Jason Daw:
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.
Peter Schaffrik:
Welcome back to Macro Minutes. My name is Peter Schaffrik and I'm your host for the day. We record this on the 30th of April 2024 and the theme is Divergence: Real or Imagined?
We spoke last time about the Fed call change and we now only expect the FOMC to cut rates in December this year. As we record this, we're just one day away from the May meeting, and we'll hear from Blake in a second, what is in store in terms of communication from the Fed this time round?
Crucially, however, the latest resilience in the U.S. has kick started debate how much other regions that do not show the same kind of underlying strength can diverge from the Fed and cut rates regardless. The Bank of Canada may be a case in point, and we'll hear from Jason shortly about that.
We've also recently changed our call from the Bank of England and RBA respectively, and we'll hear from Cathal and Su-Lin in a second what is triggering that.
Finally, and away from the central banks, we've seen a significant move in the yen that keep markets on their toes, and we'll hear from Elsa what to expect on that front. So with that we'll start in the U.S., and I'll hand it over to Blake.
Blake:
Hey, thanks Peter. Well, I guess my question is really what's really left for Powell to say at this upcoming FOMC meeting? It was only just two weeks ago. He kind of put an exclamation point on the clear shift in Fed communications we saw after the March CPI release, he said that basically the FOMC lacked the confidence on inflation needed to start cutting and that it's now likely going to take longer than expected to achieve that confidence.
Since that speech two weeks ago, I think very little has actually changed on the data front and I'm expecting Powell is largely just going to come out and kind of repeat or maybe elaborate a bit on that lack of confidence.
Now, make no mistake, the Fed's view has definitely changed since the March FOMC. Before that Powell speech, we had heard from a number of dovish centrist-type of members who were backing away from that kind of idiosyncratic bump in the road type of narrative around the inflation data.
So we know that there's been a shift and I think that if they had to resubmit the dot plot at this meeting, which again this is an SEP meeting, so we won't get that new dot plot, but if they did have to update it, I think it would certainly look different than what we saw at that March meeting. I'm guessing there'd be a fairly even split between dots showing two cuts and those showing fewer than two at this point.
Regardless of where the Fed sees the data taking them by the end of the year, I think what we also heard from Powell was that the Fed is likely in a holding pattern until they see these multiple consecutive months of good inflation data that they're looking for. Were were pretty close to crossing that bar in Q4 2023, but the Q1 2024 data has set that counter back to zero.
So even though if Powell kind of repeats that messaging, elaborates on that prior messaging, it may read a bit hawkish, especially if you're just looking at summary headlines or some various pull quotes from Powell. I don't think market participants should really be surprised by any of this language. If Powell does kind of follow along what we're talking about here, just reinforcing and kind of backing up that lack of confidence, saying they're very unsure about where they're going from here given the inflation backdrop, I think this is basically consistent with current market pricing, which is right now showing about one-and-a-half cuts this year, two-and-a-half cuts in 2025, and I also think it's consistent with the Fed call change that Peter, you referenced in the opening there.
As a reminder, we still see the first cut in December, June and July we think are on hold due to the problematic inflation data, and then September November due to the election cycle, with just two more in 2025.
I think the current market pricing that I just mentioned for '24 and '25 are still in a range that I would consider fair value given that there's still some remaining downside skew towards cuts in both of those years and because I think it's very unlikely that hikes are going to be put back on the table anytime soon for 2024.
So where does that leave us on the market side? I think we're basically in the flip side of the cutting narrative that we had dominating in December and early January, higher for longer is basically priced. I think markets still wanting to push that narrative further even though yields have stabilized a bit in recent weeks.
Just as way of context, in the last few weeks of investor meetings, we've almost not once basically heard somebody making the argument the pricing out of hard landing or cuts has gone too far, and I think the vast majority of clients are still looking for long-term rates and or steeper curves at this point.
I do think twos have probably found the top end of the range for now at around 5%. I don't think that's a particular controversial view at this point. Even though that 2024 and 2025 Fed pricing is slightly below our kind of modal Fed call, as I mentioned, that downward skew does make sense that both of those are pricing a bit below those levels.
So I think it's going to be tough for front end pricing, particularly, to your point, to move much higher without some major further upside on inflation prices.
Given that, I think the belly is probably more sensitive to any further economic positivity unless the Fed seems resolutely dovish in the face of that positive data, in which case I think the 10 year 30 year sector is probably likely to take a bigger hit on those higher growth and inflation expectations. So basically better data with the Fed being more responsive is probably more like a threes tens kind of flattener, versus better data with a Fed being stubbornly dovish probably more in kind of the threes tens steeper type of quadrant.
I prefer the former, both because the positive carry, but also I think this near total consensus for steeper curves and higher term premium that seems to exist right now.
Notably, I should say we're still not big believers in supply and demand driven term premium, or higher long run inflation, or R-star pushing the back end meaningfully higher, and if we get steep, and I think it really is more likely to be that kind of positive data, stubborn Fed type of dynamic I mentioned before.
To that supply point. We also get the refunding announcement, let's not forget, on Wednesday on top of before the FOMC announcement, that should reinforce that coupon auctions are on hold for the time being and I think could alleviate some of the angst around deficit supply that's cropped up in the last month or so and in turn be honestly supportive of long-term yields.
Peter Schaffrik:
Thank you Blake. I think let's just move north of the border where probably the argument for divergence despite the geographical proximity is relatively strong. Over to you Jason.
Jason:
Thanks a lot Peter. And indeed the theme of macro and policy divergence does seem to be the strongest in Canada relative to the U.S. I think the macro side is pretty clear, Canada's growth, we've been below trend for some time and coupled with a supply side immigration shock that's resulted in more subdued labor market and inflation data in Canada.
And today's February GDP data, that does reinforce that Q1 growth should come in below the Bank of Canada's estimate.
On the policy side, the starting point about assessing if the Bank of Canada can stray from the Fed should be framed in a historical context I think. And the conclusion is that the Bank of Canada has done its own thing many times in the past 30 years. So as an example, the Bank of Canada cut in 2015, the Fed was on hold, they hiked in 2010, the Fed was on hold, they hiked in 2003, the Fed just finished cutting and then went on hold, they cut in 2004, the Fed was on hold, and in 1995, which is maybe more along the lines of what we're expecting in the U.S. As far as a soft landing, the Fed cut 75 basis points and the Bank of Canada cut 300.
And I would say that importantly, the periods when policy cycles in Canada and the U.S. have been closely aligned as far as timing and magnitude, there was a common shock. So going into COVID, the post-COVID global inflation shock, GFC, the pre-GFC commodity super cycle, the tech bubble, the Asian financial crisis.
And outside of these kind of common shock episodes, the Bank of Canada has been willing to forge its own path. So the timing and magnitude of Bank of Canada cuts is not dependent at all on the Fed cutting in my opinion. So if the Fed's on hold, the BOC can do its own thing.
Now our base case since last summer has been a June cut, followed by four successive moves. Now this doesn't seem like an unrealistic assumption given the macro differences and the Bank of Canada's past behavior, but the risks are skewed to less rather than more, because these cuts are adjustment ones in nature and they're not in response to a hard landing scenario.
So then it leads to the question of what stops the Bank of Canada from cutting too much before the Fed? The first one is obviously the domestic data could change, inflation could pick up, growth could pick up, that would cause them to pause earlier than we expect. The housing market could accelerate. It's probably going to pick up a little bit, but the bank does not want to see it pick up too much.
The other one is if the Fed or the market pivots to rate hikes, then it's unlikely the Bank of Canada would be cutting if the Fed is expected to raise rates.
And the last one is a materially weaker currency. And the FX channel seems to be what most clients are worried about in my discussions, but we think it would probably take dollar Canada being closer to 1.45 to materially influence their policy stance.
So with that said, in our client meetings the last few weeks, the Canada-U.S. divergence view is a strong consensus and that's being expressed in long government of Canada trades versus short U.S. treasury trades. It does make me uncomfortable though when consensus is so one-sided. So maybe we've seen the lows in Canada-U.S. spreads for the time being, and we probably need to get through a couple Bank of Canada rate cuts with the expectation that there's more to come for Canada-U.S. spreads to move meaningfully lower from current levels.
Peter Schaffrik:
Thank you Jason. I think I was very clear. Let's move to our side of the Atlantic here and let's see what's in store in Europe, and particularly for the Bank of England that meets next week. Over to you Cathal.
Cathal:
Thanks Peter. Well, I think the first thing I'll say is that even before the change in outlook for the Fed, there was already enough we thought in the UK data to suggest that the MPC's ability to deliver an aggressive cutting cycle was fairly limited.
Economic activity here in the UK has been recovering since late last year in line with return to positive real wage growth. Indeed now it almost looks set that Q1 GDP growth would be above the bank's last projection. The labor market has loosened but it's still relatively tight.
As Governor Andrew Bailey regularly points out, the UK is disinflating with full employment at the moment. Now all that said, the bank's rhetoric continues to lean towards delivering a first rate cut in coming months. Governor Bailey at the IMF spring meetings for example, was at pains to differentiate between the inflation dynamics facing the U.S. and European policymakers.
In the former he described inflation as being more demand-led, whereas in the latter it was more supply-led with those mainly external supply shocks now beginning to fade.
Now the inference here was pretty clear, that the Bank of England could begin their cutting cycle before the Federal Reserve if necessary. Now the bank meets again next week on Thursday, and we're not expecting any policy change at that meeting. Instead, the question for us is how the MPC uses it to set up subsequent meetings. At the moment, the guidance still has a bit of a hawkish tilt, if you will, talking about the persistence of inflation and how long policy needs to be kept restrictive for to return inflation to the 2% target. We think that we'll have to switch to some formulation that expresses more confidence that those risks of persistence in domestic inflation in particular are receding.
Now the forecast should allow them to do that. Quite a lot has been priced out in terms of cuts which should push the central CPI projection towards the 2% target at the medium term horizon.
So certainly I think in the minutes and at the press conference we look for a more explicit signal that a rate cut at subsequent meetings is likely than has hitherto been the case.
Now for our part, we still see the first rate cut coming at the August meeting, but as to what happens subsequently, well I think as I said at the top, the Bank of England will be cutting into a recovering economy and a tight labor market, and that means it's likely to deliver what we think will be a relatively shallow cutting cycle. We see just 50 basis points of cuts in total this year, and just two more cuts in 2025, for a grand total of 100 basis points of rate cuts in total between now and the end of next year.
For the ECB, well, it's kind of a similar story, although here we think we have a better idea of when the ECB first rate cut in June, all but telegraphed at this stage. Indeed it will take a very high bar for the ECB we think not to deliver that first rate cut in June.
Similar to the UK, we are seeing a stronger than expected start of the year, Q1 growth this morning coming in ahead of expectations at 0.3% quarter-on-quarter. And in our estimates both core and headline inflation are tracking a little bit above the ECB's projections from its last forecast round.
So again, similar to the Bank of England, the ECB cutting into a recovering economy would still pronounce domestic inflation pressures, which will, as in the case the bank, limit its scope for how much that can actually deliver once it begins cutting. So for the ECB, we see once it gets started, it delivering just 75 basis points of cuts this year.
Peter Schaffrik:
Thank you Cathal. And now we're moving down under and give the floor to, Su-Lin who had recently changed her RBA call as well.
Su-Lin:
Thanks Peter. There've been some really big in Australian rates in the last week triggered by a much stronger inflation print. What was really worrying was that the details highlighted sticky and more persistent services and domestically generated price pressures. With these and other core measures running around 4% to 5% in year-on-year terms, and even higher in some cases on an annualized basis.
So we've been in this cautious camp for inflation for some time, and it's mostly reflected our concern around persistently elevated unit labor costs, and I think I talked about this in the last edition of Macro Minutes. And given the resilience and tightness of the labor market, it's really hard to see how this eases materially anytime soon. So we've been flagging the risk of an even more shallow easing cycle starting even later than November for the RBA, and post-inflation, we pushed back our RBA cuts into 2025 and we're now looking for only 50 basis points of cuts in total in the first half of next year.
In doing so, the question we keep asking ourselves is this, are we more like Canada or the U.S.? And the answer continues to shift towards the U.S. So core inflation here is not accelerating, but progress towards the inflation target is stalling it really far too high a pace, and the starting point for the labor market is stronger than we expected. It remains really pretty tight, with the unemployment rate sub-4% for most of the last two years.
So in the context of the divergence to the U.S., there seems to be far less of that in Australia versus most of the G-10 economies we've discussed today.
The next big event for us is the RBA's May meeting next Tuesday on the 7th of May, and it will release its quarterly statement at the same time as the board decision. We do expect the cash rate to remain unchanged at 4.35, but the statement will err hawkish with the risk that the very, very mild tightening bias is strengthened, and if not explicitly, definitely via likely revisions to its forecast. We'll see upward revision to their inflation forecast and downwards to their unemployment rate forecast.
And I think the RBA is likely to be less confident in meeting its inflation target within a reasonable timeframe. And if that's not glaringly obvious in the statement, it probably will be in the press conference.
We're also fairly curious to see whether there's any board discussion of rate hikes next week. Markets and clients are really pretty nervous ahead of next week. Two year yields have backed up about 25 basis points post-CPI, 10 years, about 10 basis points, and Australia has been the key underperformer in global fixed income. And incredibly market pricing has swung from almost fully pricing in a 25 point cut in late '24 about a week ago, to now being almost 50% priced for a 25 basis point hike by September.
We do think the bar to hike is high, and the RBA have proven to be reluctant hikers, but we wouldn't fight market pricing here. It could well move further.
There's a lot of uncertainty over the labor market outlook following a volatile period of data and that may take some months to resolve. We do get monthly inflation numbers, but the series is relatively new and not as comprehensive as the quarterly data, and we also have a Commonwealth budget in two weeks, which we expect to include some stimulatory measures.
We flagged emerging value in the front end in our last edition of Macro Minutes, but clearly the goalposts have shifted and patience is required to buy or receive this front end.
Peter Schaffrik:
Thank you Su-Lin, insightful as always. And last but certainly not least, we'll change topics a little bit and speak about the currency market, particularly about the yen, where I hand over to Elsa.
Elsa:
Thank you Peter.
So I'm going to talk a little bit today about dollar-yen and it ties into what we've heard previously from Blake.
First, just to talk about what actually happened. Early on Monday we saw sharp move up to 160 in dollar yen. That's a three decade low for the yen. It quickly reversed to the low 159s, and then a very sharp move driven by suspected intervention took us down to 155.
That's a 3% move, which on the face of it looks sizable, but actually just took us back to where dollar-yen was trading on Friday morning. First question is how much do we think actually went through?
Now the Bank of Japan released its daily projection this morning talking about commercial bank's deposit, expected to drop around seven and a half trillion yen, which would be equivalent to just under $50 billion U.S. That compared with an expected drop of about 2 trillion yen, which money market brokers were predicting last week.
You can couple that with our own estimates of the turnover that went through yesterday in dollar-yen, and our EFX trading team estimate that on an average day we'd expect to see around 15 yards of dollars trading in the dollar-yen market. Yesterday that appeared to be just over 100 yards. So some really sizable flow going through in dollar-yen.
The big problem for the Bank of Japan and the Ministry of Finance is that we're already drifting higher, 157.50 as we speak. And when speaking to clients, we get the sense that a lot of them were waiting for the pullback driven by intervention in order to reload on long dollar-yen positions.
The reality is that with the interest rate differential as it stands at the moment between the U.S. and Japan, it's going to be extremely difficult, if not impossible for Japanese officials to turn around dollar-yen and send it in a different direction without some external help.
If you think about it, the last time they formally intervened in late 2022, what then followed was the China reopening story, which led the U.S. dollar lower across the board, including dollar-yen lower. In late '23 when, again, dollar-yen was pressing up near the highs, it was the soft U.S. CPI data that turned things around and led to a pullback from the highs in mid-November.
This time round the U.S. data are not cooperating and with our revised Fed call of first cut not coming until December, and potentially only a couple of cuts next year, this really is a structural shift in terms of the outlook for dollar-yen. When we look at the cost of hedging dollar-yen from the point of view of a Japanese investor, and compare that to the running yield on Japan's stock of overseas assets, it's not just the flow of assets which is important, but really what the hedging behavior is like on the stock of assets, which is critical.
We've never had a gap this wide in terms of the cost of hedging against the running yield on the overall portfolio going back twenty-odd years in the data. And a lot of people will point to the current level of the yen and say it's really cheap, and it is from a PPP perspective or most valuation metrics that people tend to focus on.
But portfolio flows are far more important than trade flows in driving currencies. And currencies which are cheap or expensive can remain that way for very extended periods of time. So from our perspective, it really does feel like dollar-yen is going to continue to grind higher from here. 160 will be the first immediate target for investors, but beyond that 165, even 170 are not out of reach as long as U.S. inflation remains sticky and elevated. Trading it is tricky and people are conscious that it's not easy to jump into dollar-yen at current levels.
And I suspect that investors will continue to try and either wait for intervention-led pullbacks to quickly buy into, or try and opt to play in the options market, which, again, is particularly broken with very thin liquidity, very little going through in the inter-bank and broker market.
From our perspective, we have heard of investors using the yen as a funding currency. That still seems to be a very popular trading strategy. We do think there are better ways of funding the high carry positions, particularly when thinking about emerging markets, and we'd favor some of the more pro-cyclical risk proxy currencies, even the likes of the Australian dollar you heard from Su-Lin around the change in the outlook for the RBA, potentially no cuts at all this year.
But the reality is that we're far better off funding long-yen carry positions with short higher yielding than the Japanese Yen, but low yielding relative to EM risk proxies like Aussie or CAD, than looking at the Japanese Yen or the Swiss Franc.
In terms of trading the Japanese yen, we expect that people will still be looking to buy those dollar-yen dips, as we said, and still feel like the direction of the spot is higher from here until and when the U.S. data turn.
Peter Schaffrik:
Thank you Elsa for that. That's really insightful as always. And that concludes this week's edition of Macro Minutes, and I hope you're going to join us again next time.
Speaker 8:
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