. And I would expect that there'll be at least one or two folks in the audience that ask him that question because I think that's really at this point the outstanding question from a macro perspective. That's it for me.
Jason:
Okay, great. Thanks, Tom. Now over to Blake on what the Fed means for the treasury market.
Blake:
Yeah. Just following that. And what this is going to mean for [inaudible 00:04:39] what's likely to move pricing without dots. And with the fact that Powell's very unlikely to talk specifics on terminal rate and how restrictive they may need to get in the future. I think probably the most likely hawkish delivery for markets is going to be his discussion around a 75 point hike.
Blake:
My view is that he's very likely to leave the door open to 75, say something like all options are on the table, emphasize data dependence and an urgency to get back to neutral. And I don't think it's going to take much for markets to really take a hawkish interpretation of that. Powell thus far has been very adamant to refuse taking policy options off the table.
Blake:
I really don't see him closing the door more forcefully in a way that would get markets pricing out that 75 basis point risk or keep them from even pricing that further post-meeting. Somewhat similarly to January meeting, the setup here is looking like that meeting where Powell refused to close the door on the 50 and said multiple times that wasn't really space case, but the fact that he didn't close that door, markets took it and ran with it.
Blake:
And of course here we are later with 50s priced into essentially the next board meetings. I think markets could be thinking that a similar progression, a similar evolution is on tap for 75 basis point hike.
Blake:
That's probably where we're going to get most of the market reaction. I think if we do start to run with that 75 basis point theme out of the meeting, we probably see renewed pressure on the Fed term path, the terminal pricing moving closer, moving higher, 2023, 2024 inverting further and probably a broader curve flattening.
Blake:
Turning from the FMC, I wanted to note that we also have [inaudible 00:06:26] refunding tomorrow morning. I expect treasury to continue cutting coupon supply 1 billion cuts to two, three, and five year issuance, 2 billion cuts of sevens, 2 billion cuts to tens and thirties, 3 billion cuts to twenties and 1 billion cut to FRNs.
Blake:
This is basically being done to clear out room for [inaudible 00:06:44] supply. It's actually a little bit bigger cuts than what the Treasury Borrowing Advisory Committee had recommended back in February. But I think it's very necessary given where given some of this current strains we're seeing in bill markets, and this also continues the process of right sizing seven and 20 issuances.
Blake:
As I said, this is a bigger cut to supply that TBAC had recommended back in February. But notably back in February, overnight RRP was two [inaudible 00:07:13] smaller. Three month bills were 20 bases points cheaper to OIS, and three month, five year curve was 60 basis points flatter. The conditions around treasury's preference for issuing bills versus issuing further out the curve and turning out that debt has really shifted over that time. And I think shifted in a way favors more bill issuance and cutting longer data issuance.
Blake:
Big takeaway here is that the Fed QT program, which treasury now has to take into account, is unlikely to drive a ramp up in the pace of US treasury issuance at any point in the near future. I emphasize pace because, we still will be seeing net positive supply, but at the pace with which the markets have to absorb that is slowing down. The QT program's basically been prefunded by the current auction calendar, and it really takes away the need for cuts the treasury might have needed to make in the future, but does really nothing to reverse the slow down in issuance that we're likely to see over the remainder of this year. And that's it for me.
Jason:
Okay. Great stuff, Blake. Today, I want to discuss the exceptionally high level of volatility in government bonds with specific reference to the US. This is hugely important topic because high volatility is important for investment implications for dedicated and multi asset class investors alike.
Jason:
What's currently happening in the volatility space? Well, rates vol is very high. It's at the 87th and 75th percentile back to 1990 and 1980 respectively. And aside from the absolute level of vol being high, what's particularly noteworthy is that high and rising volatility in the tightening cycle is very unusual compared to the experience of the past 20 years.
Jason:
If you consider that in the past two Fed tightening cycles, rates vol fell quite substantially. It hasn't been since the tightening cycles in the early 1980s that we've seen volatility increase meaningfully in a tightening cycle. That lends the question, why bond market volatility behaving more like the early 1980s in the past 20 to 30 years?
Jason:
And in my opinion, it's mostly a function of the high level of uncertainty regarding macro inflation specifically, and even growth and policy rates, the speed and terminal values. In the three cycles since 1999, inflation was lower and more stable than today. And markets were better able to understand the near term inflation trajectory and Central Bank policy outcomes.
Jason:
But in this cycle, market participants are pretty confused. And this is leading to a wide range of expectations by analysts and investors, and this elevated uncertainty that's readily evident in the dispersion of consensus forecasts.
Jason:
If you look at the Philly Fed Professional Forecaster survey for CPI over the next 1, 2, and 3 quarters, the two quarter ahead dispersion and forecast is 1.6 percentage points. The last time we even came close to these levels was in 2008 and 1990. And the only time since the survey started that inflation uncertainty was higher was in 1981.
Jason:
From my lens, it's clear that high inflation uncertainty is leading to high bond market volatility. And this is consistent with we saw in the early 1980s when Volcker was tightening at all costs to rain in inflation. Then the question is when will it fall? Can it fall? And that's really all dependent on the inflation outlook and policy outlook.
Jason:
And given that inflation uncertainty should remain high for the next few months, I would continue to buckle up for a wild ride in the bond market. But if inflation does peak soon and starts to ease in the second half of the year, as many people expect, then volatility should fall quite substantially. With that, over to Peter in Europe.
Peter:
I would like to talk about two things. First of all, very specifically about the Bank of England which is going to meet on Thursday and then more broadly about the theme of a growth slowdown that the Central banks are going to hike into in Europe in general.
Peter:
On Thursday, when the Bank of England meets, they almost certainly are going to hike rates again by 25 basis points, which brings them to 1%, which is the highest rate that we've seen for over 10 years. Now, we expect 8-1 vote. It's probably going to be one dissenter, but that shouldn't really take away the messaging.
Peter:
Now, the question is also, what are they going to do going forward? We have just changed our call. We think in the next two meetings, they will probably also hike, that would bring them into 150. The more important question in my mind is what are they going to do with the announcements as regards QT?
Peter:
There's two that are pending. One, they have promised after three months after the last announcement that they're going to give us details as far as the active QT program on credit is concerned. So that we should be getting some more details here. And secondly, as they crossed the 1% threshold, they have previously guided the market that this would also be a threshold where they would start contemplating an active QT program for their government bond holding, so the guilt holdings.
Peter:
We stress that this is not the same automatism that was there when we crossed the 50 basis point that I showed and they moved to passive QT. But what we do expect is that they probably launch a consultation process with the market about how to do that at some point in the future, which we reckon would then be at a later stage this year.
Peter:
These are the three key elements, the rates themselves, and the credit program. And then as well as any guidance on the active QT program. Now more broadly in the market, what we're seeing over here in Europe, we're seeing early indicators of a potentially quite significant growth slowdown coming through.
Peter:
The data that has been released last week was weaker in terms of growth high, in terms of inflation in the market was expecting leading indicators for consumption in the UK, for consumption in Germany, for production as well. New order indices are coming down quite drastically. And it seems very, very likely to us that in Q2, in Q3, we're seeing a significant slow down.
Peter:
We're not yet forecasting a recession, but it's probably going to feel like one. Now the wrinkle is that the Central banks are going to hike into it anyway, as I was just alluding to for the Bank of England.
Peter:
And it seems to be with these high inflation levels and high inflation expectations that the ECB will also not replace their cause. Now what we think that means is for nominal bond deals, it's very difficult to see the same kind of rally, but we potentially see a stabilization. If anything, we think the money market strip is probably going to flatten a bit. We recommend deck 22, 23 arrival flattener.
Peter:
We also think the most important impact is probably going to be felt outside of the rates market in the credit market, which we think is probably going to stay under pressure. And if you want to be on the long side of the market, we recommend that you do this through options rather than through outright. And we have looked at ways to do this and one of the ways that we think is probably safe enough as a one-by-one call spread, maybe on bond futures, you can do that, and you could also do it in the swap market if you want. A little bit out of the money should give you a relatively good risk reward. And with that, I'll leave it. Thank you.
Jason:
Okay. Thanks, Peter, always insightful. To complete the around the world tour, we'll now go to Sue Lynn to provide views on Australia after the RBA rate hike.
Sue Lynn:
Hi, everyone. It was a pretty busy and fun day post the RBA today. Jason, as you noted, RBA did hike rates a bit more than market expected, plus 25 basis points. First move since 2010. We hadn't been looking for 15 basis points given their very reluctant nature, but we thought that the case for 40 even was pretty strong given some of the recent developments. They've opted for 25.
Sue Lynn:
And interestingly in the governor's press conference, 25 basis points seems to be their preferred quantum of moves. It's the moves, the size that they've done before. So signaling that would be their preferred hiking amount going forward. I think the case the rate hikes have been building for some time in Australia, but it was really the inflation numbers last week that sealed the case. It was part of the reason we brought forward slightly from June to May lift off, and lift off they did today.
Sue Lynn:
There was probably, from our perspective, three interesting takeaways from the statement as well as the governor's press conference, all [inaudible 00:15:32] hawkish in our view and signaled multiple hikes in the month ahead. The first was their big upward revisions to their inflation forecast and a real admission from them that they have been very surprised by how far and quickly inflation has moved.
Sue Lynn:
Coal that sits at three and a half percent is heading higher. They're revised up by nearly two percentage points. Inflation doesn't get back into the two to 3% target range until the end of their forecast period in mid 24 and only just at 3%. The governors, I think, secondly, talked a lot about a strong labor market revised down their unemployment rate forecast to what looks to be well below NAIRU three and a half percent late this year, early next year.
Sue Lynn:
And he also talked in the press conference a lot about two and a half percent cash being a more normal rate of cash and a desire to get there. I think when we look at those three takeouts against that global central banking backdrop that you've talked about, Peter as well, the bringing forward and small additions to the Bank of England, we're seeing it right across the board. And obviously the Fed makes sense to us that the RBA would also frontload.
Sue Lynn:
And we brought forward some of our 23 hikes into 2022. We think there's good reason to expect the bank to be hiking pretty much at every meeting in 25 point quantums from here 'till close to year end. We've got cash now terminal up at 185, could end up a bit higher than that, but we're recently comfortable there. Markets I suspect will continue to price in much higher than that.
Sue Lynn:
And we will obviously heavily influenced by that global backdrop. We're not game enough to step in anymore and keep trying to receive front end, even though it does look to us still very elevated where market pricing is. We continue to have more success on the cross market front. The two year, two year Aussie/US trade that we entered about a week ago has actually held in really well today. It's actually marginally tighter, even though we have seen a pretty decent sell off right across the curve in Australia and some under performance in other parts. It's still very much premised on our view that terminal will end up lower than where the Fed will. That's it for me.
Jason:
Okay, great. Thanks, Sue Lynn. Over to Daria on the EM side.
Daria:
Thank you, Jason. Hi, everyone. There's a couple of things that I want to flag from my end for emerging markets effects. The first theme that we've seen playing out this quarter so far is this idea that EMFX has been selling off against the dollar across the board. And what I think is interesting about this current sell off is that it seems that there's a higher sensitivity right now than what was the case back in the first quarter, sensitivity to the external backdrop for emerging markets in general.
Daria:
And if we go back to the first quarter and we look at the environment, US financial conditions were tightening, the dollar was stronger on a net basis and the Russia/Ukraine situation was posing a risk for EM. And despite all those factors are considered, EMFX as a whole was able to perform relatively well. And the currencies that you would typically expect to be more sensitive to that kind of environment, they still outperformed the market.
Daria:
And I think the big question here is what has changed between the first quarter and the second quarter? And I think from an EMFX perspective, I think the big change here has been this rising concern in the market about China's growth slowdown. And I think whether or not EMFX is able to rebound from current levels or if EMFX continues to sell off, I think a key portion of that will depend on how well China manages the downside risks to growth.
Daria:
And for example, the question is, are they going to try to depreciate their currency to support growth in China? And if the answer to that question is yes, then from a broader EM perspective, I think the question is going to be is that depreciation in the local currency going to be orderly and not excessive? If that's the case, then in that kind of scenario, I think that EM can probably do well, do okay.
Daria:
But if we have the opposite scenario where it is disorderly and it is a large depreciation in the local currencies, then it's not going to be a very good outlook for emerging markets in general. From a trade idea perspective in the current environment, when we start looking at Latin America and [CMEA 00:19:59], we think that given all of these risks considers you have the China risks, some idiosyncratic stories playing out, and also questions about Fed rate hikes.
Daria:
I think in that kind of environment, we've been thinking that Brazil is in a better position to navigate this kind of environment. And then the other thing that I also want to touch upon is also rate policy direction. And I think what's different from what we've seen in developed markets right now is the Central banks in Latin America and CMEA, they have already hiked rates very aggressively since last year.
Daria:
And for some of those Central banks who are starting to reach levels where the market is starting to ask the question is, are we close to the end of the hiking cycle? And for example, this week we have four Central bank meetings happening in emerging markets. And for three out of those four Central banks, there is going to be the question of, we are seeing some signs of those Central banks starting to slow down the pace of their tightening and starting to tone down some of their hawkish tone.
Daria:
And I think that this is a question that the market will be asking as we head into the second half of the year. And the last thing I will mention from a relative value perspective in terms of rate policy direction, what we're watching in the medium term is the potential for some diversions to happen in Poland versus Czech Republic for the idea that Czech Republic is likely to start cutting rates before Poland will in the medium term. And that's it from my end.
Jason:
Okay, great. Thank you. Last but not least, we got Adam Jones going to talk about the credit market, which at least I'm particularly interested in understanding what's going on, why spread's been widening, what can happen going forward? Because, as we know, Central banks raise rates, something tends to break in the world and credit tends to be a very much a leading indicator in that type of a scenario. So over to you, Adam.
Adam:
Good morning. I will start by saying, look, credit's very much been a follower asset. We have not really had a credit story to trade this year. We're very much following the broader macro narrative and taking our cues from equities and from rates. Liquidity conditions have been particularly bad. The most common complaint that we get from clients is about the illiquid nature of the asset class at the moment, spreads are moving around more on a daily basis in things like LQD than we've seen historically.
Adam:
It generally makes things not feel that great. There is a broad bearishness across account basis. There was a story the other day about one large real money account running a cash balance in the 10 to 12% region, which is very large for a credit fund.
Adam:
But this is all sentiment. At the end of the day, we do not have a credit problem right now. Corporates used the last few years of low rates to term out debt, especially in IG. Runways are very long. And so there's no immediate credit catalyst. However, there is just this overwhelming fear that credit doesn't like recessions. And when we see the Fed moving this aggressively, the fear is if they tip too far, that it would go that way. And that's really the concern.
Adam:
There's definitely a preference, the higher quality credit over lower. In IG that manifests itself as triple BS underperforming versus the A rated credit. That's been a theme and hasn't changed. It's also worth noting there are regional differences. Europe has got very different dynamics to the US because the ECB had a direct corporate bond purchase program in place.
Adam:
And so their impact on the credit market has been far more direct. And as that ends, it's going to lend itself to the potential for far more explosive moves in Europe versus in the US where the Fed barely had to buy a corporate bond. The market basically took care of itself through the COVID response.
Adam:
The other thing I'd mentioned, credit isn't just corporate credit and muni's and mortgages have also had massive moves. And increasingly, we're hearing people look at those as reasons to be concerned about, about US credit. So broadly, I would say, look, the drift wider probably does continue, but I think positioning more than anything is going to dictate the short term moves. And right now it feels to me like it's very hard to find a bull, which probably means that we could get a move in just because that's perhaps the most painful thing that could happen.
Jason:
Okay, great. Thank you very much. Thank you for joining us today here on Macro Minutes. We'd like to thank you for tuning in. I'm Jason [Daw 00:24:33], and I look forward to seeing you next time.
Speaker 8:
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