Speaker 1:
Hello and welcome to Macro Minutes. During each episode we will 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, everybody, and welcome to the December 6th edition of Macro Minutes called Final Countdown, so this is going to be the last episode of this year. It's going to focus on near-term central bank rate decisions and the outlook for 2023, so we have the Bank of Canada on tap this week; the Fed, Bank of England, ECB next week; and how high rates will go, whether there'll be a quick U-turn to rate cuts in 2023 and if so by how much, as a central theme for markets that's going to influence not only yield levels and curb shapes but also will be important for the currency market and broader risk assets. So to help us navigate the uncertainty on monetary policy, macro, fixed income, and currencies we're joined today by Simon, who's going to cover some stuff on Canada; Blake on the US; Peter on the UK and Europe; and Elsa on currencies. So to kick it off I'm going to turn it over to Simon on the Canadian macro look.
Simon:
Thanks, Jason. Yes, I'll discuss what we see for Canadian macros, so give some recent developments and also our expectations into 2023. So definitely we'll start with inflation. So headline inflation peaked in June, 8.6%, most recently at 6.9% for October, so definitely still elevated. What we would say, and what we've seen, is that in some of these shorter term inflation measures, so we like to look at three-month annualized measures for core measures, so both the Bank of Canada's CPI trim and CPI median, as well as more exclusion-based measures, like exclude in energy. We're seeing those three-month annualized rates moving sub 4%, so while not job done it certainly is providing some encouraging signs on inflation moderating and underlying inflation moderating, which is exactly what the bank would like to see.
In terms of our outlook for 2023 we should see headlines a fair bit lower in the first half of the year as energy-based effects come off. So, for example, it should have a three handle in Q2 and then move sub 3% for headline in the second half of next year. However, we do expect underlying inflation to be stickier. So, for example, we still see CPI excluding energy above 3% at the end of next year.
One of the main risks to inflation, certainly from the domestic side, is wages. And so in terms of the labor market what we've seen, if you aggregate since the summer, roughly flat on the employment side. And in terms of the headliner, the main employment report that's followed the Labor Force Survey, wage growth has accelerated, so it's around 5.5% year on year.
Now what I would say on that is that other wage measures, and the Bank of Canada certainly will look at a suite of wage measures, are showing wage growth still on the concerning side but not as high as that. So, for example, the productivity accounts at 4.5% year on year and also the more lagged payroll status showing the fixed industry wage measure at around 3.5% year on year. So while still concerning and still definitely the main domestic inflation risk that LFS measure is looking on the high side, relative to other wage measures.
Into 2023 we do expect the unemployment rate to move higher. It's a historically still very tight 5.1% after last Friday's data. We expect it to move into more the 6.5% to 7% range by the end of next year, which would still be historically quite low, especially given that we do anticipate that we'll have a recession in the first half of next year.
So on the GDP side the most recent data, Q3, came in stronger on headline plus 2.9%, so really not much of a moderation from around ... Or just over 3% in the annualized in the first half of this year, but the details were definitely soft. So, for example, final domestic demand coming in negative territory, and not including both residential investment and household consumption while net trade was really the main upside.
For 2023, and really where we are now as well, we're expecting Q4 2022 through Q4 of next year really, essentially, to be flat growth. We do have a mild recession forecast from our economics team in Q1 and Q2 but essentially it's flat growth and there's no big boost in Q3 of next year after that, so definitely that softer growth environment is part of what should help underlying inflation move lower as 2023 evolves.
And, finally, I'll just give some thoughts on the housing market. Now definitely we've seen a fair bit of softening here over the past six to eight months, both in terms of benchmark prices and also activity, so unit sales. Our baseline expectation is definitely that there's more moderation to come. We've certainly seen a large amount of it, so benchmark prices are down in the area of about 15% from the peak but still well above pre-pandemic levels. So we do expect some moderation to come, especially given how rate hikes flow through into mortgage costs and impact households, but that's something to watch, in terms of the timing into next year. But certainly some more moderation to come from the housing market. And with that I'll turn it back to Jason.
Jason:
Okay, thanks a lot, Simon. So I'm going to discuss Bank of Canada policy next. So obviously the key near-term event for Canada is the Bank of Canada meeting on December the 7th. We do expect a 25 basis point rate hike, bringing the policy rate up to 4%. From a probability perspective we give 70% chance to a 25 basis point move and a 30% chance to a 50 basis point hike, so from our lens another step down does make sense. The data softening, as Simon mentioned, housing is slowing, domestic demand has been week. And I would say also for reference, consensus is relatively split, as far as this Bank of Canada meeting, but most of the major local banks are in the camp of a 50 basis point hike while the market pricing is favoring a 25 basis point move.
I think importantly in past policy statements the bank said that the policy interest rate will need to rise further and this time they could possibly soften the language a bit by saying rates may or likely will need to rise further, and this could provide them with optionality for the January meeting between a no change and a 25 basis point move. I think also importantly the meeting this week it's not going to indicate a pause in the tightening cycle. They're not going to tell us that until they're finished, basically until the meeting where they do not deliver a rate hike. So the last thing that they want is a preemptive easing in financial conditions to occur.
So our base case scenario is that this is going to be the last hike in the cycle, with terminal being at 4%. [inaudible 00:07:29] could be at 4.25, so there could be a residual 25 basis points in January, and as a less likely chance the policy rate getting to a 4.5, but if we're wrong on the 4% terminal it's probably going to be because the bank elongates the cycle with additional 25 basis point moves early in 2023 instead of doing a 50 basis point hike this week, in our opinion.
Now looking into 2023 our forecast do assume that once the bank reaches terminal that this level is going to be maintained throughout 2023 and we give this a 60% chance. The next most likely outcome is rate cuts in the second half of the year, which we give a 25% probability to. These would most likely be corrective cuts from very restrictive territory to a lower level that's still above neutral. And also in that context for next year the chance of rate cuts in the first half of the year are very, very low and if anything it would be a second half story. The least likely scenario, from our lens, is rates getting above 4.5%, either through the current hiking cycle extending longer and farther or by the Bank of Canada pausing in the rate hiking cycle and then hiking kind of later on. So we don't think that that situation is the most likely and, again, the most likely in our opinion is the policy rate staying at a high level throughout 2023, and the second most likely is some corrective cuts in the second half of next year.
So next up is Blake to tell us about the Fed and the US bond market.
Blake:
Yeah. Thanks, Jason. So, look, when we look ahead at 2023 we really see it kind of divided into two parts at this point, of a very indeterminate length. The first we really see is kind of a carryover of 2022, meaning inflation remains high; terminals still potentially moving higher; the curve is still hitting new extremes of inversion; any kind of rallies, steepening of the curve, are very fragile, easily undone by inflation beats or hawkish Fed developments; and against that backdrop duration demand remains sidelined and the pain trade likely still remains flatteners.
At some point though we do move into kind of a second phase of 2023, which we see as the real 2023, if you will, and that's where we've got a Fed on hold and the market can really more fully turn their focus from this terminal story to the cutting cycle, in the shape of any economic slowdown that does pick up in the year. The real questions there will be when does the cutting cycle start? How aggressive is it? What level does the Fed reach a steady state? Those are the kind of questions that will determine the shape of the curve and direction of yield moves.
For our part we see a period of relatively tepid but not exactly terrible growth, moderate inflation, modestly rising unemployment, and all of that will serve to push rates lower and the curve steeper. But the question looking ahead is really how do we move from this carryover of 2022, this first part, to the second part? Markets really need a clearing event that gives them the green light to move more fully into that second stage. Our expectation is that comes relatively soon. We see a continuation of the moderating inflation that we saw in October and we think the Fed's going to continue further stepping up a pause, with terminal rates in the 5% to 5.25% range by the end of Q1. That would be consistent with step down to 50 at the December meeting, which is all but locked in at this point; another 50 at the February meeting, a step down to 25 in March, and then a pause thereafter.
Given that Fed outlook, in our head we tried to recommend positions that were more focused on the post-terminal longer term second half of 2023 but that still tried to offer some reduction and exposure to a higher terminal prolonged Fed hiking cycle until that clearing event that we're looking for comes. Hopefully that occurs within the next several months, but should that get pushed out that could present a lot of risk to the kind of trade that you would like for the second part of 2023, curve steepeners, long rates views, et cetera.
Next week I think we're going to get, hopefully, a fair amount of clarity on that front. We've got CPI on Tuesday, FMC on Wednesday. This is going to be a very crucial CPI print, another low print in the .2, .3 month over month core range would go a long way to confirming the more sustained slow down inflation that we're expecting is starting, but if we bounce back up to that .6, .7, even .8 type of level that we've seen over the last year that would really reject that theme and make October ... That October print look much more like noise in the midst of a very still sticky high inflation backdrop, so a very kind of crucial CPI print for either confirming or rejecting that we are seeing a more sustained slow down.
And then the next day we get the Fed. Keep in mind that this will include FEP dot updates and we have been told by Powell, and others, that that dot plot is likely to show a higher terminal rate but what we don't really know is how high that has been revised up. If it's in line with our expectations, in that 5 to 5.25 range markets are still pricing slightly below 5%, so there could be some surprise there. And, on the other hand, if they are to move up a lot less than we are expecting, if they do stay in that sub 5% range, that would be a big shock to markets who I think are expecting something higher and also would, I think, kind of move to give that clearing event to markets and kind of confirm that the Fed is not looking to prolong the hiking cycle, and continue to allow terminal expectations to slide higher.
So a big week next week, some data that I think will really go a long way towards determining when we're going to move from this carryover of 2022 into what we consider the real backdrop of 2023, with the Fed on hold; and markets really starting to look ahead and position for an eventual cutting cycle, and potential economic slowdown. And that's it for me, I'll pass it along.
Jason:
Okay, great. Thanks a lot, Blake. Now over to Peter to tell us about the UK or Europe.
Peter:
Thank you, Jason. Thank you, Blake. So first of all what I'm going to do, given that this is the last meeting or this is the last call of the year, we have still one Bank of England and one ECB meeting outstanding. We expect the following for the bank: to raise rates by 50 basis points, for the ECB to raise rates by 50 basis points, in both cases that's a step down from the 75 basis points that we've seen. We expect a further step down going into '23, in both cases to 25 basis point increments, which will see the peak at 375 for the Bank of England and we expect another 25 basis point rate hike after February and for the ECB to peak at 250.
Now what we also think is going to happen, basically because the ECB has told us so, is that they will give us, at the very least, an outline of what QT in euros might look like. We have put forward the thought that they will probably start in April with a 20 billion passive QT program, so very similar just to the conduct of what the Fed is doing, just at smaller scale. Keep in mind they are only targeting one of their portfolios, the ATP and not the PAP, so therefore the sizes are smaller at this stage. So that's what we expect in terms of the concrete outcome.
However, I would also like to do the following quickly and run you through our thoughts, at least for the first part of the year. We think that inflation, at least in euros, has probably peaked. We had the first inflation print that came in lower than the previous month at 10.0, still high levels but lower than before and going forward that's probably going to continue. Now the market is expecting something like that but if inflation falls sharply, in the first half of the year, and we think it's unlikely for markets to be able to focus where inflation will fall to and the only thing that they can see is that we're coming down from these extremely elevated levels. It's basically a base effect story on MG. But in this environment, particularly as we're probably already in a recession and as the central banks are reaching the levels that terminal is currently pricing or even stays slightly below that, we reckon that the front end of the curve should stabilize.
In fact, that has happened already. What we're currently seeing is that the terminal rate in euros is stable and sterling it has even come down from the extremes that we've seen earlier this year, but implied volatilities or expected volatility is still very high, so we expect as the stabilization continues at the year end and beginning of '23 that the expected, and realized, volatility will come down. For us what that means is when you look at the yield levels that are currently trading, particularly in the spread markets, be that in SSAs or be that in pure credit, that those levels are so attractive that by and large the expectation should be that with a carry that you're accumulating the adverse market moves that would be required to destroy your total returns would have to be very large, unreasonably large we would suggest, and therefore we have recommended as one of our key trades going into '23 to be outright long at the short end of curve, particularly in spread space and credit, in the two to three part of the curve. That's one of the things.
We also, as I just said, have recommended selling volatility and certainly setting straddles, and setting strangles. We have recommended as an example trade to do that on the Shaft contract because it's quite liquid, so that's another opportunity that we see.
Last but not least what I would mention is that further out the curve we think the situation is a little bit more tricky. It's unlikely, in our view, that the European central banks, be that the Bank of England or the ECB, will be lowering rates. In fact, given that interest rates stay significantly below levels that we see in the US the risk is probably, if inflation does not fall where the market prices it towards the end of the year, are a near target and that they remain on the hawkish side.
On top of that implied inflation is relatively moderate, relative to target in both cases, and we're going to see a fairly significant turnaround in net supply that needs to be placed in the market, particularly as the Bank of England has already started the QT program and that ECB is likely going to do so. And that, in our mind, will also put upward pressure on swap spreads, which by the way is another key trade that we have on our books for '23 and therefore we are not necessarily convinced that the same opportunity exists at the longer end of the curve as it does at the shorter end of the curve.
And with that I'll probably leave it but I encourage everyone to read our outlook piece that we labeled From Turmoil to Stability and published last Friday. And with that back to Jason.
Jason:
Okay. Great stuff, Peter. Now over to Elsa to tell us about the currency market.
Elsa:
Thanks, Jason. So from our perspective we published our 2023 trades on the 1st of December and I just want to run through some big picture themes. So as many of you will know we've been long dollars for the last two years running now, long DXY was our top trade both in '21 and in '22, and we thought long and hard about what to do with the US dollar in '23.
If you read South Side Research out there there is a very, very strong consensus that the dollar is going to go down. Almost everybody thinks it's a no-brainer to just be short dollars into next year and I think clearly there are many reasons why one would argue that the dollar may have peaked but with the information set we have at the moment we'd argue it's too soon to tell and there is a real danger that South Side analysts are premature in calling the turn in the dollar, as they have been many times before. And like many things, like a stopped clocked, they will eventually be right but I think when you've been wrong too many times, before eventually being right, it does lose it's value.
What we're looking to, to determine the direction of the dollar, is some clear indication of how inflation is panning out and we don't see that much value in piling into what is likely to be a very crowded trade in the first month of the year, that may well reverse for the remaining 11 months. Instead, we focused a lot of our attention on relative value trades for '23. Some of the trades we particularly like in G10 space are long euro sterling and long Swiss yen. And then in EMG10 cross we've got short CAD-MEX, a lot of carry still an offer with long MEX and we think short CAD is a very efficient way of funding that. Within relative value in the Asia space we've got long Korean won against the Singapore dollar. Another technical trade from our technical analyst George Davis, which is short CAD career. And then really just rounding it out with a short C set basket from our Asia strategist Alvin Tan. So a lot of relative value themes to play for.
I think on the dollar front we may well have [inaudible 00:21:10] signal within the first few months of the year, but one of the last trades we've added to our list is our January reversal trade and I think this is really highlighting how we think markets are in danger of trading for the year ahead, which is that people pile into some very crowded positions in the first month; those get overextended; and then typically if you do the complete opposite, through February and March, you have both a very high hit ratio and a very positive return over the long run.
I'll leave it there, but do encourage you to look at our Total Effects piece and come back to us with any questions. It is a place where we are differentiating ourselves from the rest of the South Side. We think there's a very valuable conversation to be had, both around the dollar and around the relative value trades within FX. Over to you, Jason.
Jason:
Okay. Thank you everybody for joining this edition of Macro Minutes. 2023 could turn out to be as challenging as 2022, as markets transition from higher rates to the next stages of the policy cycles, which could ultimately show significant cross-country differences. So this is going to be our last Macro Minutes episode of 2022 and we will look to connect again early next year, but between now and then stay tuned to our publications or reach out to us directly in the interim for additional insights.
Speaker 7:
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