Curve Chaos: Bond, Equity, FX Implications - Transcript

Jason:

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:

Hi everyone, and welcome to the April 19th edition of Macro Minutes. The past two weeks have been characterized by an extension of the bond market selloff, amid escalating worries about inflation, central bank tightening and QT in North America. The new dimension of this round of higher rates is that yield curves are steepening, a situation that we haven't seen since early January and is at odds with normal behavior during tightening cycles. Fixed income volatility is very elevated, and in a break from past tightening cycles, is likely to remain high for at least the next few months. The dollars remain strong, the DXY's above 100 recently. Equities are down a few percentage points during this big bond market growth that we're seeing, but holding in quite good, given the speed and magnitude of the move in bond yields. And equity volatility has been well behaved, which contrasts with the very high bond market volatility.

Jason:

So, to help us navigate the fixed income currency, equity and equity vol landscape, we have a full slate of experts on the agenda today. Tom's going to tell us about the US economy, peter's going to enlighten us on what's happening in Europe and the UK, Adam's going to tell us about FX trades if the negative returns in bonds and equities continues, and Lori in equity strategy will tell us why we think equities have been resilient and what we've learned in this reporting season. And last but not least, Amy in equity derivatives is going to discuss the equity vol landscape.

Jason:

So to begin, I'm going to kick it off with some thoughts about Canada. North America rates vol, curves and levels. So in Canada last week, the Bank of Canada tightened 50 basis points. This was widely expected. And they also announced the beginning of quantitative tightening, which is going to include the elimination of both secondary and auction market purchases. And in Governor Macklem's comments, he left the door opening to the central banks moving above neutral, or pausing before reaching neutral, depending on the evolution of the inflation backdrop. So, the policy increment at the next meeting is debatable between 50 and 25. But I think importantly, the upward impetus to yields has now been drastically reduced. So the market is priced in the upper end of the range for the Bank of Canada's neutral range estimate, and the risk to yields are now more two-way, with probably a greater chance that we've seen the peak in rates across the curve, which is consistent with our most recently updated forecast.

Jason:

On rates volatility, this is truly a unique cycle, like so many other aspects of what's happening in the bond market. So in the late 1990s, US rates vol, that was flat when the Fed was hiking. In '04 to '07 and 2016 to 2019, rates vol fell significantly through the tightening cycle. But this time there's such a wide dispersion of outcomes for macro and policy, that the market's confused and in flux. And on that basis, I don't think this elevated level of rates volatility is going away anytime soon, at least until we get through the first half of the tightening cycles in North America.

Jason:

On the curve, as I mentioned, new themes that developed in the rates market has been a significant curve steepening in the past two weeks. The majority can probably be chalked up to the fact that the flattening in the prior two weeks was a bit excessive, positioning might have been a bit stretched and maybe a little to do with QT announcements. So in the US [inaudible 00:04:00], that's more than fully reversed the massive flattening that occurred in the previous two weeks. And while in Canada, the curve steepened by less, it has offset the flattening over the same period.

Jason:

But history does show the curves don't steepen in tightening cycles. And our base case in Canada is steepening probably around Q3, and not in the US until the turn of the year. So the greater steepening risk in Canada versus the US are based on our relative policy rates forecast, so we see the Bank of Canada ending at 2% and the Fed finishing at two and three quarters. And the Fed much closer to market pricing, and the Bank of Canada quite a bit below. So curve dynamics, they are primarily driven by the front end, and unless rate hike pricing comes down, this recent steepening should be viewed as temporary. And the risks of higher, long end yields are probably very limited from here.

Jason:

And lastly on levels, yields probably have a hard time moving meaningfully higher from here, unless there's a material repricing higher in terminal rates in the US. I'd also keep an eye on real yields. So the US 10 year real yield, that's moved about a hundred basis points from the recent lows, now close to 0%. And similar amounts in Canada, with a 10 year real yield at 50 basis points. So, this I think would be the primary mechanism to tightening financial conditions. And if the speed is too fast, it could cause problems for other risk assets. So with that, now over to Tom to tell us about the US economy.

Tom:

Thanks, Jason. So just a couple of quick things. I'll try to keep my remarks pretty brief here. So, on Bullard's comments yesterday, I know that he just says such extreme things, I think people sometimes wonder how seriously they should take him. Look, I think you probably should take him pretty seriously. And again, people who know us well know that over the years, we have called him extreme to the point where you wouldn't want to pay attention to him. But the reality is he's been right. A lot of what he's been saying over the course of the last year has actually come to fruition.

Tom:

So I think in that regard, you cannot discount the things that he was saying. Think to back to February when he was talking about getting 100 basis points of hikes in by the middle of the year, people thought that was heresy. And as we wrote then, this was back in February, we said, "Look, it's not our preferred way of getting to 100 points, but it's actually not a terrible idea." I think the same thing is true for a 75 basis point hike. Again, I don't think it's the worst idea if you're genuinely worried about inflation. And I don't know what is holding the Fed up at this point. So, do I think they're actually going to do 75 basis points? I don't, but I don't think you can outright discount it either. So, it's just something worth noting as it relates to... Oh, and by the way it's not without precedent too. The Fed did raise 75 basis points in the not too distant past.

Tom:

Just one other quick thing here on inflation. Over the last week, we've gotten two of the big inflation reports. And again, very consistent with our general line of thinking as to relates to inflation, which is to say you're going to start to see core goods prices really moderate here. We saw that in core CPI, quote, good CPI. In fact, I think a lot of people made a big deal about, "Oh, so use core prices." Yeah, but it really wasn't. If you look at all of the core goods complex, everything moderated. Every single key component within the core goods complex moderated. That's exactly what we would expect to happen over the coming months.

Tom:

Again, do I think we're in the all clear on inflation? It depends how you define all clear. Inflation is still going to remain elevated relative to target by the end of the year, but we think it'll have moderated quite a bit. And we think that if you look at the PPI, PPI was pretty consistent with that idea too. There's some sort of preferred measures that we like to look at within PPI. Intermediate materials, core intermediate materials has continued to moderate, whether you look at it on a month on month or a year over year basis. And what's interesting about that metric, is that it tends to lead finished consumer goods by about four months. And on a year over year basis, you're actually seeing quite a bit of moderation there now. So, we would expect that in finished consumer goods, you'll start to see that too.

Tom:

So we think, again from our perspective, inflation is moving in more or less the way that we would expect. And we still maintain our view that by the end of the year, it'll be considerably lower. That's it for me.

Jason:

Okay, great. Thanks Tom, for the useful insights. Up next, Peter to tell us what's happening over in UK or Europe.

Peter:

Thank you, Jason, and good morning everyone from my side. So I would like to speak about three things. First of all, I would like to briefly look back on the ECB meeting last week. Secondly, I'd like to talk about the different makeup of our bond yield sell off compared to North America. And then thirdly, about our preferred trades. So first of all, looking back to the ECB meeting last week, they remain in a tightening bias. They have confirmed that they will end the QE program in Q3, as they had before, but they have now sounded much more concerned about growth, and we think rightly so. The European landscape is marked by a stagflationary shock, as is everywhere, but we are in the epicenter of it. And what you see is that the ECB's correction in their growth projections was very mild, and we think they have to do more.

Peter:

Now, what they have done in my mind, is amplifying the key difference that we're seeing in the bond market sell off compared to North America already. Whereas in North America, and Jason mentioned it, we already have seen a quite significant movement higher in real yields. This is not the case in Europe. Nominal bond yields are keeping almost pace with treasury yields. But it is predominantly and almost exclusively driven out of break-evens. Our break-evens are rising and rising, 10 years are now above 3%, which is the highest level since the Euro's formation. Five years at 2.40, which is well above the average that was in place before the pandemic struck. In fact, it was before the 2014 drop. So, we are at quite elevated levels. And now that the ECB has emphasized the growth risks once again, we have seen a significant jump in these break-evens again.

Peter:

Now ,we've also seen steep curves, and we've also seen a little bit of a reprising of the implied policy as a response to last week's meeting. Now, where to go from here? We think that eventually one or two things needs to happen. Either the break evens need to come down as inflation starts moderating, or the ECB will probably have to play ball with the other central banks and have to bring real rates up to curb these inflationary developments. So, we have advised real yield payers in Europe.

Peter:

And this second trade that we currently like quite a lot is that we think that the UK market should start underperforming Europe again. Because again, Europe has been at such a mad pace, and the next focus is going to be on the Bank of England. The impact on the UK economy should be smaller than on the European economies, so I think they are in a better place to drive front end rates higher. And therefore the 10 year spread in particular, which currently sits at a multi month low, to us looks like a good tactical widening trade. So, these two traits we like.

Peter:

And then I have one PS for you before I let you go. On Sunday, we've got the second round of the French elections. It has earlier scared markets a little bit, when the polls are very close. It's Macron the incumbent again, against Le Pen, basically a rerun of the last election. But the polls are widening again, they are in Macron's favor. So just keep it on your radar screen. It seems likely, or more likely at least that Macron will remain in power. If he wasn't, it would be a big shock, and next Monday you would see quite a significant market move in Europe. But our base case remains that he will stay in the Élysée. And with that, back to you Jason.

Jason:

Okay, great. Thanks Peter. Next up is Adam, to tell us what are the key FX trades, if the recent negative returns in both bonds and equities extend further.

Adam:

Thanks, Jason. So addressing quite a specific question this week, given that we're thinking in cross asset terms, and given that April so far has been a rather unusual month in terms of the asset market background for FX. So yields higher, obviously, but yields higher and equities lower is not an environment that we've traded in very frequently recently. And we've got very used to, in my world of FX, an environment where bond yields and equity prices move in the same direction. That's been the norm, at least since the GFC. And we very much understand how FX works in that kind of environment. When equities are rallying and bonds are selling off, what we call risk off, and vice versa. And currencies slot into neat performance positions in that risk parity, risk on, risk off, whatever kind of environment you want to call it.

Adam:

To look at environments where equities and bonds are both selling off together, as has been in the case so far in April, you need to go back a bit further and be a bit more selective in the periods that you look at. But in a nutshell, in that kind of market environment, what we've found is rather than markets being directional to general risk appetite, markets become very, very dollar directional in that kind of environment. So when bonds and equities are both falling, then the dollar tends to appreciate. And when they're both rallying, the dollar tends to broadly depreciate, with little discrimination between currencies, and literally in a way it kind of cross currents. It's just a broad dollar move against pretty much all other G10 currencies.

Adam:

So, what I would say going forward is even if we think a continuation of this kind of environment is a tail risk rather than a central scenario, and the rising yields as Jason said, is modest from here, I'll leave Lori to talk about the outlook for equities. But it's worth contemplating what happens in our world, or my world of FX, in that environment of parallel sell offs in both of the major asset classes. And the answer is in that environment broadly, the dollar tends to appreciate, and there are few cross currents aside from that. As I say, it's not necessarily our central scenario, but it's worth at least considering where to hedge if we were to continue to get those negative returns in both of the major asset classes. And the hedge for us in my world, is being broadly long of dollars. Back to Jason.

Jason:

Okay. Very helpful, Adam. Switching gears over to equities, we have Lori joining us today to tell us why the S&P's been so resilient.

Lori:

All right. So, I'm going to spend most of my time this morning talking about why US equities has been so resilient, and that really continues to be the key question that I get in my client meetings. And look, I would tell you that I think there are really four things that jump out in my mind. First, sentiment frankly has been washed out for quite some time. And I do feel like a little bit of a broken record talking about this. Those of you who have heard me recently, have heard me talking about this a lot, but we're seeing this on a variety of indicators. And if you look at the AAII net bull bear survey, it's been down around minus 30% at various points this year. First really touching that in late February, which was actually a touch below the pandemic lows.

Lori:

This is historically a very, very strong buy signal for US equities. We tend to see 15.5% average gains in the S&P 512 months later, 86% of the time. And you do also tend to see pretty consistent three month forward positive gains. If you look at the institutional side of the equation, we do view that AAII data point as more retail. CFTC is also showing us that on NASDAQ and Russell 2000 futures positioning and asset managers, we hit some critical lows for 2020, 2021 on NASDAQ, 2016 for Russell 2000 before starting to rally back.

Lori:

The other thing I would tell you is that at the March 8th low, the S&P came close, the growth scare pricing. We saw a 13% drop, and that's very close to some of the drawdowns we saw on the 2010, 2011, 2015, 2016, and late 2018 periods, which all had draw downs of 14 to 20%. Those were areas that we describe as sort of near death experiences, where investors greatly feared the financial system or economy unraveling, but it didn't end up happening. Rebounds do tend to be fast and furious off those kinds of lows, with S&P moving back to pre-crisis highs within four to five months.

Lori:

The other thing I would tell you is that the US is really being treated as a safe haven in here. We did a survey a few weeks ago, really talking to equity investors, it's something we do once a quarter, asking them about their views on a variety of different topics and also where they wanted to be positioned. We found that about 75% or so said the Russia Ukraine crisis would push Europe into a recession, but only about 42% said the US would see a recession. And by a wide margin, the US was viewed as being a leadership area over the next six to 12 months.

Lori:

I'll move on next to what we've learned in reporting season so far. We will be watching stats around margins very, very closely. But what I will tell you is that the buy side was already very, very negative on margins coming into this reporting season. 55% called for contraction in our survey, sell side numbers have been very resilient, actually moving up a little bit this year. They've been calling for flattening margins this year. But we really have seen that investors who really drive stock prices at the end of the day, with all apologies to myself and my colleagues, but they have already been pretty pessimistic on margins. And we are also still seeing very strong signs of robust demand and a healthy consumer in the early reporters. We're seeing this from banks and consumer companies. We have had a few goods-producing consumer companies that have encountered trouble, car companies, furniture makers, household goods providers. But the services side of the equations, including companies like airlines have really just been talking about how strong the consumer is. And with that, let me hand it back over to Jason.

Jason:

Okay. Thank you very much. So, one fascinating aspect of markets has been equity vol behaving much better compared to bond market volatility. To shed some light on the equity vol landscape, I'll turn it over to Amy in equity derivatives.

Amy:

Great. Thank you guys for having me. Thanks, Jason. I'll start with potentially an answer to the question, Jason posed in the beginning, which is while bond markets have been signaling fear and recession, why have equity markets been signaling relative calm? And indeed, volatility has come in pretty dramatically, [inaudible 00:19:43] one. If you look at the FDEX, which is essentially the market's willingness to accept a one standard deviation loss, that's in the 38 percentile over five years, the skew is quite below average. And then if you look at the TDEX, which is the market likelihood of a three standard deviation drop in S&P, it's in its 45th percentile over five years, the tails are also below average.

Amy:

And then when we compare VVIX to SX, which is essentially a way of saying should you be hedging with VIX calls or S&P puts? That's still trading relatively high. So, S&P puts are more attractive than VIX calls. Look, we reached a high of 36 during the initiation of the Ukraine crisis, and now VIX is only a little bit above pre-Ukraine war levels. I do expect that volatility is going to pick up what as we go through earning season. But I think a lot of the reasons that have contributed to this drop in volatility, into this overall com, is some of the countervailing forces in the equity market that Lori discussed. So, we've seen the same CFTC and flow positioning data, which talks about both the institutional risk reduction, as well as the broad hedging that has been deployed. But two things do remain in effect, one is strong corporate buybacks, and the other is retail demand.

Amy:

So, when you think about corporate buybacks, it's artificially dampening skew in the equity volatility market. It's essentially acting as a floor to that share price, and so that can change the skew levels from what they potentially really are. And then the second in terms of bifurcation is this retail option that we've seen. So in past times in the last two years, we've seen this explosion in call exuberance both in mean stocks like GameStop or AMC, as well as other names. We continue to see that, and that's what I think is surprising. So, a staggering fact is we saw 147 skew inversions in the Russel 2000, but [inaudible 00:21:47]. So, skew inversions are when call buying is so extreme, it actually flips skew to be negative. Now, there was one change last week and that was Twitter. So Twitter became the first S&P name to go skew inverted. It's now gone back, but I think with all the headlines going around that we're going to have to watch that closely as being another area of skew inversion.

Amy:

I will tell you, when you look historically at volatility, we looked at 30 years of data and we split the VIX into different volatility environments. Although it feels like equity volatility is low on a cross asset basis, and it is, on a historical basis we are in a much higher volatility regime. We've spent 75% of the year in what we would characterize as a medium to high vol regime. And generally those regimes are not good for stocks. So if you stay in a medium volatility regime, which is a VIX at about 20 to 30, that goes to about a down 2% return in stocks if you look at the past 30 years. And then if we go into a high volatility regime, which is a VIX above 30, this usually equates to a down of 10 to 11% on the stock market, and high volatility regimes include '98, 2001 to two, 2008 and nine, and then 2020.

Amy:

I'll just end by saying, what do you do with this kind of brave new world of volatility, and this deviation from rates volatility? Look, one thing I say when I talk to clients about hedging is when there's a correlated move down, you don't have to own the most direct thing. Because in a correlated move down, all things go down at once and you just get that vol pop benefit. So, when hedging looks attractive as it does now, especially with the skew profile, this is a time to deploy hedges. And we are thing that bond proxy ETFs like HYG, LQD, TLT, IEF. And those make a lot of sense, but then also just purely on the S&P it makes a lot of sense. Because in particular, while things aren't bleeding in now, while right now the equity market looks okay, I do think when you look at the longer [inaudible 00:23:47], it is an attractive payout to look at those hedges. And I will leave it there.

Jason:

Thank you for joining us today here on Macro Minutes. We'd like to thank you for tuning in. I'm Jason [Dolha 00:23:57], and I look forward to seeing you next time.

Speaker 8:

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