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.
Jason:
Hi everybody, and welcome to the February 21st edition of Macro Minutes called Fooled by Lags with a big question mark. I'm Jason Daw, your host for today's call, which we're recording at 9:00 AM eastern time on February the 21st. So since our last call two weeks ago, fixed income markets have accelerated their selloff. We've had 15 basis points that have been added to Fed terminal pricing, bringing the cumulative hikes over the next three meetings to almost 75 basis points. And this has also dragged up market pricing for other central banks, pushed bond yields, higher kept curves pretty flat, and introduced some modest downside risk to risk assets. To tell us if these trends can be sustained or if the market is being fooled by policy lags, on today's call, we have myself to talk about Canada and a little bit about the US, Robert on the Canadian housing market, a hot topic for investors, Blake on the US, Peter on the UK and Europe, and Adam on currencies.
So to kick it off, I'll start. So in the past couple of weeks, sentiment has swung violently. It's only been a few short weeks ago that the market was convinced that the Bank of Canada would not hike again in 2023 and that the Fed could not achieve its dots, nevermind blowing through them. And now here we are. So the market's testing whether the Bank of Canada will be able to stay on hold and is now believing that the Fed can probably hike maybe three more times and that means all the way to the June meeting, which kind of seems like a lifetime away. Now, maybe the data will justify current market pricing, but with the current information set, I do feel as though the market is being fooled by lags in the context of what's happening in North America. So normally it takes anywhere from 18 to 24 months for monetary policy to have its full impact and it's really only been six to eight months since central banks have started to hike rates aggressively.
So it's not really that surprising that some of the data's still coming in strong. And I would say that's especially the case for the labor market, which is probably the biggest lagging indicator. So if you look historically, you'll see that the unemployment rate in Canada and the US has had cyclical lows around 12 to 18 months before a recession ensues and this is because it takes time for monetary policy to work through the system. At the risk of cherry-picking, when you look at other coincident or lagging indicators, in this case in the US, stuff like manufacturing surveys, new orders, and particularly the conference board leading indicator, the signs are pretty clear. Growth is going to slow and the labor market should loosen as a result. So it does feel like the bond market selloff might have limited lags, and based on the ranges we've seen for the past nine months, we're probably near attractive levels to get long. For the Bank of Canada, specifically meeting day pricing, the small chance of a March hike that's being baked into the OAS market does seem excessive.
After today's downward surprise in CPI, we think, effectively, the chance of a March hike is zero. We find it hard to rationalize that the bank would shift gears from a pause to a hike in such a short period. Looking out further, a full hike being priced in mid-year also seems a bit rich to us and we think after the CPI report today that a 50-50 chance should be a better reflection of the probability. So with that, I'll turn it over to Robert from our economics team who specializes in Canadian housing, to tell us where we're at and what can happen going forward against the backdrop of higher rates.
Robert:
Okay, thanks Jason. Hi, everybody. I think, and you just mentioned some of the indicators that typically can lag the cycle, but this one, the Canadian housing market, has reacted very almost instantly from the Bank of Canada, which is, in some ways, a little bit unusual, but the housing market has since been in correction, and fairly significantly so, with home resales now down approximately 40% since the peak in February last year, and with the latest numbers for January still showing some of the correction being on. But that being said, what we've seen since the fall is that the rate of decline in housing, home retail activity, has slowed down, within the last four months, is that the draw from month to month has averaged just over 1% and that compares to close to 7% through the spring and summer. So there's clearly some slowing down now and in some markets, for example, in Ontario and the greater Toronto area, it looks like we've reached close to a floor here.
So our view is that the Canadian housing market is not very far from a bottom in terms of activity. However, in terms of prices, we're still seeing prices decline with a little sense that the rate of decline is slowing down, and then, we've seen that again in January. And our view is that the bottom for prices will be a bit more delayed, relative to activity. At this point we're looking at probably later, and a little bit later this year, and with still some significant risk. If, for example, if we're a little bit off on the Bank of Canada calling, the interest rates continue to rise a little bit more. Now what we're talking about here is a correction, and not a housing collapse. The Canadian housing market remains very strongly supported by fundamentals and demographics being front and center there. Very strong population growth in 2022, the strongest we've seen in decades, and we have very high immigration expectation over the coming years. No, we still see those fundamentals being present going forward, and at this point we see very little sign that the market is overbuilt.
So what we were talking, just about a year ago, about a lack of supply, will probably become an issue again, maybe a year or two from now. So what we're seeing in terms of what's happening in housing markets, it's much more of an adjustment to a higher, a tighter, monetary policy and very far from a structural change and a structural correction here. So we just [inaudible 00:07:13] kind of at the tail end of that transition. Still a few more months to go, but no. No housing collapse here. Back to you. Back over to you, Jason.
Jason:
Okay. Thank you, Robert. Obviously the evolution of the Canadian housing market's going to remain a hot topic for investors and we look forward to you joining Macro Minutes again in the near future. Now over to Blake to tell us whether Fed [inaudible 00:07:35] and the bond market has it right or wrong.
Blake:
Yeah. Hey, Jason. So I say this on a morning when we've already sold off back to the top of the ranges, but I do think that the sell off we've seen over the last week or two is near, kind of, upper bound, at least in fives and tens, probably a bit less conviction on twos here, at least until we get a new catalyst. I think we're in a bit of a lull for data, at least for the next few weeks. I think we're unlikely to learn anything from the FOMC minutes coming up. Recall that that meeting was pre-NFP, so unlikely to tell us really anything about the Fed's way of thinking after this strong data that we've gotten since NFP. And I also think the Fed have a very high bar to start talking a 50 basis point hike. The Fed, just like markets, are kind of waiting for a further catalyst.
So that kind of leaves us in this environment where I think we're highly data-dependent. Of course we're always data dependent, but I think that's even more so now with markets grappling on whether the strong January data that we've received is more a one-off and a broader weakening trend, or if this is a sign of a more lasting re-acceleration. Very near term, I think at the top of that range I do expect some modest [inaudible 00:08:46] rally to take hold. But I think it's also fair to say that we probably stay comfortably in the upper half of those November, February ranges and probably close to the top, or close to the upper end. One reason for that, I think it's very hard to restart the December, January duration demand that we saw while terminal is once again in flux. I think a necessary condition for that rally we saw in December and January was that certainty on terminal, and accounts really being comfortable that the Fed wasn't going to continue pressing rates higher.
I also think this time, cuts have been pushed out in time but they've also been priced out to some degree in this recent selloff. I think the steady state Fed funds rate that we reach in kind of 2024, 2025, it's gone from around 270 to 320 over the last few weeks. So we're not only pushing those cuts out in time, but we're also removing them to some degree. That's a bit of a different dynamic than what we saw in 2022 when we typically saw higher terminal rates be associated with this kind of hard landing, and more cuts being priced in in the back end. But now, higher terminal really seems to be going hand in hand with this no-landing possibility, and the correlation between terminal pricing and the cuts priced into the curve. So, for example, Z-3, Z-4, twos, fives, has really broken down over the last few weeks. For my part, I think strong data certainly brings terminal discussion back to life and fully puts that back on the table, but I think the pricing out of cuts is still a bit premature, or perhaps overdone, at this point.
So from here, we lean towards some short-term relief rally back towards the middle of the range, as I discussed. But even on a longer-term basis, I think we will reach terminal certainty even if this [inaudible 00:10:22] data pushes that out. I think that eventually brings back duration demand and some return of cut pricing. And these hard landing risks will continue to push yields lower throughout the rest of this year. On curve, fairly low conviction 210's, 530's, right here. But I do think there's some modest scope for that cut pricing to return, as I mentioned, because it would fade any further steepening in that kind of Z-4, Z-5 twos, fives, type of area, absent any kind of economic catalyst that reconfirm that re-acceleration of the data. But I still think that, at some point, we do get some of that cut pricing returning back into the curve, even if not to the extremes that we saw in January or even late December. And I will pause there and pass it along.
Jason:
Okay, great. Thanks a lot, Blake. Next up is Peter to tell us what's happening in the UK and Europe, and what he's thinking going forward.
Peter:
Thank you, Jason. So before I start going into any kind of analysis, it's probably worth highlighting that the selloff in bond markets we've seen was particularly pronounced in the Euro market. When you look at 10-year bond yields, we're now back at 250, so very close to the most recent highs. Moreover, when you look at the shorter end of the curve, Blake was just talking about the terminal rate. When you look at the terminal rate that's priced in the Euro market, we've pushed that to a new high. So whereas previously we were pricing at the end of the year, the terminal rate to be just above 350, now we're pricing it solidly at about 375. So after the most recent data releases, and I'll say something more about that in a second, and the relatively hawkish rhetoric that came out the ECB, we've really accelerated that process once again.
So what has led us here? Well, I mean Jason was saying earlier that there's a bit of a discrepancy between forward-looking indicators and backward-looking indicators. That's less the case over here in Europe. Quite to the opposite, I would say. The backward-looking indicators, particularly the labor market, remains very strong. But most recently, the prime forward-looking indicators that everyone is focusing on, the Purchasing Managers' Indexes, the PMIs, they have started to rebound quite vigorously. And now that's not totally surprising because they were at really low levels going into the winter when the threat of energy shortages was all the rage, and that has dissipated, and now they're rebounding and that should have an impact, of course, on the economy. And the real activity data that came out so far has also been stronger than expected. So clearly that leaves the ECB a little bit in a conundrum because, on the one hand inflation is coming down but the activity data is stronger and it's stronger than they were expecting.
And, potentially, that implies that inflation remains at levels that they feel uncomfortable with for longer than expected, and hence the hawkish rhetoric that we've seen most lately pushing the market. So where does that leave us? Now, at the moment, we are still inclined to think that with 375 implied, the odds that this could be significantly advanced from there seems low. But obviously that was the case already 25 basis points before, and the market has sold off nevertheless. But still, it looks about right to maybe a little overdone, to me. Also, so far, the range for the longer end of the curve, for the 10-years in particular, has held. So we haven't printed a new high, we haven't broken out to the upside. And for the time being, I warn everyone that in a sideways market, typically, when you approach the boundaries of the range, it always feels like you're breaking out.
Having said that, we remain very attentive, because, as I was saying earlier, if there is a place in the economies that we are focusing here at RBC where you could say there is a justification from the data, it is probably in Euro area. So in terms of trading strategies, for the time being we remain content with what we've been recommending for quite a while, namely credit longs at the shorter end of the curve, even though that hasn't really performed that well lately. We also recommended for quite some time, and that has worked quite well, asset swap tighteners against the backdrop of relatively high issuance that comes out of pretty much every quarter in Europe, and that has, probably, further legs to run. Now, as far as duration strategies are concerned, I think I would probably hold back for the time being and see if we can manage to break out. But as Jason was saying, when you look at our forecast grid, we also think that the ranges here in Europe will hold and that this is probably more of a tactical opportunity on the other direction. But that's not something that I would currently strongly recommend. My conviction at this stage is just not high enough. But maybe in two weeks time that will be different. And with that, I'll hand you back to Jason.
Jason:
Okay, thanks a lot, Peter. Last but not least, Adam Kohl on the currency market.
Adam:
Thanks Jason. So it seems pertinent for me to add the Bank of Japan to this debate, not least because that's a central bank where change definitely is coming in the form of a new governor that we now know the identity of, and Ueda, the incoming governor, speaking really for the first time for quite a few years late this week when he speaks at his hearing in the lower house of Parliament. So change is definitely coming at the Bank of Japan and markets are positioned for that. Where I think market positioning is quite wrong is what the implication of that change is for the currency, for the yen, where yen bullishness is one of the most crowded positions in current terms of both investors' and analysts' expectations. So I think the message from Ueda will be, "Normalization is coming in Japan," that further widening of the yield curve control band is likely, and at some point complete abandonment of yield curve control is ultimately where we're going.
The question is, is that game changing for the yen? And I think, for two reasons, it probably isn't or less so than is generally perceived. Firstly, I think JGB yields are not far, already, from where they would be in the absence of yield curve control. Looking at other points on the yield curve where the BOJ is not active, or looking at other low yielding markets, JGB yields I think are probably not far from equilibrium already. So the yield curve controls is increasingly a non-binding constraint. And secondly, when change does come, it will come gradually, consistent with Ueda's pragmatic approach to economics that he revealed when he was last on the policy board. Given that, as I've said on this call before, I think, by far, the more important revolutionary change in policy is what the changes at the Fed and the ECB have meant for domestic investors in Japan is more important than the relatively mild changes in long-term interest rates in Japan.
The great irony for me, as far as the yen is concerned, is that the policy action from the BOJ causes large shifts in positioning on the part of foreign investors, who I think [inaudible 00:18:07] short dollar-yen and short JGBs, whereas the flow on the part of Japanese investors is dictated much more strongly by policy developments outside Japan. So BOJ drives foreign flow, Japanese flow is driven mostly by foreign central banks and to the extent that they are still dollar-yen buyers, ultimately, that's the trend I think that will likely reassert itself in the longer term. How do we trade that? Dollar-yen has a lot of dollar direction, of course, it also has a lot of imported equity direction. So the way we've expressed this in our strategic views for the year, and also tactically in short-term trade for the week, is to play the weaker yen view versus the Swiss Franc. So, knocking out some of that dollar directionality, knocking out some of the equity correlation and making that a cleaner play on yen direction in isolation. And with that, back to Jason.
Jason:
Okay. Thanks a lot, Adam, and thank you, everybody, for joining this edition of Macro Minutes. Investors do continue to heavily debate the path of policy rates, whether central banks are on hold, going to cut later in this year, or hike more, and this does make 2023 a challenging environment to deploy risk. We're probably in a tactical market for the next little while as investors grapple with this uncertain macro backdrop, but with a structural drift lower in yields once the market's convinced that central banks are finished. So stay tuned to our publications or reach out to us directly in the interim for additional insights on what we're thinking.
Speaker 7:
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