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:
Hi, everyone. Welcome to the January 24th edition of Macro Minutes entitled Emerging Divergence. Recent months have seen widespread hikes across most G10 Central Banks, but the potential for divergence is high in the coming months as some Central Banks are approaching the end of their hiking cycle. While the possibility of a 50 basis point hike from the Fed next week remains, market pricing and some Fed speakers have outlined a preference for more normal 25 basis increments following moderation and recent inflation reports. Indeed, this quarter may well be the last for any hikes from the U.S. Central Bank.
To provide some insights on the global Central Bank landscape and beyond, we have a full lineup of RBC experts. Peter will kick off with this views on the ECB and BOE meetings next week and Adam will provide the latest from FX space focusing on the BOJ in the short term and long term. I will discuss the Bank of Canada meeting on the 25th, which we think will be a final 25 basis point hike, and Amy will discuss the equity options market. Finally, Sue-Lynn and Rob will share their views on Australian CPI and the next RBA meeting. Over to you, Peter.
Peter:
Thank you, Simon. As you suggested, I will present a little bit of my views on the ECB and the Bank of England, but before I do that, what I'd like to do just very briefly is revisit the investing climate that we had over the last couple of weeks here in Europe. The European markets have performed quite well actually on all fronts. The fixed income market has performed both in rates and credit. The equity market has performed up until recently quite well and has outperformed particularly the North American counterparts. And I think the main reason for that, as we discussed last time round, was that, on the one hand, we had falling inflation, actual falling inflation numbers, but also at the forward-looking indicators, so break evens have been falling quite sharply basically as a response of the falling commodity prices. Energy prices in particular.
And the second thing was that the activity data and the forward-looking data for activity have held up reasonably well. And just today we had European PIMs, which were generally better than expected, safe in the U.K. So that was a relatively good climate for pretty much all asset classes, and that has worked up until about a couple of days ago when we started to get quite hawkish Central Bank speak, particularly out of the ECB. And I think that's the backdrop against which we're going into these meetings. So what to expect. If I start with the ECB, now, the ECB is still at a relatively moderate absolute interest rate level and they have made it very clear that they want to continue their rate hiking cycle. The market is expecting a 50 basis point increase, and that is most likely the outcome. That's what we are forecasting as well.
The question rather is, what are they going to do afterwards? And this is I think where the battle lines will be drawn. We had an article quoting unnamed ECB sources earlier last week suggesting that they would then consider a step-down to 25 basis points. And that was followed by basically a barricade of hawks that came out of the woodwork and were arguing against it. So there seems to be the battle that will be fought. We do think that after the 50 basis point in February they will step down to 25 in March and then in May again, and we'll end up at 3%. That's slightly below where the market is currently pricing it, somewhere between 3.25 and 3.50. But the key for us going forward is that the terminal rate that's currently priced is unlikely going to be pushed much higher.
So we just send a note out where we argue that going into the meetings because of the hawkish speech, one should probably take a little bit of a step back, but by and large we think that the investing climate that I outlined earlier will probably prevail over the more medium term. Now, for the Bank of England, the situation is slightly different but only slightly because also here the debate is whether they're going to do a 50 or a 25 basis point step, and the market is also firmly in the camp of 50, although we think there is a very decent chance that they will do 25 instead. But given that they're further advanced in their cycle and that the data has been at least up to recently a little bit more mixed, the question is also, what are they going to do thereafter, and whether or not the rate hiking process is going to end much faster than it would be for instance for the ECB.
So our view is then we'll get another 25 basis point step and that this is then probably the end, and there is a chance that they're going to go a little bit further than that. Last time round, we had a three-way split between two voters who didn't want to change at all. One that voted for 75 and then the majority who voted for 50. And we think it's also going to be interesting whether there's going to be a two-way or three-way split again, which seems very likely. And with that, I'll probably leave it, but the key is really not necessarily what's going to happen directly at the next meeting, but what's the guidance thereafter? And back to you, Simon.
Simon:
Thanks for those insights, Peter. And now we'll shift to Adam on the BOJ.
Adam:
Thanks, Simon. So arguably one of the greatest divergences over the last month has been the divergence in expectations for the BOJ. Just as other Central Banks are reaching close to the peak of their cycles, markets are moving to try to discount the normalization of policy in Japan after 20 plus years of [inaudible 00:05:52] policy. So the BOJ slackened its yield curve control at the December meeting. There was a rapid buildup in expectations that there was more to come only for the BOJ to do nothing at the January meeting. So the question is, where do we go from here, and what does it mean for the currency from our perspective? And I think our expectation is that in the near term there is potentially a lot of noise. So the March meeting will be current Governor Kuroda's last, and given that the BOJ, as well as leaving policy unchanged, it left its forecast showing inflation below target for the next two and a half years.
Really, from my perspective, that makes it very unlikely they'll change policy at the March meeting and all eyes now are on the April meeting under the new Governor. There are at least three possible candidates for the Governor, all of which are still live. Current guidance is that we should around mid-February know who the government is proposing as Governor and two Deputy Governors. If it turns out to be one of the more hawkish candidates, then it is highly likely I think that we will get another buildup of short JGB, short dollar-yen positions that push big moves in both fixed income in Japan and in the currency. Equally, if it's one of the more continuity candidates, Amamiya in particular probably fits into that mold, then the reaction will likely be more mild and the markets will be calmer.
However, the key point I think I would make in this context is most of the transmission mechanism for this expectation for BOJ policy and what the change in the Governorship implies for that is coming about as a result of positioning outside Japan. It's outside Japan where the JGB shorts built up. It's big moves in positioning in dollar-yen have moved the currency. From the perspective of Japanese investors, the likely shift in BOJ policy are actually quite mild compared to the paradigm shift that's been driven by the Fed in the ECB. So my expectation is we get a lot of noise over the next couple of months as we build in the expectation of the changing Governor and potentially build in another expectation for slackening the yield curve control or even abandoning yield curve control. But once we get through that noise, the flow that really matters is the real money flow from within Japan.
And what yen based investors are still adapting to is not a potentially 10 basis point move in Japanese policy rates or 15 basis point move in JGB yields that happened, but it's the rise in the cost of hedging their huge stock of foreign assets. So the cost of hedging a dollar asset started last year at about 50 basis points, fell over 500 basis points recently as six months ago. Yen based investors were getting paid to hedge their Euro assets. They now have to pay you almost 300 basis points, and it's that shift in the cost of the hedging that is really the revolution in investment arithmetic that yen based investors are facing, not the relatively small moves in front end or longer dated yields in Japan.
So my expectation is, when we get through all the noise over the next two or three months and settle down to the expected policy changes within Japan, we go back to the main real money driver of flow from within Japan as the principal driver and the trend of yen weakness that dominated last year begins to reassert itself when that flow from outside Japan settles down. So potentially a noisy two or three months as we build in the expectations for the change in leadership and what that implies for policy. Longer term, we think that the trend of yen weakness that was with us most of last year will reassert itself. And with that, I'll pass back to Simon.
Simon:
Great, thank you very much, Adam. Shifting to Canada now, we think this week's BOC meeting will see the final hike of the cycle with a 25 basis point move to 4.50. BOC messaging in December was that going forward they would be looking at whether they would hike again rather than how much they would hike by. However, they also presented a relatively high bar to a pause in noting that while there were risks to over tightening and under tightening, the latter was the bigger risk given how high inflation remained. Supporting our 25 basis point call and consensus in market pricing is that data in the intermitting period has been close to neutral. We have seen some flowing on the activity side, especially forward looking activity in the business outlook survey, but underlying inflation is uncomfortably high, and inflation expectations remain lofty over the next few years.
The labor market remains very tight. Moderation in three month annualized inflation for the core measures has stalled somewhat in recent months after strong progress into October. This is not an environment where data has softened enough to warrant a pause given their communication nor has it been strong enough to continue at a 50 basis point clip. We give a 70% probability for this 25 basis point move. Support for a 50 basis point move, we put about 20% probability on this, so we're leaning more on the hawkish side whereas market pricing is giving more probability towards no change. But support for a 50 basis point move really comes from the still elevated level of inflation, high inflation expectations over the coming years, and the tight labor market. And really that tight labor market leaves a lingering risk of a wage price spiral. Definitely, not a base case scenario, but while that risk remains, that is something the bank needs to be aware of and has highlighted.
The main argument for a pause, we've put this at a lowest probability for us at about 10%, is that forward looking activity indicators in the business outlook surveys softened and given the lags in monetary policy transmission, they may think that they have done enough to bring inflation down to 2%. So the movement lower in the underlying inflation from the core measures is certainly something they like to see, but those three month annualized measures remain in the 3% to 4% plus range. So even those short term measures are not showing inflation down to 2%. In terms of market views, we continue to see the 2023 cut pricing by the market, which is around 50 basis points of cuts by year end, as premature, and expect the bank to keep policy unchanged throughout the year due to underlying inflation remaining above 3% or around 3% or more.
We therefore see some scope for the front end selling off though we are neutral to bullish on term yields, currently under 3% for five through 30s. And our year end target for tens is 2.70. So definitely something to watch tomorrow and we will be. Again, our view is that it's a 25 basis point move but also to note, in terms of the messaging from the bank, we don't think that they're going to give a hard pause language. We do expect that their language will be similar to December where they'll be looking at whether to hike again and certainly leaving the market with a clear view that they are open to a pause. But we do think data will result in them actually pausing at the March meeting. And with that, I'll shift over to Amy for discussing the Canadian options market. Amy.
Amy:
Thank you. Good morning, everyone. So one quick plug. We did host the call that Simon was part of as well yesterday called Volatility in the Market Outlook for Canadian Housing. It was quite in depth alongside our Canadian diversified financials research analyst as well as our financial services research analyst. There's a full replay of that. I'm certainly not going to dive into the full details, but please take a look at that for that replay. Just before we discuss that specifically, I want to provide some context. If you look to 2022, what happened in the volatility markets was quite a big surprise for a lot of investors. So we had the S&P draw down 20%, but actually the strategy in the option side that worked was actually being long the S&P plus owning puts. That was actually drawn down 21%.
A big question coming into this year is, what happened? How did we get a hedging market that underperformed when there was such a drawdown? There are a lot of details technically, and so why that was the case, that's in our volatility outlook. But needless to say, there was a bit of a boy who cried wolf in the market. And so the way clients came positioned into 2023 was quite the opposite of the beginning of 2022. Investors came into this market, under-invested, under hedged, and far more focused on up crash. We saw far more call buying and focus on the right tail of events. Now, so far that's actually been the right strategy. We've seen the S&P up roughly 5% and we've seen strongholds in the higher correlation names like mega cap tech hold in fairly well. But this really has been the opposite of what expectations were set into 2022.
So if you looked across Wall Street at what different strategists said, they essentially almost all expected a bearish to limited upside first half and a rally in 2H. But we didn't actually see that in positioning. We always saw that focus on up crash. Now, one thing I would point out is that this is beginning to shift. Not in S&P, but elsewhere. So within S&P specifically, you're skewed. So that demand for downside protection still remains historically low on almost every metric. But on a one standard deviation drawdown, it's fifth percentile over five years and it's three standard deviation drawdown is in its sixth percentile over five years. And even though you're seeing a continued floor to VIX, it's still quite inexpensive relative other VIX proxy metrics on a cross asset basis such as the move index, which tracks treasuries, or the CVIX Index which tracks the FX market.
But, as I mentioned, we're starting to see clients focused on downside in other markets, and that's how we get back to Canadian housing. This was actually a call that originated because of the activity that we saw in the market. So a lot of options buying particularly in the put side in XIU as well as EWC. So three trades that came out of the conversation yesterday was really a way to play leverage downside exposure for the Canadian housing market as well as companies that would also be related to that. So specifically short term, we like looking at March in XIU in [inaudible 00:17:18], which are larger ETF proxies, but also the ZEB as a financial services proxy. For more details, feel free to reach out to me. I won't go through the complete structure on the trade. The other area I would focus on is the options market was quite early in focusing on upside in China.
So even towards the middle half of last year, we already saw investors buying calls in FXI, ASHR, KWEB, as well as the larger cap Chinese single stock names. We're now seeing that reverse, which is interesting as Asia just headed into the Lunar New Year. But most of the flow has shifted from FXI and EEM, which is a correlated proxy to the downside. So does that mean that we're starting to see this trade being over? I don't know, but you're starting to see that activity in the market shift far more defensively than you otherwise have. And then I'll just end on this, a big technical point that we discuss in the volatility 2023 outlook is what happens with tech is really what is going to happen with the S&P this year, because the end of the day, mega cap tech still makes up nearly half of the queues and substantially more of smaller ETFs like XLY or XLC, and still about a quarter of S&P.
So right now, tech is held up, but if that shrinkage starts to happen, it could act as a volatility dampener in S&P where other companies that take over the weights are more diversified. But it won't act as a dampener in tech specific ETFs where, by definition, the weightings re-weight back into tech. So you'll likely start to see a volatility spread between tech related ETFs and the S&P in general. And that's another pocket where we think we could start to see leverage downside. And I will end it there. Thank you.
Simon:
Now over to Sue-Lynn to discuss the RBA.
Sue-Lynn:
There are two key events in Australia in the next couple of weeks that should lend support to our view that the RBA is close to the end of this hiking cycle and our bias towards lower yields in 2023. So first up is the latest inflation data and that's released on Wednesday the 25th of January. We expect the numbers to confirm a peak in annual inflation in Q4 similar to the global trend with headline around 7.5%, and the two key core measures averaging about 5.8, not far from 6%. Australian wages in the labor market are lagging a little and we've got very resilient domestic demand so service sector inflation is likely to have lifted further in the fourth quarter of last year. The data should confirm a multi-decade high in inflation, but the odds are it'll be lower than the RBA's most recent set of forecasts which had headline inflation at 8% at the end of '22. So the RBA may well revise down its inflation forecasts lower at its quality statement on monetary policy on the 10th of February.
Inflation though is going to be pretty high, elevated, well above target, and coupled with a tight labor market, we still think it's consistent with further modest tightening, but it's clear we're approaching the end of this hiking cycle. We've had 300 basis points of rapid tightening since May of last year, and at 3.1%, cash sits in slightly restrictive territory. So the second key event then is the RBA's first board meeting of the year on the 7th of February. We are looking for a 25 point hike taking cash to 3.35, but the risk is the statement errs dovish. A debate we think is starting to emerge towards a pause and or a flat or 25 point move at that March meeting. A final 25 point hike in March remains our base case for terminal cash at 3.6%, but we have emphasized the risk of a pause or more drawn out cycle given a similar narrative in the global Central Banking cycle, a likely peak in Australian inflation, and the lagged impacts of cumulative tightening thus far.
Simon:
Finally, Rob will finish up with Australian market views.
Rob:
From the market side, [inaudible 00:21:30] position depends heavily on timeframe. Over the course of 2023, in line with our macro views, we think yields will trend somewhat lower. Over a more tactical time horizon though given RBA, terminal pricing has fallen from almost 4% a month ago to just 3.55 or so today. We'd probably prefer to be short. The market's only got 18 basis points priced in for Fed and less again for March versus our expectation, the bank hikes 25 basis points at both meetings. But then, at an even more micro timeframe level, heading into tomorrow's CPI, we think the risk is a lower print, especially on the core side, so we're weary of getting short too early ahead of that. Marrying all those views up, we'd thus prefer to be long or neutral into CBI and then use the softer print to enter tactical front end shorts. Thanks.
Simon:
Thanks, everyone. We'll talk to you again in two weeks.
Speaker 8:
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