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.
Jason Daw:
Hi everybody, and welcome to the March 21st edition of Macro Minutes called Humpty Dumpty. Um, I'm Jason dah, your host for today's call, which we're recording at, uh, 9:00 AM Eastern Time on March the 21st. So it might be an overly simplistic argument, but in hindsight, it should not be surprising that aggressive fed hikes have broke something in financial markets and policy actions to ring fence. The problems have been fast and furious, but, uh, the question is, can all the kings, horses and all the kings, uh, put dislocated markets, uh, back together again? So, on today's call, we're gonna discuss the, uh, current situation for, uh, European and US credit, uh, macro and monetary policy. So we're joined today by, uh, Cola Dransfield in our, uh, European financial, uh, credit, uh, strategy team, Adam Jones in US Credit trading, Tom Corelli in US economics, uh, Blake Wynn in US rates, uh, Peter Schaffer in, uh, UK and Europe Macro Rates, and Adam Cole on currencies.
So to kick off, uh, today's discussion, I'm gonna talk about some high level points on macro and policy. Uh, the first one is, is that, uh, policy actions are working to some extent, and I think the good news is that, uh, financial stability concerns, uh, have been limited to certain areas such as bank credit, government bonds and bank equity, and the contagion to other asset classes has been, uh, pretty limited. The bad news, in my opinion, is that the bounce that we've seen in, uh, dislocated, uh, assets, uh, has been pretty small so far relative to the aggressive policy actions taken so far. And I think the longer the markets, um, you know, fail to mostly recover the moves, uh, since March 8th, uh, the more worried we should be. Um, I would say one item to watch, um, is the news, uh, today that the US is exploring ways to guarantee all deposits in the regional banking system, and this would surely be a game changer given.
Um, you know, one of the big underlying risks for financial stability right now is, uh, deposit outflows. Um, on my second point, um, you know, the economic damage, you know, is real. So smaller banks in the us, they have been an important contributor to bank lending, outpacing that of larger banks, uh, the last few years, and especially in areas like, uh, commercial real estate, which was already, uh, in a bit of a vulnerable position. So, uh, with lending standards already tightening significantly, uh, this is a new, uh, downside risk, uh, to economic activity. But I would say though, with everything going on in the us, uh, the situation in Canada has been, uh, calmer by comparison. Um, bank stocks, they have been dragged down, uh, by the us, but they have significantly, uh, outperformed, uh, their US peers. And at the end of the day, uh, Canadian, uh, banking, uh, does not face the same problems as the US uh, banking sector.
Now, even with the new, um, downside economic risk, uh, probably emanating from the us the chance of near term rate cuts in Canada. Um, so the markets pricing these by July, uh, seem quite low. At the end of the day, macro simply doesn't support it. And, uh, for rate cuts to be justified, I think would require the worst case scenario, uh, for financial stability unfolding. Um, so there's probably value there in fading, uh, tail risk scenario rate cut pricing. And the last point I wanna make is that a lot of the move in fixed income, uh, has probably been due to positioning. Uh, we saw record shorts in US futures, and those collided with one of the biggest rallies that we've seen in the bond market on record. Now in Canada, uh, 10 year yields are about 25 basis points, uh, too low based on market pricing for the terminal rate and, uh, rate cuts. Um, so while we've been bullish on duration in 2023, uh, there is little value in being, uh, long at these levels and risk reward, probably fa favors, uh, paying for a bounce. Um, so now on to the fun stuff. Uh, next up is, um, uh, Nicola, um, who will, um, tell us what's happening in the European, uh, financials credit space?
Nicola Dransfield:
Yep. Hi everyone. Um, I just wanted to talk through real quickly about what happened with Credit Suis and, and kind of where we've ended up, um, the starting point here. I think what we need to remember is that Credit Suis was a highly problematic bank to begin with. Um, the group was in the middle of a restructuring. There were already a lot of questions going around, whether they'd be able to execute those successfully while remaining a viable operator. Um, on top of that, there were issues at the bank around risk controls, um, as well as outstanding litigation cases. Now, if we take a step back and we think about, um, the year so far, um, before SVB or any sort of issues at US regional banks, investors were very positive on European banks, um, and a number of them were overweight in the space. Um, and you know, this really made sense to us because we are finally getting rate hikes in Europe, and broadly speaking, bank balance sheets on a good place.
Unfortunately, when SVB happened, um, the sentiment towards banks changed pretty quickly, uh, and people started looking for the next cracks in the system, and that's when we saw credit suis emerge as the weakest link and concerns regarding their viability as a bank ramped up very aggressively. So over sort of the last week or so, things deteriorated rapidly. Um, the Swiss regulators eventually stepped in and over the weekend they broker a deal whereby UBS a much more solid, uh, Swiss bank would buy credit suis. Um, now this deal with ubs, it really should have been, uh, a positive because it removed a lot of the contagion risks and fears, um, that credit suis introduced. Remember, this is a globally sort of systemic bank here. Um, however, um, in order to facilitate the deal, the regulators decided that credit SU 81 s so their most junior subordinated bonds would effectively be zeroed.
Now, this caused a significantly negative reaction in the 81 market at large. Um, and I'd say really across financial credit more broadly, why, um, two things. So firstly, um, this is the largest 81 write-off that we've ever seen. Plus it happened in, in such a, a large systemic bank, um, a really a key banks globally. Secondly, and more importantly, 81 holders got zero, so debtholders got zero, but credit Swiss shareholders were still getting something. They were getting to get UBS shares. Um, and this is just simply not how the creditor hierarchy should work. What we then saw, um, as yesterday progressed was other bank regulators coming out with statements, specifically the Bank of England and the eba. Um, and they were saying that this is really a uniquely Swiss outcome. Um, and if you, if they were in any similar situation, they would look to respect the hierarchy such that AQ one s would only absorb losses once equity has been wiped off.
Effectively, they were trying to stop the read across to all AQ one s at large. Ultimately, this did help the a one market somewhat as the day progressed. Um, we did see some of the initial declines reversing somewhat. Um, and then just to give you a sense of the spread move that we saw in, in credit fees itself, if I just take a, a simple Euro senior bond, uh, in the longer end there, we still spread move from about 400 basis points to a peak of just over 800 basis points. Um, as of today, we've, we've retraced back, um, most of that, and we're actually now tighter on the month as credit sus spreads converged towards the much more solid gbs. So I think, um, at the end of the day, we've avoided the catastrophe of credit suis going under. Um, the tone in bank creditors is somewhat better today, but I think, you know, uh, ultimately the cost of issuing these 81 instruments after the situation is definitely higher. And I'd say risk premium in Fins more broadly, um, certainly has increased for the time being. So I'll finish up there and hand it back to Jason.
Jason Daw:
Okay, thank you very much. Um, now over to Adam Jones on our us uh, credit trading desk to, uh, discuss the situation from his lens.
Adam Jones:
Yeah, I mean, this morning's probably the first time we've had a chance to breathe for about a week. Um, obviously the, the trouble in the banks has, has ripped through credit markets, um, catching everybody a bit flatfooted. Um, you know, we saw substantial widening as you would expect in, in bonds and in and in hedge instruments. You know, IG hit wides of CDX IG hit wides of 94 basis points, um, but it's rallied into 80 this morning. So the last day or two has seen a significant improvement in sentiment. Um, but obviously front and center's been the regional banks. Um, nobody, nobody's been wanting to touch that paper. We've seen material selling, uh, across accounts as, as you would expect. Um, I think the biggest surprise though has been how that has fed through very quickly to, um, to broader credit, um, and indeed curves.
Uh, we've seen significant pressure at the front end. Um, I mean, my favorite proxy for front end is S psb, which is a front end etf, and the spread on that has moved from 67 basis points a couple of weeks ago to 150 basis points. Uh, if you compare that with L Q D, which is more like a 10 year benchmark, that's that move from 1 55 to one 90. So, you know, there's a difference between a 35 bit move and, you know, almost a hundred basis points. Uh, you can also see the extent of the selling and sentiment change in the infl in the floating rate market. Um, FFL n is probably the best ETF to look for that, and that just has completely fallen outta bed, which is a, a mixture of, you know, lack of liquidity, ETFs leading the charge, and just a general aversion to, to notional at risk.
Um, now, so where do we go from here This morning has definitely been an improvement in sentiment. Uh, I think for us to have any meaningful rally, we're gonna have to see curves, uh, normalized though, you know, this, this damage at the front end has to, has to be reversed. You know, the, these front end funding spreads pretty much can't remain at these levels. Um, and I think that, you know, as far as where I expect to see changes, that that's gonna be one of the first things that has to start to come back down. Um, but obviously the fear is still there. You know, the, the regional banks have scared everybody. Um, people are starting to look at balance sheets, which is always a bit scary when it comes to financials. And we're getting lots of questions about hold to maturity portfolios about commercial real estate exposure.
And the truth is, you know, when you start to peel back the onion on these banks, you know, there are, there are issues there, and typically a bank would be allowed to earn its way out, but right now it feels like people aren't giving it the time that's needed. And so there's certainly a tension on whether the F D I C do indeed extend insurance on deposits beyond 250 K, uh, to just make larger depositors feel comfortable at these regional banks. Um, you know, and in the background, the longer play is, you know, credit conditions are materially tighter because of this. We would expect a decrease in lending, and then ultimately, you know, does that guarantee a recession, but that, that's a somewhat slower moving, uh, animal. And given the severe move we had in spreads, it's not surprising to see a bit of a bounce.
Jason Daw:
Okay, great. Uh, thanks a lot, Adam. Um, you know, so fed pricing, it's, um, you know, bounced around over the past, uh, week or so, between 15 80%. Now it's, uh, closer to, uh, 80% going into tomorrow's, uh, fed meeting. And, uh, Bloomberg consensus, um, you know, seems to be in the camp of a 25 basis point hike. So, um, you know, now over to Tom, his take on, uh, the Fed this week.
Tom Porcelli:
Look, I think that the Fed is gonna hike race tomorrow. <laugh>, I mean, as we wrote last week in the daily decks, I mean, it was gonna be a game time decision B basically based on, um, how things evolved over the last week. Um, and right now things have evolved in such a way, um, that the Fed will likely feel comfortable hiking tomorrow. So they go 25, they don't think that they're supposed to go 25, but we've also been saying that now for, uh, the last, uh, a few meetings. I mean, the Fed is still fighting yesterday's war at inflation. Um, and it just goes to, uh, again, it just drives home, um, how dreadful they think the, in the inflation outcome is that they're willing to hike rates in in the midst of bank stress. I mean, you know, that, that just strikes me as, um, as, as off base, um, and slightly tone deaf, but it's, it's their, uh, it's, it's their ballgame.
So, um, you know, all in the context of, uh, what the Fed should do, verse what they will do. Um, look, I think the, the, the bigger, the biggest thing that we're worried about, and again, we, we, we mentioned this, uh, last week in, in, in a daily or two, you know, look, lending standards were already on the rise. Um, we've been fond of saying for, for months at this point, that if you look at just the, the sort of, you know, like a four quarter delta point to point change, um, in lending standards, this is the biggest increase, um, since, since the, since the gfc, um, if you exclude the pandemic. Um, and so what do you think is gonna happen to lending standards going forward? Um, uh, you know, this, this is a, gonna be a challenge in that, and we, we sent this note out, um, uh, or set a chart, um, uh, uh, yesterday, um, just to a few folks just to take a peek at just, just just so they can understand this idea that we've been talking about, which is to say, if you look at, um, the thing that has been the key driver from a spending perspective, um, it's obviously first and foremost, it, it has been the drawdown in saving, um, the drawdown in saving is starting to sort of, um, normalize here a bit now.
Um, stabilize, uh, is probably a better way of phrasing it. Um, and so what's picked up the baton? Um, well, credit <laugh> and, uh, we can easily see a scenario where, uh, where in, in the, on the back of all of this happening that that really starts to fade. So, you know, if there's an irony, and I'm not even sure if irony is the right word, but, but if you consider the, um, if you consider Q1 growth, Q1 growth is gonna look pretty good. Um, I, I mean, you probably looking around 3% growth, I think Q2 growth will look a little softer, but it'll still be pretty decent. I think the second half of the year though is gonna look very different. Um, and, uh, and I think that's, that therein lies the, the challenge for, for this fed. So mark pricing of cuts, I think, again, anyone who reads our research well knows that we've been saying that for quite some time, but they would cut, um, a couple of times in the second half of the year. Um, uh, we, we, we feel even more emboldened, uh, in that view, uh, than ever. Um, that's it for me.
Jason Daw:
Okay, great. Thanks a lot, Tom, for the insights. Uh, next up is Blake, um, to tell us, uh, where maybe the Fed might surprise us tomorrow or, uh, any other thoughts on the US bond market?
Blake Gwinn:
Yeah, thanks Jason. And, and I have to say right up front, I mean, I think, uh, you know, as you were kind of describing the price action, we've we're almost underselling it to a, to to a degree. I mean, since the last time we had this call two weeks ago, um, you know, fed pricing for year end 2023 is, has been trading in a a 220 basis point range, which is absolutely mind melting. Um, you know, we've had the markets focus whips off from two weeks ago when they were focused on, you know, some, some still kind of resilient economic data and, you know, we were starting to hear more chatter around the possibility of returning to basis point hikes to the point where we have, we, we now have, you know, some of the major, uh, banks out there calling for cuts at this meeting.
And, um, you know, at at least a decent contingent kind of seeing a a a likelihood for, for a pause at this meeting. So really a a a shocking kind of turn of events. Um, you know, particularly for something as short as two weeks, um, this has come both, uh, you know, this price action has come both via falling terminal pricing. We've seen that move from, you know, around five 70 level down all the way down to, to kind of four 90. Um, you know, we've seen, uh, uh, uh, expectations for the start of the cutting cycle, as you mentioned, pull pulling forward, you know, that had been in January, uh, around January 20, 24, 2 weeks ago, that has pulled all the way into, you know, having the first full cut around July, 2023. Um, and you know, I I, I think it, it's important to note that, you know, a lot of this, uh, uh, price action, a lot of these issues around the banking sector really only started to heat up after the Fed was entering into the black period, which is important cuz that's basically left us with, you know, virtually no guidance as to how the Fed is, is kind of weighing recent economic data, kind of their base case as it existed two weeks ago, uh, against these kind of potential systemic risks, you know, all of this instability, uncertainty and, um, you know, the, the, the likely kind of medium to longer term impacts that this banking sector stress is going to have on financial conditions.
We, we just really don't know how the Fed is looking at these things. But, um, you know, in, in our view, uh, I, I do, um, see a decent possibility that we basically come outta this fed meeting, uh, with the Fed essentially looking tone deaf to markets. Um, you know, I think with only kind of two weeks, uh, you know, with only two weeks of this, I think it's unlikely the feds majorly have recalibrated a lot of their models. I think they are going to come out and express confidence that the actions they've taken on the liquidity side have, um, you know, kind of effected, stemmed some of the broader risk, uh, around these, uh, financial stresses. And, um, you know, try to separate out, uh, rape policy from, uh, you know, from financial stability and say, you know, look, the cool kit we have for financial stability is these liquidity, uh, you know, liquidity facilities and, and actions and rape.
Uh, you know, the, the, the setting of rape policy is entirely dependent on kind of, you know, the, the, the inflation goal and kind of macroeconomic policy. If they do that, I think that's probably gonna come as a disappointment to mar to disappointment to market too, I think are hoping for a bit more reaction, uh, from the Fed to these recent stresses. So, um, in that event, I mean, I think we probably see what's been a, a fairly classic reaction to hawkish, uh, you know, hawkish fed surprises where, um, you know, the front end starts to price the fed essentially putting on blinders and trying to hike their way through this. Uh, but at the same time seeing, um, you know, some of those, those probabilities of costs later on, um, exaggerate. Um, and I also think that, you know, given how many kind of stop outs and how much paint there's been in the, the kind of fast money sector over the last two weeks, um, you know, I think some of the people who would normally be playing around and some of this front end fed pricing are on the sidelines.
And, and what that means is that, you know, if we do get this kind of hawkish interpretation, a broader kind of risk off move could, um, you know, could be the bigger driver of rates and, and any kind of duration bid on that risk off flow, uh, you know, could serve to push some of that cut pricing below levels that even we, you know, as Tom mentioned, we, we've long expected cuts, um, but, you know, push it to levels that even we see is, is probably somewhat extreme. It's just very difficult to, for those views now because you're basically taking an implicit bet at, you know, there's not another shoe to drop in the banking sector that things are going to, uh, essentially calm down and, and, and that, um, you know, that, that the cut pricing that we've seen enter into 2023 is, is, is going to reverse. Um, so I will pause there, pass it along.
Jason Daw:
Okay, great. Thanks a lot Blake. Uh, now over to, uh, Peter to weigh in on the situation in, uh, Europe.
Peter Schaffrik:
Yeah, good morning, uh, to everyone North America. Good afternoon to everyone in Europe. Um, so what I thought I'd do was, first of all, I'll try to look back a little bit because we obviously had a bit of a, um, sneak preview how central banks might react last week when we, when we had the ECB meeting. Take a look forward to the Bank of England meeting and then, uh, make a more general comment, uh, about my view on the situation over here. So first of all, when you look back, um, what did the ECB do? Um, well, they did high rate a 50 basis point actually as they had indicated previously that they would, um, but they also refrained from giving any further strong guidance going forward. Um, and I think how we can interpret that is they look at the inflation fighting part of their mandate saying, well, the situation has not sufficiently changed, we need to deliver that.
Um, and they have, but we don't really know how the situation will continue in the future. And we feel less confident about giving strong guidance as we did before. So they basically left all options on the table. They could hike further, they could stop hiking, and they could do something entirely different. What they've also done however, is a, they stress that the European banking system as a whole is significantly more stable, um, and particularly as the credit su situation was unfolding, um, and that the US situation was unfolding, they stress that they see that, they think there's a significant difference to the European system, which is well capitalized, um, much less leverage, um, and quite typically quite well, um, oversight. Now, what they've done though is that if push comes to shove, we have significant tools, a significant amount of tools at our disposal to address the situation, reading, um, liquidity injections, <inaudible>, these type of things.
And so far that seems to have worked. Um, and particularly as Nicola mentioned earlier, since the clarification that the credit that the capital stack, um, the, the margin order would be upheld in Europe, the market has calmed down. So is that a blueprint, uh, for particularly the Bank of England? We think it could be. Um, I mean, again, um, we don't have the same kind of situation, um, in the UK banking system either, and the Bank of England has been less committing to, um, forthcoming action, um, compared to the ECB anyway. So we expect actually that it will high 25 basis points, um, mainly justifying that with the inflation fight and will then continue to keep all options open. We actually think that because the rates are already higher and the economy is probably a bit poorer, um, sorry, excuse me, performing a bit poorer, um, than, um, the, uh, than say the US economy, and they probably, um, already will, um, bring their rate hiking to a close.
It's not entirely clear, of course, and the market has a small probability of them going further. Um, but uh, we think that 4 25 is where they're going to stop. Just as Blake was saying, for the US the market's already pricing cut, it's pricing cuts in both markets, and we think that's very unlikely to be delivered. So last but not least, what might taken in the entire situation, what clearly, as Nikola was saying, um, the, um, credit three situation has been fairly unique. Um, could there be any other unknown unknowns in the European markets? Of course, but also keep in mind in Europe and the continent of Europe in particular, rates are significantly lower compared to where they are in the US particular, particularly because the ECB started later, so that the, the same while there is a feed through obviously of the higher rate is not to the same degree.
Um, and secondly, liquidity provisions are significantly, um, are significantly higher at this stage because no, no real purposeful QT has yet started. So I actually think that here in Europe there's quite a few opportunities, um, after the market dislocations that we've seen, um, just to name a few. Um, I think for instance, if you just look at how be that sovereign credit be that, um, um, sub sovereign credit be that credit in general has performed, that's probably opportunities here against the goy market. Um, I also think that there are in the implied rate path that there are opportunities now when you look for instance where the market is pricing ECB rates by December 23, there's not much higher than where it is now after pricing, um, a hike to, to 3 25 and then implying cuts again, I think there's a good opportunity here to pay or to sell your arrival futures, for instance, and that's probably going to drag the outright level along. So I think the market's probably probably rallied a bit too much over here, and I'll probably be leaning towards like short position and also if you're so inclined, um, volatility, implied volatility in the rate market has shut up, implied three months, 10 year, three month, two year, um, implied, um, swapping walls have, uh, back at the peak, um, where we've seen them in 2022. And I think there's good opportunities here and where you could start being, um, short volatility again. And with that, I'll leave it and hand 'em back to Jason.
Jason Daw:
Okay, thanks a lot, Peter. Uh, last, but now least, uh, Adam Cole on the, uh, currency market where the dollar has been, uh, unusually stable during this period of turmoil.
Adam Cole:
Absolutely. Thanks Jason. So, um, indeed for all of the, uh, volatility and, uh, moves in in other markets to look at the, uh, FX market through the dollar index, you'd think it'll all completely passed us by, um, compared to the, uh, just before the, uh, SVB event, um, dollar index is down about 1% or so, and it's traded up a percent and down a percent in a, in a very tight range. Um, it's not the case, I think, however this is passed aside, but what we have seen is something of a regime shift in the way FX trades from, um, prior to the s e B event. Um, and we've talked many times about this before, bond and equity markets, uh, moving in, uh, the same direction typically for the last year or so. What this has done is take us right back into the world that existed before that period that, um, people call roro risk on risk off.
Um, we call it the world of one trade, but where bonds and equities move in opposite directions and FX trades in line with currencies, statuses, risks, proxies or safe havens, and the dollar is kind of caught in the middle in that kind of environment. Dollar doesn't comfortably fit into the risky bucket or the safe buckets. And what we tend to see, and what we have seen over this period is therefore FX marketers are dominated by movements in the safe currencies, Swiss Franken, the Yen, and the risky currencies at the other extreme, the commodity currencies in the candies primarily. Um, and that's really what's, uh, what's dominated, um, going forwards. I I think the, the risk is that we stay in this kind of environment while the uncertainty overhangs and that, um, the dollar again is trapped in the middle and we are in markets that are a lot less, what I would call dollar directional than they have been for the last year and, uh, play out more through this risk on, risk off theme.
Um, as far as generating ideas is concerned, I think we, we have to go back to, um, the applying discipline that we applied prior to the last year or so of price section, which is being very, um, uh, focused on relative value. So looking where possible to express macro ideas in currency pairs that are, uh, not correlated or likely correlated to swings in broad risk appetite. Um, so as to take a, a cleaner view on macro themes and that that's indeed exactly what we are doing in terms of our short term idea generation. Ultimately, if asset markets do stabilize, we can go back to thinking about, um, dislocation in terms of monetary policy and relative rate movements, relative physical positions, et cetera. But for, at least for the near term, I think the discipline is, um, is being aware of those asset correlations that are freshly reemerging and, um, and setting our trades up to, um, to take account of that. Um, finally, I would just say again, on this context of shifting dollar directionality and diminishing dollar directionality, um, we wrote about this in the latest edition of our weekly Total fx, looking at ways you can express that shift in dollar directionality through vol or implied correlation in options markets. And with that back to Jason.
Jason Daw:
Okay. So thank you for joining this edition of Macro Minutes. Uh, the narrative and financial markets has pivoted from one extreme, uh, that everything is okay and significantly more hikes are in the pipeline, uh, to the other extreme that Ray cuts are forthcoming soon. And in reality, the answer probably lies somewhere in the middle. So, uh, stay tuned to publications or reach out to us directly in the interim for additional insights on what we're thinking,
Speaker 1:
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.