Speaker 1:
Hello and welcome to Macro Minutes. During each episode, we'll be joined by R B C 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 will be your host for the day. The title of this call is Higher, wider, steeper. What is the Bond Market Seller tell us? And bond markets have been pushing higher, yields have been pushed higher curve steeper. And the question really is why it appears to me that it's a combination of other than expected macro data, particularly labor market data in combination with central bank communication, that rates will be held around present levels for longer than previously expected. And that's leading to a repricing initially at the US money markets that have started to unwind some of the implied rate cuts already as well as longer dated forwards generating then upward momentum in bond yield along the yield curve. The risk at the moment is that that not only continues out of the US market, but probably also spreads into other markets, most notably here in the European time zone where I'm sitting, where precious little of the rate cut so far have been priced out despite the same rhetoric that we get from E C B or other speakers.
Meanwhile, I also think that we have quite a bit of lopsided positions, a lot of particularly real money accounts that we have spoken to have been sitting in long positions in the bond market and probably need to scale some of that back over the last weeks. And I also think there is a fear of supply indigestion really getting hold, and that particularly last piece I think also leads to a development of res steepening of the curve. And then just to add the final piece to the jigsaw, the developments in the yen market are also getting quite a bit of attention and I know that investors both in Europe and the US are a bit jittery about this and the fears of Japanese yen intervention make the round but also worries about substantially reduced investments from the Japanese investor community To make sense of this all today, and once again joined by a very notable host of R B C experts on both bond and FX markets.
But before I go over to them, I just thought it is very pertinent given the unfolding situation in the Middle East to just share a word or two on what that might or might not mean for our markets over here. And I'll draw a great deal on a call that our commodity strategists held just yesterday with clients. First and foremost though, I would like to express my deepest sympathies for everyone who is directly or indirectly impacted by the events. And personally, I also have to admit that I find it sometimes difficult to relate to market implications when you have to watch these horrifying pictures. But nevertheless, that's what we are here for today. So first of all, I would argue that the market direction that we have seen yesterday, classic risk off move should only be sustained really if the situation becomes even more difficult and potentially spreads to other countries and across the region that isn't necessarily a given that it's not going to happen, but it might well be avoided.
Secondly, as our colleagues have argued in their call yesterday, the most direct implication for our market is through the oil price. We have seen an increase straight away on Monday and it hasn't been really reversed in full yet. And the immediate question I guess to ask is whether Iranian barrels stay in the market or whether Saudi Arabian barrels will be brought to the market in more quantity. The letter of course is made much more complicated by the fact that the potential deal between Israel and Saudi Arabia doesn't seem very likely to come to fruition now and again, so that probably has after effects as well. But again, the key question to my mind is whether the situation can be contained in the near term or not. And given the severity of the situation, the market movements so far have been relatively limited. That all being said, back to the behavior of the market from the beginning, and as I was just saying, I'll turn over to our experts now and I'll start with Izaac Brook who will speak about the US market. Over to you Isaac.
Izaac Brook:
Hey, thanks Peter. So yeah, I'm going to talk a little bit about the US selloffs and where we think things currently stand. So in the past we've liked to break down selloffs into three parts, the fundamental, the technical, and then what we call the aimless wandering. So the fundamental leg here began on the back of stronger economic data and supply concerns over the summer that shifted to the technical post September F O M C, where we had a hawkish fed keeping buyers on the sidelines and longer end yields breaking through key levels to decade plus highs. And we think that the breaking through those highs put us into the aimless longing territory. There's nothing left to cling onto in the form of support or past levels to look to. So the buyer's strike is only intensified and yields have continued to push past what we see as fundamentally justified.
The real question is where to now. So in our piece last week we had flagged three potential catalysts that we thought could help trigger a reversal, one bad data, two, something breaking including geopolitical risks and or the Fed getting nervous about the long end move and what it might mean for financial conditions. And the latter two of those have been born out to some extent over the past few days. Clearly emerging geopolitical intentions in the Middle East have prompted a flight to quality bid overnight, although some of that move has already retraced today. It also seems that every day in the past week or so we've had another fed speaker come out and say that the long end move might mean they're done tightening. And we've heard that from both hawks and dubs, which I think is especially interesting. Yesterday we had Laurie Logan, who notably was the first to introduce the concept of a rate skip back in May.
And she said if the move here in the long end is a term premium story, then the Fed would have less need to tighten again. And we subscribed to the belief that this is a term premium driven move. So while our call has long been that the Fed has already done hiking, the long end move and the recent Fed speak around this has only increased our conviction there. So from where things currently stand, seems to us the sell off momentum has been slowing thirties tested and rejected 5% twice last week, both times prompting a pretty strong reversal rally. When you combine that with flaring geopolitical tensions and a Fed that's sounding increasingly aware that the long end moves are doing some of the tightening work for them, we think the bias could begin to shift back towards lower rates or at least sideways chop around current levels rather than reducing the risk of breaks to new highs. Of course, with fed minutes c P I data and long end auctions all due this week, there's certainly event risk remaining and we think that rates markets will remain jittery in the near term. Thanks, and I'll pass it back to you Peter.
Peter Schaffrik:
Thank you Izaac. And for everyone who has not seen the note, Izaac just omits that the title is extremely catchy knife catchers wanted. So please be on the lookout and take a look for that. I'll hand it over now to Simon who's going to speak about the CAT market.
Simon Deeley:
Thanks very much, Peter. Yeah, I'll compare and contrast the situation in Canada with the broader global macro picture around higher yields and steeper curves. The first thing to note is that Canada curves have mostly steepened, especially two 10. So that's gone from minus 1 0 4 to minus 77 if you're looking at the swap market. But relative to the US, Canada curves are quite flat. So if you look at twos tens core versus S O F R, we're at minus 27 beeps from a sideways trend really around minus 10 beeps through early September. So general situation Canada curves are steepening, especially outside of the very long end, but we are steepening less than the US related to this supply picture in Canada is not the same as the US in general, G O C issuance has been focused on twos and fives and even especially on bills as well.
While 30 year issuance has been especially quite light, so it's tracking to just 10 billion for the fiscal year. So it could end up a little bit higher than that. Fiscal risks are present. So deteriorating G D P growth around flat in Q two and tracking that way in Q three do impact federal finances and alongside we have the potential for additional spending measures as well from the center left government, the possibility of C M B issuance. So Canada mortgage bond issuance rolling into GCs is lingering in the background as well, but it is far from a done deal at this point. So that program has recently upsized to up to 60 billion per year from 40 billion per year. So the overall picture has fiscal risks, but generally not as concerning and not as much upside to issuance as in the us. The higher for longer theme in Canada makes a lot of sense to us and we have long argued against early rate cuts.
We currently have a first cut in July next year, but we will need to see better recent trends on the wage growth and core inflation side in order to get there. Indeed, these factors are moving higher on shorter term metrics in the most recent reports and these are the biggest risks that could even lead to the B O C delivery and another hike even at G D P softens and the unemployment rate trends higher. Next Tuesday. C P I report will be the last major release ahead of the October 25th B O C meeting with the VOCs own business and consumer surveys the day before the C P I report providing very timely updates on the expectation side of the equation as well. And with that, I'll flip it back to Peter.
Peter Schaffrik:
Thank you Simon. That's very insightful as always. We're moving geography now quite substantially and I'll hand it over to Rob Thompson who's going to eliminate us how the situation unfolds currently in Australia. Over to you Rob.
Robert Thompson:
Hello and thank you, Peter. I'll leave geopolitics aside for my segment instead give more medium term take on this Australian fixed income market. To start off, I'll have to note it's been something of a passenger to other markets ever since the RBAs last hike back in June. And since then it's been four meetings with four on hold decisions keeping the policy rate steady at 4.1, including at this month's meeting where the new governor Michelle Bullock took the reins. The accompany statement was actually so devoid of changes relative to Septembers that the main message we took away is that Bullock was trying to make a statement about continuity and avoid being immediately bracketed as moral or less hawkish than the previous governor low. So the R B A has given us relatively little to play with slightly on the policy rate front, but where it gets more interesting for markets here is how it's led us to price the Aussie curve shape relative to the rest of the world.
Our benchmark two is tens curve for instance, remains much steeper than peers and in fact it only briefly went inverse at all getting to negative 20 basis points back in June and July briefly. At the moment it's plus 50 basis points, so well above treasuries, g cans, balloons and so on, which makes the Australian long end look optically very attractive on carry grounds. But this comes with a bit of a warning. So the frontend element of this divergence makes a lot of sense. The RBA a's not going to hike to 5%, we don't think so short end Aussie rates probably will stay lower for some time, but figuring out where the belly and backend of the Aussie curve shape should price is the million dollar question here for us. So if we look at the Aussie versus US tenure nominal yield spread, for instance, it's about negative 17 basis points.
This is a much less extreme spread than at the front end, but we have been arguing for some time that this tenure spread should move positive because the RBA is introducing additional inflation risk by keeping rates slower than elsewhere and thus tolerating slower return to in target inflation and quite explicitly doing so. In fact, if we break the 10 A, the US spread into break even inflation versus real yield components, Aussie tenure breakevens are about 20 basis points higher than treasuries and applying higher inflation over that time, which is reasonable, but we think that a bit more can be factored in on this. But what this means is though, given breakins are above us breakevens, it's the real yield spread that's driving this expensiveness of Aussie 10 year bonds compared to treasuries. So the real yield spread has actually reached about minus 50 basis points, which is pretty much as big a difference as we've seen since the G F C. We acknowledge it could go a bit further on relative supply dynamics with Aussie bond issuance remaining very low versus a much more imposing treasury supply task. But the key point we want to make here when looking at these relative curve shapes is that when this real yield spread finds a base, we then expect 10 year Aussie bonds to start underperforming treasuries again, which in turn will keep Aussie curves we think relatively steep for the near future. That's all for me today. So back to you Peter. Thanks.
Peter Schaffrik:
Thank you Rob. That's great. Fantastic, great insight as always. And then last but certainly not least, I'll hand over to Adam Cole who's going to speak about the FX market and potentially also about the implication, particularly out of Japan. Over to you Adam.
Adam Cole:
Thank you Peter. So as Peter mentioned, there are two potential conduits from Japan into the global bond market conundrum at the moment, the first via the private sector and the second via the public sector. So on the question of whether the, particularly the rising, the cost of hedging foreign bond positions is sufficient to discourage Japanese investors to the extent that they become net sellers of foreign bonds and to the pressure on yields to the extent that that happens, I think it was largely last year's story. So in 2022, Japanese investors were net sellers of 24 trillion yen, 185 billion roughly of foreign bonds in 2023, they have in six of the eight months for which we have data so far been fairly substantial net buyers of foreign bonds.
And that went on right up to August the latest data that we just got this morning. So the liquidation I think was probably last year's story. What we are seeing this year is that Japanese investors have greater ability and greater appetite for taking currency risk than is often perceived. And I think it highly likely given that virtually every major G 10 bond market is now negative yielding in currency hedge terms, I think it highly likely a lot of that bond buying is unhedged. And so is generating yen selling another fundamental flow that's keeping the entrenched weaken in place. So I think in terms of the private sector flow, to the extent that Japan contributes to the upward pressure on yield, that probably mostly played out last year. And then on the public sector, clearly there is a concern that if the Bank of Japan intervenes on behalf of the Ministry of Finance, again the counterpart to buying the end and selling foreign currencies would be liquidating foreign asset positions, primarily US treasury positions.
And that is mechanically almost certainly true, but I think it needs to be kept in context. And the Bank of Japan's and MFS objectives I think are strictly limited in terms of what they can achieve in intervening very little chance of them turning around the trend in the end, and this is not a return to the early two thousands when the B O J were very, very active in FX markets multiple times each week. Their objectives are much more limited in terms of slowing the pace of depreciation and managing volatility in the currency. So I don't expect to see the B O J active in the FX market at a high frequency though intervention risk clearly as we push up back up towards the highs in do end is there. It needs to be kept in context and as I say, this is not a return to the early two thousands when the B O J is there day after day. And with that back to Peter.
Peter Schaffrik:
Thank you very much Adam. So if I wrap it up here, we've clearly been pushing bond yields to very important levels. The question is whether we get some knife catchers who would be willing to buy at levels, but clearly the underlying risks remain as well. Simon has been pointing out that we will get more central bank action potentially, or at least sort of not the implied cuts and that the market has been pricing and I guess over the next coming weeks and months, the strength of the underlying data is going to be one of the things that has to be watched extremely carefully and will be guiding us, not withstanding the near term geopolitical risks that we talked about at the onset of the call. With that, I'll close the call. I thank you again for listening in and I hope to speak to you again next time. Thank you.
Speaker 7:
This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.