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.
Simon Deeley:
Welcome to the July 15th edition of Macro Minutes, being recorded at 10:00 AM Eastern Time. I'm your host, Simon Deeley. The title for today's episode is Deficit Defying Spending Plans. Indeed, fiscal loosening has been a feature across many geographies, and we are fortunate to have experts to discuss the similarities and differences across them. Blake Gwinn will give details on the US situation, Peter Schaffrik on the Euro area and UK, and myself for Canada.
The first question is for Blake here. The Big Beautiful Bill is done and dusted, and there are some very big numbers being thrown around as to the potential impact on the deficit. Yet, we have the 5s/30s curve basically unchanged since the end of June, and you have 10-year term premium and 30-year swap spreads basically smack in the middle of their post-April ranges. Why aren't we seeing a bigger reaction in markets, especially in these areas where you would expect to see deficit impacts?
Blake Gwinn:
Yeah, thanks Simon. This idea of the maturity distribution is something we've been talking about a lot, all the way back to the time of the election, thinking that Treasury would probably be leaning more on [inaudible 00:01:22] This last week we did see some very big increases in bill auctions, and I think some people are wondering, okay, is this some confirmation of this idea that Treasury is going to really be leaning more heavily on bills, is going to start shortening their weighted average maturity or WAM, but this is almost entirely a function of debt limit dynamics. So the Big Beautiful Bill that we just discussed, that also contained a resolution to this debt limit issue and solving that has basically allowed Treasury to now start rebuilding their precautionary cash balance that they tend to keep at the Fed. They like to have that cash on hand probably somewhere in the seven to $800 billion range at this point, and that has run down as they have been constrained by the debt limit.
So freeing those constraints, they need to get that back up to where they want. That rebuild of cash balance basically has to happen through bills. Coupons, we issue once a month. It's very slow. You can't make major changes. If you really want this precautionary cash balance and you want to rebuild it as quickly as possible, you have to lean on bills. So we're not really connecting these two ideas yet. This bump in bills is not really saying anything to us about what Treasury is kind of thinking of doing over a longer run timeframe. It's entirely about these kind of debt limit mechanics. And that's not to say we don't think there is going to be a shift over the long run, but this is really just related to the debt limit. So we have them basically boosting bill supply by about $580 billion in July and August.
That should get this precautionary cash balance back to around $500 billion by the end of July. That's consistent with some of the preliminary guidance that we've gotten out of Treasury. They kind of said, "Hey, by the end of July we hope to be at $500 billion." Still a little bit below that 700 to $800 billion range that I mentioned there. So we will see some continued bill supply increases later this year. The bulk of that's going to be in July and August. In September, you're going to get corporate tax receipts that will help to boost cash balance. Coupon auction sizes as they currently exist are already raising a lot of cash, so that should kind of hold them over until October, November. That's where we see some further modest increases in bill supply and that will eventually get us into that 700 to $800 billion range for most of, we would think for most of Q4. So all told, probably about 750 to $800 billion total increase in bill supply for the second half of 2025. Very, very big boost. But again, this is mostly about the debt limit here.
Peter Schaffrik:
Blake, apart from the [inaudible 00:03:47] debt limit, cash balance rebuilt, we obviously also have the quarterly refunding announcement coming up in a few weeks. What are you expecting there? Any announcements on WAM already in there?
Blake Gwinn:
Yeah, Peter, let me first start by saying kind of what markets expect. I think we've been on this idea that Treasury would be leaning more on front end issuance, especially if we started to see long end yields rise to a point that they didn't like, that they could use that kind of WAM pullback to push back against higher yields and try to maintain that 10 year yield, which we know they're very focused on because Bessent has told us so. To keep that kind of in a range that they want, to keep that from rising too high. But that's kind of what we've been expecting and I think that has become much more expected by markets over the last month or so. Bessent has made some direct comments that they're not really looking to increase long-dated issuance. I think markets are really looking at this for funding and looking for some very explicit guidance.
We did get Treasury sending out their usual pre-refunding survey to dealers and to buy-side participants late last week, and I think everybody in the markets were kind of looking for a special question there that really teed up this idea that they were going to come out at refunding and announce some explicit pullback in WAM. We think it's actually for now going to be a bit more subtle than that. They've had this forward guidance language in their statement for a couple of refundings now that says they're not going to increase coupon issuance for at least several quarters. We interpret that to mean three quarters out. But if you look at where deficit numbers are, at least our deficit forecast, which suggests that if you don't increase coupons over the next three quarters, implicitly, that means bills are going to have to start to rise as a share of total outstanding.
So they're kind of implicitly saying by maintaining this forward guidance on not increasing coupon issuance, they're kind of implicitly saying they're going to start leaning more heavily on bills and likely start pulling in that WAM of total treasury is outstanding. Now, I do think at some point we could hear more explicit guidance from Treasury where they do say much more clearly and much more forcefully that we are not going to be increasing particularly longer term coupon auctions, say 10, 30 years, for a long period of time, and maybe even go so far as to say that they're cutting 10 to 30 year issuance. With all of that being kind of dumped back into higher front end issuance, whether that's bills or 2, 3, 5 year coupons, et cetera. I think they probably reserve that more explicit guidance for when it's needed. So right now I think long-dated yields have been fairly well-behaved.
As Simon's set up at the beginning there, 5s/30s has basically been unchanged since the end of June. 10 year yields have been kind of trading in a range, 30 year yields have kind of bumped up against this 5% ceiling many times and seem to be holding there. I think Bessent and Treasury probably hold that card close to the vest, potential cuts or a more stronger explicit guidance that they're pulling in WAM. I think they save that for when and if we see those yields starting to rise and see the starts of a mini supply-related term premium freakout kind of like we saw in August, October of 2023.
If something like that starts, that's where I would expect them to make more explicit mention of this. But at least for refunding next week in two weeks, I think they're going to keep this very implicit guidance that they've been using in the last few quarters. So let me turn this around to you, Peter. You've been pretty consistently arguing that term premium and European market should be increasing and you've specifically singled out the Euro market as an opportunity in terms of positioning along that front. Has anything changed there?
Peter Schaffrik:
Hey Blake. Well the short answer is no, this hasn't changed and just maybe at this point it's worth recalling or repeating. Well, the reasons for this were, I mean, first of all, I mean obviously curve steepening has been more of a global theme. We've seen that in other markets. I mean you mentioned the dollar market, we've seen in Japanese market, in the sterling market, and the Euro market has been no exception, but it has been lagging behind. So when you look at the amount of steepening term premium increase that we've seen, the Euro market has been quite slow to it. Secondly, I think one of the things that has been less pronounced, I would say is this element that we're specifically seeing in say the sterling market of fiscal worries because the one country that has announced a big fiscal increase is Germany and they have very little concerns around their fiscal stance. So from that point of view, I think that's probably lagging behind, but obviously we're going to see more and more issuance coming through.
Every time we see any news pop up about an increase in funding, we see another lag steeper. Then there's a third element that I would mention, which is that we get quite a lot of QT from the ECB coming through for years and I think that will also add to the steepening pressure. So frankly I think we're not done that, we're not done yet. We had a steepening trade on since the start of the year and we've just put our mid-year outlook through and have reiterated that call. So I think there is room for further steepening in my mind, particularly on the Euro curve.
Blake Gwinn:
Peter, you briefly mentioned the UK there and we know that the UK market's been a bit in the crosshairs. Going back to the trust budget issue a while back, so has these kind of fiscal concerns, is this anything new to talk about there? Any impact on UK curve and what's the path forward from here?
Peter Schaffrik:
Yeah, thank you Blake. I think it's a brilliant question mainly because going into autumn we'll get the next budget and there might be quite a few changes here in the UK, but let me retrace the steps. So I think you mentioned the Liz Truss situation there, and I don't want to go that far back. That was in '22, but certainly ever since then we had increased scrutiny I would say on the fiscal position in the UK. Furthermore, the new government, when it came into power, if the UK operates a system of fiscal rules, they are self-imposed, but they're nevertheless measured against it and typically every UK chancellor leaves him or herself a bit of room against their own targets, not so this government. So any kind of things that are going sideways have the tendency to erode that room quite quickly. And then last but not least, some of the spending cut downs that the government was planning have simply not been able to pass Parliament.
So the market has quite rightfully questioned the ability of the government to live up to its own promises now, and that in my mind has particularly in the UK market, steepened the curve quite a bit. Now having said all that, you asked about the path forward. So I mean one of the things that will probably change is that in the next budget it seems likely that the government will now rather than focus on spending cuts, go after some form of a tax increase. And whilst that might weigh on growth to some degree, probably has more chance of passing and will therefore we think probably alleviate some of these pressures. So going back to my previous answer, I still think that the steepening theme is probably more widespread, but the Euro market rather than in the current case, the sterling market is probably going to take over the mantle over here in Europe of the one that's driving it predominantly, I would argue.
And maybe if I may say one of the other things that I think go in the same direction is that the QT envelope in the UK is probably also going to shrink going forward and the Bank of England is head of the ECB there. So again, it argues that probably the Euro market is the place to be when you want to be positioned for these kind of term premium increases over here in Europe.
Simon Deeley:
Thanks Peter. On the QT side, you mentioned a couple of times now, can you go into a little bit more detail on how this plays a role in the debate and how much of the difference really is there between the euro and gilt markets?
Peter Schaffrik:
Thank you Simon. And I think particularly for North American listeners, it's worth reiterating that both the Bank of England and the ECB have a slightly different strategy.
What they want to do with their balance sheet compared to the Fed, whilst obviously all of them have been QT-ing, the bank and the Bank of England and the ECB have both said that the ultimate aim is to reduce the balance sheet so much that or reduce the bond holdings, I should say so much, and that the levels of reserves that they're providing through bond holdings or through the ultimate QE angle in the first place is so low that the marginal Euro, sterling should be demanded from the market in the form of repos.
Now we can have a debate about where that level is, where banks will start to use the repo facilities more, but the point is that this requires the bond holdings to shrink by quite a considerable amount. That's quite different to where the Fed for instance wants to go. Now in terms of comparing the ECB and the bank, and again, an argument why I think the Euro market is probably more steepening to do than some of the other markets is the ECB was quite slow in starting the QT process in the first place and therefore in my mind has probably two, maybe even three years to go at the minimum in its QT program and also particularly compared to the Bank of England.
The Bank of England has been fairly quick in its process because it has also been conducting active QT where it has been selling into the open market and almost certainly in the next review in October or rather in the September meeting from the Bank of England and that total envelope will be reduced and the bank has already indicated that it believes that somewhere next year it will be in a position where the reserves have been reduced to a meaningful enough degree that they could slow things down considerably or maybe even they have reached the final point.
I think that's probably a step too far, but certainly that they can slow things down. So what I'm trying to say here is that A, for both of these European markets, the QT strategy has been slightly different and then to the Fed, and when you compare the two, the Bank of England is clearly ahead of where the ECB is and therefore the ECB will have to do even more QT for longer period of time, which again puts bonds in the market that the private market has to absorb and from a sheer demand supply perspective should put upward pressure on the curve and therefore increase the term premium. That's essentially my argument as far as QT is concerned. Hopefully that is helpful.
Simon Deeley:
Yeah, very interesting.
Peter Schaffrik:
Yeah, Simon. But let me also maybe come over to you and to turn around. So as has been discussed already, fiscal themes have been top of the mind in the US and over here in Europe. So what's the development in Canada in that perspective?
Simon Deeley:
The federal budget has been delayed to the fall, timing still to be determined, but the current government has passed an income tax cut and increased defense spending. Combined, these are worth about $15 billion on an annual basis. The government has also publicized plans to reduce the operational budget or spending by up to 15% in a few years time. So that's not the full budget, but a sizable portion of the spending or expenses on the budget. Time will tell how successful they will end up being on this. Further fiscal developments will likely have to wait until the federal budget and we highlight that weaker macro assumptions relative to the original platform baseline, combined with the other measures, could see deficits approaching a hundred billion, so greater than 2% and potentially approaching 3% of nominal GDP in future years.
Peter Schaffrik:
So in a recent note, you discussed the Bank of Canada returning soon to the regular bill purchases. How will this influence the issuance picture in your mind?
Simon Deeley:
Yes, we see the Bank of Canada returning to purchasing Treasury bills for regular balance sheet purposes next month. They ended QT earlier this year with a return to term repo operations and bill purchases is the next step in the return to normal balance sheet operations. Our expectation is that they will buy 15% of bill auctions, which translates to about 45 to $50 billion based on the current bill stock. This issuance can soak up a lot of the upside risk to issuance from the factors discussed above. To be clear, bond issuance is already tracking well into record high territory, especially for the ten-year sector. We don't expect any decreases from current levels, but the return to bill purchases by the BOC should see the government lean on bills for upside financial needs from here.
Blake Gwinn:
Simon, can we net that out a little bit? As far as market impacts, we've got looser fiscal policy, higher bond supply globally, pushing yields higher and curves deeper, but you also have a steady BOC call. How does that shake out with regards to curve shape?
Simon Deeley:
Yeah, Canada has definitely been participating in the steepening of the yield curve with the BOC 5s/10s particularly impacted. So it's up to 46 beeps currently. While the 10s/30s has been more steady around 30 beeps. Our view that the BOC is on hold going forward should have a mild flattening bias on the curve given there is a small amount of cut pricing still remaining in markets, but to date the term premium induced steepening has been the more dominant market driver. Indeed, even the core swap curve, which should be less impacted by supply induced steepening and it has been, but has been moving with a broader trend on the bond curve, which is steeper in that 5s/10s portion. So if we do see more pricing out of what is priced for the Bank of Canada, a full move towards the no change and potentially even some hike pricing, then we do think that the curve can flatten from here. But to date, the steepening trend has been the more dominant one. And that concludes this episode of Macro Minutes. Hope you all found it useful and look forward to speaking to you again soon.
Speaker 5:
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