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.
Simon:
Hi, everyone. Welcome to the October 25th edition of Macro Minutes, entitled Let's Get Restrictive. With most central banks at a maturing stage of the hiking cycle, terminal policy rates are firmly in focus. The BoC and Fed are poised to move into clearly restrictive territory in upcoming meetings, while next week's BoE meeting comes after more than a month of fiscal-policy-induced volatility, and a 75 basis-point hike from the ECB seems all but assured on Thursday.
Outside of rates, FX moves have been outsized and attention on commodities remains with implications for inflation. To provide some insights on this landscape, we have a full line-up of RBC experts. Peter will kick off with the latest from the UK and this week's ECB meeting, Elsa will provide an update in FX space, and Blake will discuss next week's fed meeting and views on the treasury market. I'll look at tomorrow's Bank of Canada meeting with implications for terminal rate and curves, and Michael will conclude on the oil-market dynamic, the fundamental push versus the policy pull.
With that, we'll start with Peter. Over to you.
Peter:
Thank you, Simon. What I'll try to do in the next two or three minutes is, first of all, give you a little bit of insight on the latest moves here in the UK and the implications for markets, and then secondly, as Simon was alluding to, speak about the upcoming ECB meeting.
So first of all, I guess one of the things that you have undoubtedly noticed is that the political leadership here in the UK has changed once again, and it has been relatively quick. So the prior chancellor, Rishi Sunak, is now the Prime Minister, and it seems likely that he will leave the current chancellor in office.
He gave his first speech, but we don't really know all the details about what they will do in terms of fiscal policy. But the key thing is that they seem to be radiating a little bit more competence, seem to be radiating a little bit more respect for the market, and seem to be also radiating a willingness to have at least a little bit more grips on the budget itself and the amount of borrowing that is required. And you can see that in some of the announcements that's already been made, for instance, in the tax policies that have been announced, or, for instance, in the changes to the energy support package.
Now how that all plays out over the medium term remains to be seen, but I think the key message in the here and now is twofold. First of all, the market seems to take the change in leadership as a positive. Whilst markets are still relatively volatile, yields have come down. The volatility, despite still being relatively high, has also come down. And I think it seems also clear in the currency market, and with the recent re-strengthening of Sterling to some degree, that the market has taken a little bit of heart here. Now, some of the structural factors for the UK and the UK economy and the UK fiscal position certainly won't go away, but the air of at least having a somewhat more competent leadership in place is helping markets here.
Now, what does it mean for us in terms of positioning? We have argued for quite a while now over the last two weeks that what was priced in the front end of the UK curve in particular, where at one point we were pricing short-end rates over 6% as a response to the instability that we had, was exaggerated. We think that currently, we are better priced but probably still exaggerated. We have been long in June '23 SONIA futures and we remain long here, and we think there's another 50 basis points probably of profit to be made.
Now, shifting gears a little bit to the ECB on Thursday Simon was alluding to in his intro, it seems very likely that the ECB will high rate again by 75 basis points, and in my mind, that's not necessarily what's going to move the needle. The two things that, in my mind, have a much larger propensity to move markets are, first of all, how are they guiding markets, if at all, going forward? How are they treating in the press conference in particular? So the question about where they want to get to.
Last time around, we didn't learn a lot because Lagarde has been quite evasive. Previously, he said they want to get to neutral but hasn't put a number to that. Will it do anything like that? Because at 150 where we're most likely going to be in the deposit rate... But probably still quite at neutral, probably closer to numbers that have been handed around, such as 2%, slightly above 2%, and the market is still implying something around 3%. So also here we think that the front end provides value. We don't have the same positioning on as we have at Sterling because we think the opportunities in Sterling are greater. But also, here, I think there is potential for the market to recover some of the losses that we've seen over the last couple of weeks.
And then the second point, and that's my last point I'm going to make as far as the ECB is concerned: what else is in store? Well, there has been a lot of talk about changing either the remuneration of reserves or changing the TLTRO details, how the banks have been borrowing from the ECB. And that is something of a bit of an unknown and has already created quite a lot of volatility, both in the front end, in repos, as well as in the basis markets. And this is really something that we should be paying close attention to.
What is the ECB's intention here? Will they allow a negative tiering, for instance, or will they maybe change retrospectively the details of the TLTRO and cause fairly significant early repayments? All of these are quite unknowns. The market doesn't have a good steer. So I think this is something that could cause a volatility, and we should be paying close attention to when the details will be announced.
And with that, I'll probably leave it and hand it back to Simon.
Simon:
Thanks very much for those insights, Peter. Now we'll shift to Elsa on FX.
Elsa:
So from my side, I'm just going to say a couple of things on currencies heading into this week's Central Bank meetings. And we're working on a piece at the moment which will be published and in your inboxes very soon, looking at something that we've heard anecdotally, both from our traders internally and also from clients. And that's the sense that G10 FX is not really trading up on short-end rates like you would expect.
In fact, if you look at the correlation between dollar pairs and foreign yields, so dollar CAD against Canadian yields or Euro dollar against European yields, we're finding that the correlation is positive, so the dollar is actually outperforming when foreign yields are going up: the complete opposite of what you would normally expect. We think that's a function of two things. One, US yields are highly correlated to yields than the rest of G10; and two, US yields are driving the dollar higher against the rest of G10, so by extension driving that positive correlation between dollar and non-US front-end rates.
What does that mean for, say, CAD going into the Bank of Canada tomorrow? Well, the decision is finally balanced, and I know, Simon, you'll have more to say of that in a bit, but [inaudible 00:07:31] split roughly 60-40 in favor of 75 [inaudible 00:07:34]. Either way, there should be some reaction, but dollar CAD may not be the best way to play it. If you look at CAD correlations on the crosses, Aussie/CAD, Euro/CAD, [inaudible 00:07:45], there you find a stronger impact for Canadian front-end rates. So we've gone with short Aussie/CAD as our trade of the week, heading into Australian CPI tonight, Bank of Canada tomorrow. But of course, you could be looking at Euro/CAD or Sterling/CAD depending on your underlying bias. I'll leave it there and pass back to you, Simon.
Simon:
Thanks very much, Elsa. Moving to Blake now on the US.
Blake:
Hey, thanks, Simon. So yeah, we've basically got two events coming up next week that are really in focus for the US. That includes, obviously, the FOMC on Wednesday, but actually, earlier on Wednesday we will also be getting an announcement from Treasury for their quarterly refunding process. First with the FOMC, we've entered the blackout period. We're holding on to a terminal ceiling at 5% percent and tens at 4.25 ceiling. Until then, I think markets are potentially locked in the 75 basis-point hike for this meeting. Remember, we won't get any FDP update at the meeting next week, so I think all the attention is really going to be on Powell's characterization of a potential step-down or slow-down in the pace of hikes.
The focus on this topic has grown a lot heading into the blackout period. We had some dovish comments from Brainard and Daly. There's also an article from the Fed whisperer himself, Nick Timiraos at the Wall Street Journal, that suggested there would be a debate about the pace of hikes at next week's meeting. So I think that's got a lot of people looking to this to see some guidance on whether they're going to start to step down that pace in hikes at the December meeting.
However, I do think Powell's going to be hesitant to say too much, particularly with two CPI prints between now and the December meeting. I don't think he's going to want to lock himself into any course of action, and probably try to spend most of the press conference avoiding those dovish pitfalls, in the way that he did fairly successfully at the last press conference.
I think the one difference here, though, is that if there is a growing chorus of dovish members who do want to see some step-down in the pace, when he speaks at these FOMC prep conferences, he is speaking on behalf of the committees. So there's a possibility in wrapping in those discussions and giving some weight to all the views being presented at the table that those comments could come off a little bit dovish in that he has to give some kind of nod to those wanting a step-down, and markets could interpret that as his view or even the core view. And I do think that's probably the dovish risk coming out of that conference.
Turning real quickly to the refunding meeting, I'm not projecting any more cuts to coupon auction sizes. Recall that over the last year, all four quarters, we have seen pretty significant cuts to coupon auction sizes. I expect that campaign is basically over, starting this next month. That also, I should note, includes 20s, a lot of focus on the 20-year sector. It has been targeted for larger cuts than the rest of the sector, and I think there's some thought out there then maybe the Treasury would continue to cut those auction sizes. But I have those stopping, along with the cuts to the rest of the curve.
Given that there won't be, in my view, any changes to auction sizes, I think most of the focus is going to be on potential for the buyback program. A lot of chatter about that after Treasury asked about potential buybacks in the dealer refunding survey that they sent out last week. It really got that marketer conversation going around the possibility they'd be coming in and doing buybacks.
My view is that question on the survey was likely more exploratory. I don't think they're on the precipice of announcing some major buyback program, and even if they were to give some guidance on how they may use buybacks in the future, I think it's probably going to be less than what some market participants are likely getting excited about, which is probably more of a regular steady program where they're in a day-to-day, much like the Fed was during QE, buying off to run securities and bolstering the day-to-day liquidity conditions. But I think even if they were to do something, it'd be something much lighter than that.
So that's it for me, and I'll pass it back to you, Simon.
Simon:
Great, thank you, Blake. Very useful. Now, shifting to Canada, as Elsa said, meeting this week on Wednesday, one of the most difficult to call in the cycle, we think. We're on the lower end at 50 basis-point hike, while market pricing and consensus has shifted to 75 following communication from Governor Macklem earlier this month, and also last week's September CPI report.
Supporting our view for a 50 basis-point is that the macro backdrop has likely evolved pretty close to the Bank's expectations since the September policy meeting, with headline inflation moving lower, 6.9% currently, and underlying inflation showing signs of stabilizing around 5%, though both certainly remain too high for the Bank of Canada to be comfortable at those levels. Medium-term inflation expectations are similarly too high, though with some early moderation visible in recent Bank of Canada business and consumer surveys.
Moreover, we think 50 basis points at this meeting gives the bank sufficient flexibility at subsequent meetings to maintain that size if progress on inflation is slower than anticipated, or continues to reduce the increment with 25 basis points in December if they feel like inflation progress is sufficient. Into restrictive territory, even 50 basis-point increments provide a better ability to calibrate policy than larger hikes such as 75.
Support for a 75 basis-point move comes from the level of inflation outlined, and in an economy still deemed to be an excess demand, so in other words, domestic sources of inflation pressures, the currency depreciation is a new factor that the Bank has highlighted and adds to inflation concerns, modestly, we would say, but we'd argue it looks less on a trade basis than just against the US dollar.
For terminal, we do think a 75 basis-point hike opens up a likely pass to 4.50% to 5% for the terminal policy rate, with a gradual step down, say 50 basis points in December, 25 basis points in January, resulting in a 4.75 setting. So that gets them to quite an elevated policy rate by that time. Is the bank convinced that they need to take it there at this stage?
One thing that stands out to us in rates market is that despite the yield move higher curve inversion, so [inaudible 00:14:29] tens around -63 basis points as I'm talking, is not the most pronounced it's been for the cycle. If the Bank does deliver a 75 basis-point hike and is on a path to 4.50% to 5% on a policy rate, then that will increase the pain on the activity side, output side, and could easily result in inversion pushing 100 basis points, as has been seen in earlier high-inflation periods.
And to finalize things, we have Michael speaking on the oil market. Over to you, Michael.
Michael:
Look, there's clearly a lot of natural-driven factors impacting the oil market, and we see a lot of chop in the push-pull between what we're calling a fairly strong oil market fundamental backdrop versus the soft economic backdrop that those on this call have been highlighting. So I think the key question is, we're trading in the low 80s right now for WTI. We anticipate that prices will likely just chop around this level in a fairly wide range, but I think it's fair to really highlight: how did we get here.
So I think there's been really two oil markets so far this year. First half of 2022, what we saw was a fundamentally driven market. We really looked at supply and demand factors, inventories, crack spreads really driving oil market sentiment, oil market direction. Come Q3 of this year, what we saw was a market that's been entirely policy-based. So what I mean by that is we went from OPEC and a loosening policy to a tightening policy in just the very short couple of months. We saw the Biden SPR program in the biggest volumes we've ever seen. There's headlines about the EU embargo and Russian energy price caps, to China's COVID Zero policy, to Iranian nuclear talks, to of course the Fed.
All of these are major swing factors for the oil market, but they're all driven by policy and less driven by fundamentals. And oil-market participants loathe trading off of a policy-driven market and would rather trade a market that is focused on following the barrel, being able to count the barrels and understand the supply and demand factors.
So what we've had here over the course of the past three to four months is a very high degree of what we're calling policy paralysis, and this leads to a high degree of positioning paralysis. What we've seen is liquidity in WTI is about 42% below normal over the course of the past three to four months. And when you get low volumes throughput traded, what happens is you ultimately get a high degree of volatility.
Now, I think there are two oil markets right now as well, the near term and the medium term. We continue to be constructive the cycle over the medium term. There's little that can change our mind about that, just given the fundamental setup for the next several years. But over the very near term, we do strike a cautious tone here. I mean, you simply just have to respect the natural backdrop. What we have going into next year is a fairly sluggish growth theme. We see oil demand growth at about 700,000 barrels a day or so, which, save for the COVID year of 2020, we haven't seen a year like this in quite some time.
Now, in a recessionary scenario, we think that there's scope for prices to move potentially down to the low 60s, which is about $20 lower from where we are now. Just to give everybody a sense of framework here: in 2008, that recession, what we saw was we lost about 2.2% of global oil demand and we saw demand contract for five quarters.
Now, my main concern here in the global oil market that's different than recessions in the past is that in this downturn, we do not have the backstop of China, just given the Zero COVID policy. Now, China's really pulled us out of almost every soft oil demand backdrop over the course of the past 20 or 25 years. But at this point, it's difficult to see that there's a natural buyer of last resort if China's not there. And rarely in our careers have we ever seen a strong oil market and a weak China at the same time. But with that, why don't I leave it there and pass it back to Simon?
Simon:
Thank you, Michael. And thank you for joining us for Macro Minutes.
Speaker 6:
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.