Jason Daw:
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 Deeley:
Hi everyone. Welcome to the February 26th edition of Macro Minutes entitled, return of the Living Spread being recorded at 9:00 AM Eastern Time. I'm your host Simon Deeley. Trump. Headlines continue to hit markets with a focus on tariffs specifically, but market reactions have been relatively muted so far. The degree to which lingering uncertainty impacts both market and general economic outcomes remains unclear. Economies are evolving regardless with Europe and Canada seeing some improvement while US exceptionalism is perhaps fading issuance and regulatory developments have brought swap spreads. The difference between so rates and bond yields of the same term back into focus, persistent bond weakening in North America is now in question. I'm fortunate to be joined by the resident experts for the US and Europe, Blake Gwinn and Peter Schaffrik to discuss the latest developments kicking off with you, Blake. Last week's PMI data showed the services component dropping below 50 for the first time since January, 2023. This game is a pretty big surprise to markets and more broadly, it does seem like the positive US economic narrative that has been in place since election is starting to show some cracks. As someone who had a pretty optimistic view into 2025, are you starting to get worried or thinking about pulling back on your long held hawkish fed call?
Blake Gwinn:
Yeah, thanks Simon. So I would say conviction is definitely coming down a bit in that call. I mean, part of the call, if you remember, we were pretty sanguine on tariff implementation. We thought there would be some noise, but overall did not think that there would be implementation of some of the widespread tariffs that were talked about in the run up to the election. We haven't really seen anything concrete enough to change that view, but I think what we didn't necessarily anticipate was just the pace of the headlines and what that would do to the uncertainty for businesses, for markets, et cetera. That uncertainty has just gone through the roof and it's really freezing businesses, and I would say even markets a bit like deer in the headlights. So the way I'm kind of thinking about it, if you're a business that's relying on any government flow, whether that's grants, small business loans, contracts that you have with the government, or if you're a business that relies on some type of global supply chain or you export products and services abroad that could be hit with countermeasures, are you really looking to invest in your business, buy new equipment, hire new employees, et cetera, when every day we're seeing these kind of tariff headlines coming across the tape?
I think it's really just frozen people in their tracks. So you're really killing all those positive vibes that we saw with businesses, consumers, and markets coming out of the election. You mentioned PMI, but I mean across nearly all the sentiment surveys that we've seen, whether it's NFIB, small business, the ish conference board, consumer sentiment, you saw this big surge in all of those measures out of the election where I think most people shared our view that was relatively sanguine tariffs and that you would get this dereg and all of this kind of positive business environment. But the data we've gotten so far for January and into February on all of those fronts has shown a pullback. And I do think that's really related to this uncertainty that I'm talking about on both the tariff front, but also government flows around some of these doge headlines that have been hitting us several times a day.
So the way I'm thinking about it's if this uncertainty goes on, even if we never see wide scale implementation of tariffs or lasting government spending freezes, just the uncertainty around those things is enough to kind of slowly chip away conviction in that more optimistic base case for 2025. But at least for now, that call still remains. We do think the Fed is on hold for the rest of the year and see a possibility that they do start to remove that cutting bias and move more towards a hiking bias by late this year. But the conviction level is much lower than it was a month ago.
Peter Schaffrik:
Hey Blake, if I can chip in here. So I mean clearly your conviction has dropped as you just said. So what do you think, what would be needed to regain that conviction and to move past this uncertainty that you just described? What could get you back to your positive economic or hawkish fed outlook?
Blake Gwinn:
Yeah, well the positive thing is most of what we've seen so far has been on the soft data side, it's mostly been in sentiment surveys and headlines. We haven't really seen signs that this uncertainty is starting to spill over into the hard data. So there is still a chance that we can see some reversal on that before it ever really starts to drag on actual activity in a major way such that we would have to change that call. So what we really need to see I think, is that Trump just kind of moves on a bit right now. Like I said, we've come out of the gate so strong. I mean we're only a month and a half into this administration, but I think he just came in with such a head of steam on tariffs. He's been tweeting two or three times a week on it.
We've seen just constant headlines on various regions, these kind of rolling deadlines that we've seen on Mexico, Canada tariffs, and also on the spending side, the Doge headlines have just been hitting multiple times a day. It's all over news media. So I think if we see that kind of die down, and that could be just because you're getting growing pushback from congressional Republicans or because Doge is getting bogged down in court battles with some of these spending freezes. And I also think the possibility that Trump does just kind of move on to other things as this spending bill gets further through Congress that may pull some of his attention, more attention probably getting diverted to Russia, Ukraine talks. So I think maybe if his attention is diverted, doge just kind of bogged down a little bit in this kind of headline fury that we've seen the first month and a half of the administration.
If that dies down, then maybe that allows businesses and markets to move back to where we were say a month and a half ago where the vibes really were a lot more positive coming out of the election and kind of get back down to business. Also, I would just say that hawkish fed in particular was kind of based on growing upside inflation risks that was partially due to immigration curves and some expectation the labor markets will start to tighten a bit in 2025. And keep in mind that the first CPI print we've seen for 2025 still showed that we are repeating that kind of seasonal heat that we've seen in Q ones the last few years. So if that CPI data continues to come in strong, continues to come in hot, we start to see some of those impacts of immigration showing up and labor pressure in Q2 and through the rest of the year.
That's something that could also bolster that hawkish fed call if the inflation data continues to come in strong. If I can turn that question around a bit too, I'm actually a bit curious because this tariff narrative obviously doesn't just involve the US and our US outlook. So Simon, how are things developing on your side? We're about a month in change into the Trump administration. We've already had Canada tariffs pushback once I imagine Canadian markets and business as well. Still very much on edge about what happens with this new deadline. So how do you see it impacting the outlook both for the economy but also as it relates to our Bank of Canada call?
Simon Deeley:
Thanks, Blake. Definitely tariff uncertainty sowed by Trump's ongoing threats has become a feature of the Canadian macro backdrop. The general view is that growth will be severely impacted in year one on the order of two and a half percent, and inflationary impacts from retaliatory tariffs complicate the monetary policy reaction. Comments from last week's speech support our view that the BOC would look to provide some economic support easing in the event of universal tariffs and provided the inflationary impact is not too big. It remains unclear what will happen next week when the 30 day tariff reprieve expires, but we are of the view that universal tariffs are unlikely to come into effect. The macro backdrop has improved for Canada in recent months with multiple strong labor market reports and firmware core inflation featuring this Friday's Q4 GDP report is expected to confirm a relatively solid quarter, so one and a half to 2% annualized growth. BOC communication has shown a degree of contentment with the current situation, though tariff uncertainty even without actual tariffs is already having a negative impact. Lemme switch it over to you, Peter. I think what Blake was describing represents some loss in confidence in the US exceptionalism theme that many were expecting to play out in 2025, but that is actually coming from both sides of the coin with pessimism on the European side looking like it may have already peaked and sentiment improving recently. Where do you see things headed on your side?
Peter Schaffrik:
Yeah, thank you Simon. A little bit tongue in cheek. I think we also had a European exceptionalism story here. It's just an exceptionally weak situation and that in my mind was never quite credible. I mean, clearly things are not great over here and we've got huge amount of problems. But I mean on a previous episode of this podcast, I said that whenever I talk to any of our clients or investors out there, there is not a good word to be heard about Europe. And so I think that the point was so weak that the possibility to surprise to the upside that that was very high. So the hurdle was very low and that has happened. So when you look at the surprise indicators, economic surprise indicators, they have clearly turned better. And in fact, one of the things that we've talked about before is that we had the seasonal pattern and whereas in the US it hasn't played out in Europe, it clearly has or at least for the time being. And the same is true for the uk. And on top of that, I would argue that we probably get a bit of a boost from the fiscal side as well, and that would clearly be helping. That's the current talk. So in my mind it's a combination of those two that we on the one hand had very low expectations to begin with and then the actual outturn so far seems reasonably good.
Blake Gwinn:
So Peter, we just had German elections. What are your thoughts there? Are there any potential impacts on anything we've just been talking about there?
Peter Schaffrik:
Yeah, indeed. I mean I just mentioned the fiscal angle and I think that's closely tied to the German elections. I mean not only there's been talk about a fiscal expansion, particularly for the military side that Trump is pushing the Europeans hard on anyway. And that there has been a talk about fiscal expansion coming out of national government's budgets, but also out of pan-European budgets. But clearly, I mean one of the big problems was that the largest economy in the eu, Germany has not been doing well and the government in fact fell over the vexed question whether or not the budget stands should be loosened. And because it was a three party coalition and one of the parties didn't agree, the whole government fell. And that's how these elections have been triggered in the first place. And the fear was that going into the elections, we would get into a situation where it's equally tricky to form a government.
And I won't go into all the details about how the German elections been run, but suffice to say that the outcome was nothing of the sort. So we have a possibility now that will almost certainly get a two party coalition of two parties that are strong enough and most likely responsible enough to hold together for the next four years. And the very early noise that we're getting is that they're really trying to push through a significant increase in fiscal spend A for military needs, but secondly also for the economy. I mean the only fly in the ointment is that they don't together with the green party, which is also one of the more traditional parties don't have enough votes to change the constitution. And there's a little bit of rumblings about that, but I'll disregard that because I'm pretty sure that even in the new parliament that will be put together, they need six additional votes and I'm pretty sure they can find them from the opposition party.
So long story short, I think the biggest outcome that I see is a fiscal expansion. Now I want to add one more. What we also see, and that's what I've said before because it was quite clear that the conservatives will win this election is that the focus of the policies will shift. Whereas the previous government was quite focused on energy transition on social things and has almost disregarded the economy to some degree. And clearly the market didn't like that as the economy wasn't doing well and they weren't really trying to resurrect it. And this government has very clearly said they will focus their energy on the economy and I guess we're going to see some support programs for key industries, probably some tax cuts and we don't know exactly what kind of measures, but clearly the sheer fact that they're going to focus on the economy much more than before should be helping as well.
So yes, I think it has been a crucial moment now we have to sort of seize that moment and see them actually do something, but I think it's a positive development as well. But Blake, let me change subjects a bit because it's definitely something that comes up over here in Europe in client conversations as well. There have been some pretty big move in massive swaps in the US lately, and I know that you guys wrote about it, but can you run us through your thinking and a what do you think is driving this move and where we're going with this?
Blake Gwinn:
Yeah, sure. Peter, and you mentioned we did write about it. So I'll just say, I mean I'll keep my thoughts here very high level, but if you want to read much more about this, RC clients can obviously go back to our piece and see some of our more in depth coverage of this. But from a very high level, I would say you have to go back to the starting point, which is that coming out of the US election, one of the more popular themes for the red sweep outcome was that deficits would get a lot bigger and that the new Trump administration would look to extend the maturity of treasury debt. So basically increase long dated treasury issuance. So that was a popular theme that led to I think some pretty large positions in long and swap spreads to move considerably lower. So that's kind where the setup was coming into this move.
Now what flipped a few things happened in early February. So one was we started to get comments out of bessant, the new treasury secretary, both direct comments, but also through the quarterly refunding announcement that treasury makes. That did start to imply that the extension of treasury's maturity, so the increase in duration supply, that that was not going to happen. So you kind of took this upside risk to supply and kind of flipped that on its head. So the comments out of treasury comments out of besson, that was one piece. Then there was a second piece at the same time that we were getting some comments around deregulation. Those came both from Governor Bowman at the Fed who is presumed to be the next vice chair of supervision. So who would have a lot of say or sway over the course of regulation. And also from Powell himself when he was giving hill testimony kind of mentioned that it was time to move on some of these regulatory changes that have been talked about for the last several years.
So that is also seen as a positive for those long dated spreads by markets. So we got both of those things at the same time and it really stressed that short spread positioning that I had mentioned we came out of the election with and that was still kind of persisting into the beginning of February. So that started to unravel and that's really what we think drove that move. But I will say I have a much more sympathy and I think the issuance, the removal of those kind upside duration risk that is much more meaningful than I think the deregulation stuff. We're not quite as big of buyers of, I think markets overemphasize or overestimate how much some of these potential deregulation actually mean in terms of spreads. But I think the supply piece of it is a very real fundamental development.
Simon Deeley:
So it sounds like you think this move might be a bit overdone there. Blake, are you expecting long end spreads to fall from here?
Blake Gwinn:
Well, like I said, I mean I think that flipping supply risk is certainly worth some spread widening and we're a bit less convinced on that deregulation theme. And obviously just given that positioning shift, I do think the move itself is probably a bit overdone from a fundamental perspective. So if you just think about from a basis point perspective, how much that duration supply is worth and how much the SLR deregulation story is worth, we certainly moved more than what I would've ascribed to those two factors. That being said, I still think we're a bit out of the consensus on that deregulation story. I think there's still a pretty persistent belief out there in markets that that story has more room to run throughout this year and that that's something that's going to continue to push spreads higher. And anecdotally, I would just say I've been a bit surprised.
I mean we have seen interest. The interest I would say has still been skewed after this move, even though spreads have moved so much higher in the backend, still seeing more interest to go with that move and to be long those backend spreads than to kind of fade it and look for a retracement. I would also just say we have debt limit issues starting to pick up that has generally been positive for spreads as well, just given the treasury does have to pay down some of their debt. That's typically more in the front end and belly than it really is in the backend where we've seen the biggest spread moves, but still something that's just adding on, I think to that desire of people to be long and general for spreads. I would also just say it's worth noting the catalyst for sharp correction in this move aren't really that obvious given that you've taken away some of this duration extension, deficit term premium supply stuff that was really in vogue at the beginning of this year that kind of takes that deficit story off of the table for a while and any of the kind of funding concerns we had, so around repo markets and that kind of thing, which can impact spreads as well, that had kind of picked up into the year end last year.
But that's largely faded because we had a pretty benign year end. So those funding concerns, which could have been a catalyst for move lowering spreads, that has quite a done as well. So we just don't really see an obvious reason for spreads to move back in the other direction even if we think the move is a bit fundamentally overdone. I think the slight retracement we've gotten over the last week in spreads is probably right, and I do think the path of least resistance might be a bit of a grind back down lower over the coming weeks, but our conviction in that move isn't particularly high just given the markets still do seem to be leaning towards that deregulation theme and wider spreads. Now Simon, the swap spread move hasn't just happened here. We've seen it up in Canadian rates as well. So is your guys' outlook or the drivers kind of similar, could you just give us a brief update on how things have moved on your side and basically just kind of tell us how that compares to the us?
Simon Deeley:
Yeah, definitely. We've seen some fair bit of movement. Generally soft sweats have been on a downward trend since Q3, 20 23, 10 year spreads moving, for example, from plus 20 beeps in August 23 to as tight as minus 30 beeps before coming back to around minus 20. Currently with comparable moves across maturities, multiple drivers have helped push this trend, kind of like a perfect storm for cash cheapening. These include a soft housing market, high term deposit inflows, reduced purchase needs from commercial banks as bankers acceptances were eliminated. And also an ongoing lack of BOC purchases of GOC bonds. So during the quantitative tightening period, while the housing market has shown some signs of life since the BOC started cutting in June, it has been in fits and starts. The most recent data for January for example, had a sizable lift in new listings while unit sales fell and benchmark prices have moved sideways for the last month. We did see a noticeable fall in term deposit levels at the end of 2024.
Peter Schaffrik:
Hey Simon, let me follow up here. So the supply story is clearly important for short spreads as well. So what's the latest there from both the fiscal and the central bank authorities and do you have any regulatory developments on the scale that Blake was talking about or any prospective ones anyway?
Simon Deeley:
Yeah, thanks Peter. GOC supplies continued to rise. So short-term debt issue during the pandemic has needed to be renewed while the Bank of Canada wasn't buying any bonds. Indeed, we will see a record high in net bit bond issuance this quarter of around 70 billion for GOCs. The bank did announce the end of QT at the January meeting, but GOC bond purchases are not part of that until the end of 2026. So no purchases until that time. Alongside the risk of tariffs and possible sizable fiscal response, the supply side of the story remains favorable to tightening. So bond under performance against swaps, Canadian swap spreads did follow us, spreads wider on regulatory development south of the border that Blake mentioned on Feb 12th, Canada's bank regulator Osfi did announce a deferral to increases in the so-called output floor, the amount of assets that they need to hold.
But we are skeptical that this supported the widening scene. Instead, it looked like more of an expectation, hope that USD regulation will prompt the same moves from Canadian counterparts to avoid differences in regulatory environments across the border. Back to you now, Peter, on the European situation for spreads, we have seen buds trading above the swap curve for a while now and a looser fiscal policy should in theory not bode well for government bonds. How do you see the developments here from a European lens specifically also against the backdrop of what Blake mentioned earlier about potential regulatory changes in the us?
Peter Schaffrik:
Yeah, thank you Simon. I'll actually say something about Sterling here as well, but I'll start with the Euro market. I think you're absolutely right. So first of all, it's quite an unusual situation to see BUN trade B swaps. And when you go back like a year or two, I mean in the midst of the pandemic actually we were trading about 120, 130 basis points through. So this is quite something, but clearly where it comes from is on the one hand, the QT program that the ECB is running. So they're letting bonds go and that will be ongoing and recall that the ECB started much later than let's say the Fed or the Bank of Canada or the Bank of England for that matter. So they're behind the curve there and that means that other participants in the market have to pick up the tab. And then on top of that, what we talked about earlier, I mean we have wider budget deficits coming down the pipe.
We got pressure to fund our own military spending or increase our military spending and where is it going to come from apart from increased bond supply. So the same theme holds here and what we've seen in contrast to what happened in the dollar market is that we tightened further. I mean not much, but we tightened further. We certainly bucked the trend that the US said, but we even went in the other direction and sadly, from a point of view of the European is even if there is regulatory change coming through, and I know Blake said we'll have to wait and see for that, I mean even if that came through, I would be fairly certain in saying that the Europeans will probably be much, much slower than any other jurisdiction because things are just taking longer. Now, very, very briefly on Sterling, we've seen a little bit of a movement in the same direction as you guys have been describing in North America in the Sterling market.
Now I think in part that's a bit knee jerk just because the sterling market sometimes is a bit closer in mirroring or mimicking what happens in dollars than the Euro market is. But also at the beginning of the year, the Bank of England, they suspended the next stage of Basel implementation for a year and specifically saying they want to wait on what's happening in the US because they're fearing that the British banks would end up with a competitive disadvantage if the US makes regulatory changes that then would not be mirrored here in the uk. So I think the market has taken that as an excuse to at least tentatively put the UK a little bit closer to the UK with all these stories. But so far certainly there's nothing that I'm aware of that makes this much more concrete. But I mean, long story short, I think the situation is slightly different here in Europe generally, and it's even within Europe. There's a slight differentiation between the sterling market on the one hand and Euros on the other hand.
Simon Deeley:
Very interesting, Peter. Now that wraps up thanks for this week. Thank you all for listening to our somewhat esoteric discussion today on spreads. Talk to you again soon.
Jason Daw:
Thank you everyone for joining this episode. If you have further questions, you can reach out to us directly or via your sales coverage or visit RBC Insight to read our content.
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