Speaker 1:
Hi everyone, and welcome to the November 22nd edition of Macro Minutes called as Complicated. So, while 2022 was complicated, it was dominated by a one-sided risk event, how high rates would go. But 2023 should be even more complicated depending on the depth of the growth and inflation slowdowns. Markets still need to find their way on where terminal rates will end and what will happen next year. So policy scenarios could oscillate between three outcomes rates on hold, further rate hikes or rate cuts. So to make sense of the current and future complicated macro and market environment, we are joined today by Blake to discuss the US treasury market, Peter, to talk about the complicated situation in the UK and Europe, Adam on the dollar, being complicated by cross asset themes and Amy on the complications of data dependency on vol and positioning, and also the crypto market.
I'm gonna kick it off today, uh, with a brief summary of the 2023 Canada rates outlook that we published last week. And so for monetary policy, we think from a base case point, a lengthy period of the Bank of Canada keeping rates at a high level, our forecasts, uh, assume that the Bank of Canada reaches its terminal rate, which is 4% in our base case. But realistically, anything in the four to four and a half percent area, uh, is not unreasonable. And at this level will be maintained through 2023. So we think that's probably a 60%, uh, probability, a 15%, uh, probability we give to, uh, rates going beyond four and a half percent or scenario where, uh, the Bank of Canada pauses and then, uh, needs to, uh, hike rates later in 2023. And we give a 25% chance to rate cuts, uh, most likely in the back half of 2023.
These would probably be more, uh, corrective in nature rather than a long lasting, uh, easing cycle. And you know what that means for the rates market, we do think it'll be a better environment next year. So the front end of the curve, specifically twos, they'll probably be, um, almost entirely dictated by what happens with monetary policy. But rates, uh, further out the curve that have been closely linked to terminal rate pricing should see the beta all quite rapidly, and the macro drivers start to become more favorable. So stuff like consensus expectations for, uh, the policy rate expectations for GDP and inflation, these should start to become more favorable at the minimum cap, any large increases in yields and probably lead to, uh, declining yields through, uh, 2023. Um, as far as the curve parts of the yield curve, uh, with twos as the front end leg, these should stay quite flat or they could even flatten further.
But stuff further out such as five 30 s or 10 30 s could show a great propensity, uh, to steepen. Now what does that mean for, uh, trade ideas next year? Um, obviously it's a very, uh, difficult environment to be having a medium term trade idea. We kind of took a stab at it and a few that we like are receiving Canada versus the US and the front end, so the two year sector. So that's spread becoming, uh, more negative. And this is based on our view that the Fed is gonna need to tighten, uh, much further than the Bank of Canada and especially versus what's priced in currently. We do like a steeper trade, five 30 s uh, in Canada. This is a lower risk, but obviously a lower reward also, but is a good way to kind of enter into a steepening, uh, dynamic without being susceptible as much to monetary policy.
We do like the Canada curve flattening versus the us uh, steepening in two tens. This is probably more of a a three month plus type of trade because in 2023, the chances of the fed cutting rates we think is a lot higher, uh, than the Bank of Canada cutting. But we also like, um, a six month, 15 month swap rate steeper to play the view that, uh, we do not think, uh, the Bank of Canada will cut rates as a base case scenario. So that part of the curve should steepen. We also like a 10 30 a swap spread, uh, steeper and we do like being a long duration in the 10 year, but we prefer to wait. And if we get back to three 30 to three 40 in 10, then we look to enter that at that point. Uh, with that, uh, now over to, uh, Blake to make sense of the treasury market and the, uh, current and future, uh, complicated
Speaker 2:
Backdrop. Yeah, thanks Jason. So I just wanted to flag real quickly, we will have our US 2023 Outlook, uh, published hopefully by the end of today as well. But given that that is not out yet, you know, we'll probably discuss that more, um, the next time we have one of these calls for today, probably keep it a little bit more, uh, near term, um, fed speakers since cpi, um, since the CPI miss have, have generally settled into this kind of 4 75, 5 25 terminal range. I think most of the comments have been pretty balanced in talking about the risks. Um, I'd say, uh, even a bit more so than than Powell who has obviously read as a bit hawkish, um, I think has stepped down to 50 basis points in December, is now nearly a lock, um, you know, take a pretty large beat in the November, uh, CPI data or, or, um, you know, some kind of other large surprise in, um, you know, either NFP or inflation data, um, you know, over the interim to really kind of move that expectation away from 50.
Um, keep in mind the November CPI plan is also the first day of the two day FMC meeting, so they'll have very limited, uh, time to really kind of process that and work that into their assumptions. I I would think that, you know, the decision on the step down to 50 would largely be made by the time they see that November CPI print. But, um, just something to keep in mind. Um, today we do have the, or I'm sorry, tomorrow we do have the minutes being released. Um, I think they're largely gonna echo the vibe of, um, you know, most of the Fed speakers we've been hearing from over the last few weeks. Um, and I think in general, it, it's probably gonna be viewed as a bit dated given just that, um, you know, those minutes did predate the c p miss, um, you know, so, so probably kind of a, a, a little bit stale in that respect.
Uh, I still think there's a bit of a, of a, a dovish lean to the risk. If you remember, um, the prepared remarks from Powell, the statement, uh, were actually quite doish. It was really only when, uh, Powell started speaking more freely during the q and a portion that we really got that kind of hawkish, uh, the hawkish side of the message that ended up being kind of the takeaway, but everything that was prepared, um, and kind of discussed by the committee presumably, um, was really more to the double side. So I would expect the minutes, uh, to be more in line with that than kind of the comments we heard later from Powell during the q and a. Um, as far as what markets are doing right now, still pricing in a pretty reasonable path in my mind. We've got, um, 50, uh, again, basically a lock for December with some very small risk for 75.
Um, you know, I think a toss up in February between 50 or 25, and then something closer to 25, you know, a further step down in, in March, uh, with some small chance of a pause that leaves terminal around 5 0 5, which as I said is pretty in line. Um, you know, with, with our current call for five to five twenty five range, um, what that means is that all the flattening we've seen choose tens over the last week's really been driving by additional, been driven by additional cuts being priced into 2024 rather than, uh, kinda a continued march higher in terminal, which is really what's driven most of the flattening we've seen up until this point. Um, twos, tens, uh, at least the last few section sessions looks like it's very tentatively trying to find a new bottom somewhere around this negative 75 basis point level, um, outright basis tends look like they're also settling into a bit of a new range and kind of 3 75, 3 85 area.
But of course, you know, any ranges are tentative nowadays. Um, and kind of pending today's minutes release. Um, I do tend to think that these kind of new flat, lower flatter ranges generally likely hold at least until the setup for the next round of inflation data and the Fed, which will get into, you know, the second week of December. Little bit of risk around NP next Friday. But really I think the inflation data and the Fed are gonna be the major risk events that, that are more likely to kind of push us out of that range. Um, with regard to that data, I think biggest risk in my mind, um, you know, again, not our base case, but is, is really a bounce back into the CPI data back to those kind of high levels we've seen up until this last print. Um, in which case, you know, that could see twos, tens, plum, even new depths looking for new flats, uh, for this cycle. Um, although this time we would expect it to be more of a bearish move than, than what we've seen with the bullish flattening that we, we got after the CPI move. Um, on the other side, if it's a low print, um, you know, for the low print, I think that's really more just confirmation of current pricing than, than a catalyst for a major shift out of these ranges. Um, and with that, I'll, I'll pause and, and move it along.
Speaker 1:
Okay, great. Thanks a lot Blake. Um, next up is Peter to discuss the UK and Europe and the complicated situation there.
Speaker 3 :
Thank you, Jason. First of all, I would like to stay on the topic of inflation that, um, uh, Blake was just talking about, because next week, um, we will get, um, the next batch of inflation data for November, um, last for the Euro area. So it starts with regional data on Tuesday, um, and then comes, uh, with a, uh, pan-European one on Wednesday. Now the rub here is that this is the first number where the market now expects a lower print compared to the previous month. Previously we have surprised to the upside, but the market was expecting, um, the number to rise. Um, so we, we had a stronger rise, but now we're expecting it to come down, so this could actually turn out to be the turning point. Now, one of the things that we have said for quite some time now is that because the market was expecting to turn around in inflation to come round about this time and because in contrast to North America, a good part of our inflation or much stronger part of our inflation is driven by energy prices, which will exhibit very strong base effect inflation will fall.
It's just a question of when that's going to come to pass. So as a result, as a result of that, we place quite a lot of weight on this number that will be coming up. Now in the broader picture, however, what I have stressed before, and I wanna stress it again, is that in the environment where inflation is likely going to come down whilst we're going into a recession, it seems unlikely to me and that the terminal rates either in sterling or in euros will be pushed significantly further higher. In fact, in Sterling we've been coming down now for weeks and in the Euro market we have been trading sideways somewhere between, let's call it two seventy five and 3 25 in the terminal rate. And I think that is likely going to prevail. Now, what springs out of that in my mind, is that the environment that we're going to go into will provide much more stability for the front end, and if it provides more stability for the front end, it will invite people particularly sort of in the spread markets to buy more yield, to buy more carry.
And we've seen that to some degree already, and I think that's gonna be a major theme going forward. And we would also recommend to do so. Volatility should also come down, um, um, absolute volatility as much as implied volatility and, um, option trades offer themselves accordingly. Now, before I hand over, I would like to raise, however, a slightly different topic, um, because one of the other elements that is already, um, in the market for quite some time in the US has started in the UK already, um, is going to, um, start in the Euro market as well, which is the topic of qt. We already had last week the, um, release of the early repayments of the TLT O and why they was, they were, um, in line with our expectations at the lower end of expectations or actually below market expectations. Still the topic of QT will become much more dominant.
Quite a lot of ECB speakers want the next ECB meeting on the 15th of December to make a firm statement about when they're going to start rolling down their bond holdings as well. Um, initially most likely in the passive form. But nevertheless, um, this will be a theme and the TLT roll repayment saga is not gonna be over. And there's going to be, uh, other repayment windows where the, where the banks will probably, um, repay some of the TLT o money that we have. So the balance sheet of the ECB will be coming down, and the question is how that's been, um, how that's been received by markets, particularly in light of an environment where governments are selling to a very large amount, um, bonds in order to pay, uh, for the energy support packages that they have launched. Now, the market takeaway for us on that is, and that we think that asset swap spreads will move. They have started to move forth in Sterling and in euros quite a bit, but we think there is more to come as we go into the year end and into next year. And with that, I'll hand back to Jason.
Speaker 1:
Okay, great stuff. Peter. Uh, shifting gears to currencies, uh, Adam's gonna tell us why the dollar view is being complicated by, uh, cross asset themes.
Speaker 4:
Thanks, Jason. So, um, a complex world indeed in fx and, um, why I say that in particular is that in FX we generally think about, um, the world in terms of relatives. So across currency pairs, the drivers are typically relative monetary policy, the prospect for relative interest rates, relative equity, market performance, relative cyclical positions. Um, and that's the world that we've been used to living in for at least the last 20 years. 2022 has been nothing to do with relatives. It's been all about es So what what's dominated the FX markets this year is just an overwhelming rally in the dollar, uh, against everything. With a couple of emerging market exceptions, the dollar is just higher against everything. And as we've mentioned on this call before, what what we think is driven that in particular is the parallel moves in bond and equity markets. The fact that as we draw towards the end of the year, we are looking at a 200 basis point plus rise in 10 year yields, accompanied by a 20% falling global equity prices.
And that is an environment which is unambiguously dollar positive. When we've had those kind of parallel moves in a negative direction, the dollar can only go up looking at where we go going forwards. The consensus view is that we are reaching peak dollar. If I look at analyst forecasts for 2023, then um, the overarching theme is dollar generally lower. Now, this is not new. This is the sixth year running where the beginning of the year call has been dollared down. And for most of that period, that call has been wrong. And we would, I think at least for the early part of next year, again, want to position ourselves against that consensus. So the consensus seems to be, again, driven by a view that the world reverts in FX to being driven by relatives, whether it's we finally get the relative outperformance of European equities relative to the US whether it's relative rates because the Fed moves more aggressive, it's the downside than central banks in the rest of the world.
It's a view on, um, relatives reverting to drive the dollar down. And I think the danger for us is that we continue to be driven by absolutes in the early parts of the year at least. And if we continue to see softness in bond and equity markets, not the steepness of selloffs that we've seen this year, but no convincing evidence of recovery in either market, then the broad trend will continue to be dollar strength. And equally, if we move the price in a deeper recession than most economists are forecasting at the moment and a comprehensive downturn in both the US and the rest of the world, that again, is a background against which the dollar generally tends to go up. The major risk to our positive dollar scenario is that we see the mirror image performance of performance this year. So not only do we see the peak and policy rates, the peak and inflation, but that comes against a background where lower discount rates mean higher equity markets. And, um, we see the complete mirror image of the performance we've seen in 2022. That, for us is a tail risk at the moment rather than a central view. Uh, central view is that we should start the year as we started last year and the year before, pushing back against the various dollar consensus driven by ES rather than relatives. I'll leave you there and pass back to Jason. Thank you.
Speaker 1:
Okay, thank you Adam. Uh, last but not least, we're, uh, pleased to have Amy join us today to, to discuss the, uh, complications around, uh, data dependency and its impact on vol and positioning and also the complicated issues happening in crypto.
Speaker 5:
Thank you. So, you know, equity volatility is a market that tends to overcomplicate itself anyway, so it's definitely complicated and investors have generally had three big questions around equity law in 2022. They are first, why is skew the demand for hedging so low? Why is VIX and equity volatility lagging so much relative rates and FX volatility? And then finally, what is the growth of zero dpe? So essentially the growth of the zero data expiration trades. Why has that exploded? Uh, to give you context on the data, cpi, more than one third of all s and p options volume was zero DTE trading. So, you know, look to answer all three of these questions, it really comes down to positioning. Investors have remained offside, they've de levered, they're in higher levels of cash. We've seen that consistently and flows through 2022. And as a result, this has, um, come down to less demand for hedging.
And overall, those who hedge beginning, uh, this year, it hasn't worked for them because of the path market, because of the grind of the market that we've seen. In reality, if you look at the put index versus the P put index, were actually better off selling volatility, even with the spikes that we saw. Now on days like the big CPI rally, what are we seeing from option investors who are seeing a huge reach for upside optionality? When I speak with most investors, their most critical tail remains to the upside and the concern about missing the rally. So, you know, we're seeing much more demand for calls than puts as the market moves up. And we can see this in the switch of correlation for VIX and s and p, what is historically an inverse relationship, uh, and intuitively makes sense as an inverse relationship has been positively correlated.
So essentially both the Vics and the s and p moves up on rallies as investors demand options to the upside. Why are we seeing this? This is a function of the extreme data dependence we're seeing in the Fed, and this is also dramatically changed the tenors that options are being traded in the market. Um, and I think that means that zero DT is the shortest you can really get, but we're also seeing investors who traded one month options going to one week and those who traded one week going to one day. Now on a functional level, that really means the exacerbation, um, in terms of real eyes volatility swings on days like CPI is greater than ever, as the gamma dynamics become more pronounced due to the tenor reduction. And so what do you do with that information? You know, we continue to recommend that investors be tactical, uh, particularly around dated events where that gam exacerbation is going to be highest on CPI days or non-farm payroll days, where you really get high payout attractive, um, results for using out the money call spreads with weekly tenor ahead of those data dependent events.
And obviously the next one will be in December. One note I wanna make specifically on mega cap tech, uh, is, is the implication that has for volatility and correlation. So obviously we know fed rate policy has a very meaningful impact on long duration assets this past earning cycle, we saw what that meant for names like Meta or Amazon last summer in 2021, meta comprised 22% of the xlc, the s and p communications index, it's now only 12%. Historically, seven names composed over a quarter of the entire s and p and over half of the queues. So one thing to keep in mind is as mega cap tech declines, this meaningfully changes the correlation make of the ETS as well. So for s and p where cyclicals or healthcare or financials can replace tech weights, this can serve to dampen volatility. But one thing to watch out for is if we see a reversion in these long duration assets, especially in mega cap tech, this is going to have an outsized volatility effect for tech based ETFs like xlk, QS and xlc to a larger degree than you will see in s and p.
So one trade we've, like there is when you see relative cheapness in the implied volatility ratios of tech, uh, it is a good opportunity to put on those relative traits if you believe there will be a reversion and long duration assets possibly correlated to if the Fed makes more aggressive cuts of downside than were initially planned. Um, I wanna move on to crypto quickly. So a few months ago we interviewed Sam Bankman Freed, um, and Brett Harrison, who was the president of ftx. As I said to investors, this seemed like a good idea at the time. And if you're interested in the replay, we actually did ask Sam and Brett some questions about FTX and if it was too big to fail and what that would look like on a systemic risk basis. And I think the one thing I'll tell you is investors have come to me Postoc call given everything that's gone on with FTX and essentially said, what is, why is the resiliency, you know, relatively strong for crypto, for a Bitcoin, for a theory?
And given everything that's happened? And there's basically two answers to this. The first is wait and see. Maybe it won't be we're, we're getting more information every day with Genesis, with Block by, with ftx. And so it's possible that, you know, it is just a matter of time. But the second answer is there was one theme that not only SDX pointed to, but a lot of other crypto firms pointed to as well, which is just the overall idea of institutional adoption. And I think that is something that is real, and you are seeing it in the relative resiliency of Bitcoin, which is that most investors I speak to on the institutional side who do have a digital assets book are not selling, but they're not buying either. And as long as that is the case, even with the flush out you're seeing in retail, it is possible that that resiliency will continue. So I will leave it there. Thank you.
Speaker 1:
Okay, thank you everybody for joining this addition of Macro Minutes. As mentioned at the outset, uh, 2023 is going to be complicated. Um, you know, how quickly inflation eases how much growth slows down, uh, these are gonna be paramount in assessing, uh, monetary policy, uh, reaction functions, uh, what happens to bond yields, currencies, and the broader, uh, risk assets space. Uh, so stay tuned for our publications and future episodes of macro Minutes, uh, to stay up to date with the evolving landscape, uh, from our RBC experts.
Speaker 6:
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