Dog Days of Summer - Transcript

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 and financial markets and the global economy. Please listen to the end of this recording for important disclosures.

Jason:

Hi everybody, and welcome to the July 12th edition of Macro Minutes. The weather isn't the only thing heating up at the moment. North American central banks are expected to deliver large rate increases in July, and the ECB should hike for the first time since 2011, and August should see sizable rate hikes in the UK and Australia. So the big question is will the heat from rate hikes suffocate economies and markets? So to help navigate this increasingly aggressive monetary policy stance by central banks and the growing tug war between inflation and growth worries, we have on the call with us today, myself, Jason [Da 00:01:01], Blake Gwinn in US rates strategy, Peter Schaffrik in UK and European rates and economics, Adam Cole for FX, and Adam Jones for US investment grade credit.

Jason:

So I'm going to kick it off today and discuss two topics. The first is going to be RBC's updated growth forecast for the US and Canada, and the second will be the Bank of Canada meeting, which is coming out tomorrow. So on the first topic, RBC updated their economic growth projections, and we now forecast a recession in Canada and the US in 2023. The growth downturn is mild, but the greater that the Bank of Canada and the Fed needs prioritized inflation over growth. The risks are clearly to the downside. So for now in the US, we look for domestic demand to lose momentum towards the end of this year, ultimately giving way to a contraction in the first half of next year. We're really only forecasting around half a percentage point contraction during those quarters, but that should push the unemployment rate higher from its current 50 year low, which should be necessary to get inflation back to target. So we think 1.3 percentage point increase in the jobless rate by the end of next year, that would be on the mild end of historical recessions.

Jason:

In Canada, we do see growth slowing into 2023. The impact of rising debt servicing costs on Canada's highly indebted household sector is only going to continue to worsen next year. So we look for GDP to decline in the middle quarters of next year, so Q2 and Q3, which should leave annual growth at less than 1% for full year 2023. And similar to the US, Canada's low jobless rate should rise by about one and a half percentage points, and that'll also be mild in the context of past recessions. Moving on to the Bank of Canada meeting tomorrow, we expect a 75 basis point hike. We give a 25% probability to a 100 basis point move, and consensus is firmly in the camp of 75 basis point hike. And as of the time of this call, the market's showing a small 10% chance of a 100 basis point move.

Jason:

So all the macroeconomic data, whether it's CPI, wages, employment data, the recent Bank of Canada surveys, all argue for an aggressive move at this meeting and probably beyond. So the Bank of Canada, they shouldn't prolong reaching restrictive territory. So the risks to tomorrow's meeting are decidedly on the hawkish side. As far as the risks to the shape of the curve, they're decidedly asymmetric, still toward near term flattening. A lot of the parts of the curve, 2s/10s, for example, 2s/5s, they've inverted, could invert quite a bit more if policy rates continue to march higher. Steepeners, these are classic rate cutting cycle trades, but in both the US and Canada, they can probably wait. It doesn't really pay to be early in these trades rate cuts could happen anytime in 2023, and when we get to the end of the tightening cycle, it's probably more fruitful time to put on cash, spot starting or forward starting steepeners.

Jason:

On the duration side, just to conclude, it has been a rollercoaster ride, but I'm still happy to have the view that Q2 will mark the peak in rates in the five to 30 year kind of tenors, and that long duration is a better bet than being short. Obviously front end rates are going to be pulled higher by policy rate moves, but term yields should be weighed down by the aggressive tightening, bringing down inflation expectations and weaker future growth. And that's been one of our key tenants from our midyear outlook where we thought Q2 would be the peak in rates because we thought that growth risks would balance inflation risks. This has started to happen, and this should become more pronounced as the year progresses. So with that, over to Blake to enlighten us on the US treasury market.

Blake:

Thanks for that intro. So look, a lot of the recent conversations we've had with market participants have pretty consistently revealed a very broad lack of conviction on the outlook for rates and also fairly light positioning. I think a lot of that's due to a number of factors, uncertainty on the path of inflation is certainly one. I think there's a lot of confusion on the Fed's reaction function, especially after the breaking of forward guidance and how they kind of refocused on headline inflation at the June FOMC meeting. I think poor liquidity has been playing a role in a lot of the volatility we've been seeing. I think there's still uncertainty around the impacts of QT. And finally, and I think perhaps most importantly, there's this kind of dissonance, markets trying to process and position for both a hiking and a cutting cycle at the same time.

Blake:

What I mean by that, markets have essentially been caught in this back and forth between two themes the last few weeks. On the one hand, we have a Fed singularly focused on crushing persistently high inflation. That comes with a possibly still higher terminal rate, bearishly flatter curves. This is really the theme that dominated the first half of 2022. But on the other hand, we also now have this growing potential for a near term recession, a possible Fed pullback, and I think that's overall bullish for rates, a bit more ambiguous on curve direction, but I think generally seen as leaning towards steepeners. Really depending on how soon that turn occurs, how soon the kind of tipping point for the Fed really happens, and whether or not it happens before the Fed has already reached the currently priced terminal rate of 3.4%. And also I would say how deeply the Fed is seen as cutting, but overall, I would say markets have seen this as leaning towards kind of a bull steepener.

Blake:

The latter of these two themes does seem to be that a false setting the last few weeks, with a hawkish turn by the Fed being seen more as kind of the risk case that is possibly going to flare up as we move on. But I think kind of the day to day has been the real focus on the recession side of this back and forth. And we saw this in the reaction to the big NFP print last week, markets quickly priced in 10 basis points more of terminal, it brought a rate sell off, but that very quickly retraced this week as markets kind of refocused on that recession theme. So again, that seems to be the backdrop. And then we get these kind of flare ups of the more hawkish theme.

Blake:

Tomorrow, obviously going to be another test with CPI, very likely could see a [inaudible 00:07:44] headline and a beat. It could see a more sustained reaction than NFP, given how much the focus really is on the inflation side of the mandate, a beat there or strong print there could move things more sustainably, pull things more sustainably back to that kind of hawkish narrative, that kind of bear flattener that we spoke of earlier. It's this kind of potential bouts of hawkish bear flattening that I think is largely kept this broader discussion about curve steepeners, particularly forward curve steepeners, from actually turning into a lot of positioning.

Blake:

We've had a lot of conversations over the last week, a lot of investors kind of looking at forward steepeners, given how flatter curves have moved and kind of this expectation for a recession, expectation for cuts. But as far as we've seen, this is not really turned into actual positions yet. It still really remains in the discussion phase for most of the investors we've talked to. Longer run, we do like those positions, but I think much like the people we've had these discussions with, we think [inaudible 00:08:43] closer to the end of global hiking cycles, it's really too early for these trades, given these kind of risks of near term flattening and bouts of hawkishness that could come from the Fed, that could negatively impact those positions.

Blake:

Real quickly, broadly, I think this back and forth between the two themes likely to continue into the late summer, but I think as we head into Q4, we think the narrative is going to shift more squarely towards this kind of recession dovish case. The slowing of the economy's going to worsen, and it's going to get a lot harder for the Fed to ignore. That being said, until then, I really don't think there's going to be enough accumulated data, again, highlighted by NFT last week we're not going to see enough for the Fed to really start pulling back before the September FOMC and for markets to kind of fully commit to that dovish case, the recession case, start challenging a 3/10 terminal floor, or to really start layering in heavily to those forward curves steepeners.

Blake:

So from there, I think we see things as kind of settling into a range over the summer. I think that given kind of our bias towards this recession theme picking up as we head into Q4, that means playing that range from the bullish side on duration and from the flatter side on curves. But right now both of those things are at relatively unattractive levels, given that I think we are probably near the bottom end of those summer ranges at the current moment. But we would look to any kind of spike that we get from CPI print and from other data, from Fed speak. If we do get those kind of bouts of hawkishness, that's where we would look to use those things, to move into those positions, to head back to the bottom of those ranges. And there I will pass it on.

Jason:

Okay, great. Thanks a lot, Blake. Next up, Peter, on the European situation.

Peter:

So I think the situation, so first of all, on our assumptions about the economy going forward, we have also changed our assumptions somewhat. We already had a relatively weak profile in anyway. In the Euro area, we have now penciled in a recession. So technical recession in Q4 and Q1. In the UK, we see that just about being avoided, but the growth forecast that we have, 0% and 0.1 for the two respective quarters I just mentioned, being very close to recessionary question anyway. The market is currently rallying and we have a slide long position because we think the market is pivoting from solely being focused on inflation towards more of a growth risk, but I think particularly sort of over the last day or two, the market is pivoting even much more.

Peter:

And one of the key reasons here is because there is a risk out there that is potentially quite important for Europe specifically, and that has to do with the delivery of gas and the gas situation that we're facing in Europe. I guess everyone is aware that Russia has reduced its gas deliveries into Germany by 60% to 40% of the normal levels. They are now on a regular maintenance basis shutting down one of the key pipelines, the Nord Stream I pipeline, and there's a big question mark about whether it's going to be reopened after that maintenance period. And most people who understand the situation and that I'm following tell quite clearly that if it's not been restarted, that this would potentially be a very big deal for Germany and the wider EU. And because it would probably require some industries to make drastic reactions, such as for instance, in some cases, even shutting down their production.

Peter:

So that's the risk out there. And I think that's another reason why the market is rallying so drastically. As I was saying currently, we like longs. We have been buying bond futures as a response. We think that the market has to reprise some of the front end hawkishness that is out there. We are now, when it comes to the ECB, much closer to our central scenario of hiking to 150, but in the UK, for instance, we still think that the market is probably overstating what's going to happen. So we're still pricing around about 3% as the peak rate where we think that the bank will only get a chance to go to 250. So that's roughly how we're seeing the market.

Peter:

I want to say one other thing that is slightly related only to that. Before we have the next call, there will be the next ECV meeting. And the key here is that they almost certainly will hike rate by 25 basis points. That's our forecast, that's what they have communicated. And I think despite some harsh voices out there that say they should be doing more, I think that's extremely unlikely. But more importantly than that, because that's been so well flagged, I think the key is what else they're going to announce as far as the anti fragmentation tool is concerned.

Peter:

They have already given us a little bit of insight and press speculation has it that they will reveal details or significant details in the July meeting. So far will be seen as we've seen a significant compression of sovereign spreads from the time when they made their announcement a couple of weeks ago. That has not filtered into the corporate market. The corporate market is widened, nevertheless. So if the details fall short or if they try to play for time, I would think that there is a negative repercussion, particularly in the sovereign markets or in Italian market and Spanish market, and Italian market in particular. So that's very important. We think they will give us detail, but if not, I think there's another downside risk in spread product in particular. And with that, I'll [inaudible 00:14:37] and hand it back.

Jason:

Great. Thanks, Peter. Next we're going to hear about FX market from Adam. Obviously a lot going on. The Euro approaching parity, I think to five decimal places. It did not hit parity overnight, even though that's kind of what it'll show on your Bloomberg screen. So over to Adam to tell us about currencies.

Adam:

Thanks, Jason. So let me touch on this question of how FX trades in different growth environments. And I direct you to a couple of pieces that we had in the latest position of our total FX. One of them looking at the general relationship between currencies and growth, and one looking specifically about how FX behaves in recessions. And I'm going to focus on that one here, given all the talk that preceded me on the prospect of recession in different regions. So looking back historically at how FX has behaved in recessions, one important factor we wanted to control for in looking at that is whether we're looking specifically at US recessions with the rest of the world continuing to grow, or whether it's a case of US recession with the rest of the world also in recession. And we've got roughly equal numbers of those two situations historically.

Adam:

By far the most pertinent I think at the moment is a situation where the US and the rest of the developed world are all contracting together. And looking back at how FX trades in that kind of environment, there is a very consistent pattern of the kind of FX moves that we would typically call risk off. So in those periods, you tend to see the Swiss Frank and the Yen as the top performing currencies, but the dollar gaining against everything other than the Swiss Frank and the Yen, particularly so against the commodity currencies, the Scandinavians, Sterling, and to a slightly lesser degree, the Euro. But the picture broadly is what we would associate with what we'd call risk off, of dollarizing against everything other than the Swiss Frank and the Yen. And that pattern is very consistent.

Adam:

Less pertinent I think is when we see the US in recession in isolation and the rest of the world continuing to expand, and in those instances, we see far less consistency. Actually returns are much more around idiosyncratic stories and relative growth positions. But I think at the current juncture, the more pertinent example is when the developed world is all in recession simultaneously. And indeed, if you look at the surveys of recession probabilities from Bloomberg, the probability of recession in the Eurozone for example is perceived to be bigger than that in the US at the moment.

Adam:

So if we do see continuing the focus on the risk of recession, and ultimately that's where we end up, then our expectation would generally be that the markets look like they do in periods of risk off. But another important qualification to that; markets tend to carry on trading that way until economies stop contracting. So, one thing I think to be very cautious of in that kind of environment is early calls for the bottom in the riskier currencies that you don't tend to see reversal in their under performance until economies actually stop contracting and we come comfortably out of recession.

Adam:

So that was the main thing I wanted to discuss. Just to mention that Jason mentioned parity in Euro Dollar and [inaudible 00:18:36] generally. As you know, we've been dollar constructive all year. We had parity as a target for the end of the year. Clearly the market is about to leap frog us again, and just a note that in our latest Currency Monthly, which was out little less than a week ago, we moved our target for Euro Dollar down to 97 cents in the early part of next year. So we've been negative Euro, positive dollar, but market is moving more quickly than we'd expected, and we've moved out targets to reflect that. That's it. Thank you.

Jason:

Okay, great. Thanks. Over to Adam Jones for US investment grade.

Adam Jones:

Yeah. Thanks. Yeah. I mean, investment grade has actually been a little bit better the last week. It definitely felt like things got a little bit close to the edge. Just the other week we had, there was a big deal, an 8 billion deal from Celanese in the market. And on the initial attempt to print the deal, it basically didn't get done and was shelved. Now that kind of occurrence of an IG issuer coming to market and then failing to get a deal done is somewhat rare and always alarming. I mean, one of the things in IG is you expect issuance to happen. And in some sense, issuance is always market positive. It shows the market's clearing, it shows there's a clearing level, things are functioning properly. So on the odd occasion that you get a deal where, for whatever reason it doesn't manage to clear, it is very alarming.

Adam Jones:

And indeed, when that happened, we saw spreads hit recent wides in the US. That deal then came a week later and it was a slightly restructured form. It was shuffled a bit across maturities. They did some Euro paper as well. But ultimately it got done and it cleared, and whatever you think of them having to shuffle it and change it, ultimately it did print. It actually traded reasonably well on the follow because it came at a level that was good enough. And I think having seen that clear, the market's kind of breathing a bit of a sigh of relief that perhaps things are not as bad as feared when there was that initial concern. So since then, spreads in US have come in from wides of 160 on the index, we got into 147, eased up a bit to 150 yesterday. And I would say, chances are we're now going into a kind of summer trading mode.

Adam Jones:

Liquidity is a bit lower. We've obviously got earnings coming up. There'll be some issuance out to the banks. On the real money side, spreads are now attractive enough that we're starting to see some people put a bit of money to work. The thing that stops more of that is obviously the ongoing concern of outflows. Real money raised cash ahead of outflows. There have been outflows so far this year, and without seeing that completely stop or preferably reverse, the incentive for them to just plow into paper is a little bit more limited. But it does feel shorter term that with their Celanese deal out of the way, things are in a position where we can at least trade sideways to slightly better knowing that's now gone.

Adam Jones:

It is worth noting though, high yield remains a little bit different. It's somewhat tricky to is issue in high yield. There has been relatively limited issuance this year. And it is because it's not that easy. It's gone from being a market where you could issue any day of the week without thinking about it, to being one where issuers perhaps do need to be a bit more aware of conditions, opportunistic. The syndicates are basically having to do some work to get deals done nowadays. And so broadly there is still that bit hanging over credit markets. Additionally, you've seen the stories about banks set on loans and trying to shift loans off their books at discounts, et cetera. And so there are still those aspects in the background that are of concern. But as far as US IG, it feels like the fear that that's spread into IG, for now at least can be put to one side and that sets us up to perform reasonably well, sideways to better.

Jason:

Okay, great. Thank you. So that concludes the call for today.

Speaker 7:

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