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.
Jason:
Hi everybody and welcome to the May 17th edition of Macro Minutes. The epic movements and volatility of various asset classes continues unabated. But as the uncertainty around monetary policy outcome starts to narrow, there is a glimmer of hope that assets can find their footing and start behaving more normally. But for now, it's been another poor couple of weeks for equities and credit. The dollar has retraced modestly, but remains very strong, while government bonds have recovered sharply from their weakest levels.
Jason:
To help us navigate this treacherous landscape, we have with us today, Simon, Blake, Peter, Adam, Michael, and Amy. So along with the usual fit topics, Michael's going to speak about oil and Amy on equity derivatives. I'm going to kick it off today and discuss three topics.
Jason:
The first one I want to mention is the massive portfolio VaR shock that's occurred this year and the unusual situation that we witnessed in the day after the FOMC meeting.
Jason:
So on May 5th, we did see a 3% down day for the S&P and a 1% down day for 10 year treasuries. This has only happened on six other occasions back to 1990, with the most recent being the COVID crisis GFC and the 2001 tech collapse. So a traditional 60/40 portfolio, it's down about 11% in the past six months. And while this might not sound like a large number, you might be surprised if I told you that in March 2020 and the depth of the 2001 tech bubble bursting, it was also down 11%.
Jason:
During GFC, it was much larger. A 60/40 portfolio was down 25%. And the reason that we're seeing this large draw down now is due to the unusual correlation between stocks and bonds that's occurred over the past six months, which is something that we've never seen over the past 30 to 40 years. But there are signs that the higher bond yield and lower equity correlation is starting to shift. So it was all about inflation that was driving rates, but now groups are starting to percolate more visibly. And in the past few days when stocks were down, bond yields actually fell.
Jason:
So bonds can regain their typical relationship with stocks against the backdrop of the Fed not considering, at least right now, policy moves greater than 50 basis points. It would probably limit the upside in yields and create some space for them to fall further from here.
Jason:
Which leads into my last point, that the worst of the bond market route is probably in the rear view mirror. If inflation remains high and sticky and central banks need to tighten beyond current market pricing, then it could get worse, but that's not our base case scenario. So we do think that yields are probably peaked across the belly and long end of the curve in Canada and the US with the balance of risk pointing to modestly lower levels from here.
Jason:
So for the long end to materially rise, I think would require a decent increase in terminal value pricing. So as the uncertainty bands around the central bank policy path start to narrow and yields stabilize somewhat. So they have been volatile, but over the past a month, the 10 year bond yield is basically flat. You know, there's going to be some investors that are the natural duration buyers and that like to carry getting back into the market. So coupled with inflation and growth fears, probably coming off the boil, growing discussion in the market and retail circles about recession, our forecasts have longer term yields stagnating to falling slightly through the end of the year.
Jason:
The front end that should remain stickier than the long end as central banks deliver further rate hikes. And the front end of the curve gets pulled towards the policy rate outcomes. We do think curves should be biased towards flattening, less in Canada compared to the US and volatility should remain elevated until inflation uncertainty subsides.
Jason:
With that, I'll pass it over to Simon for some additional color in Canada.
Simon:
Thanks Jason. So I'll go through our updated call for the Bank of Canada, this was out last week. So we now see the bank hiking 50 basis points twice more. So at the next two meetings in June and July, that would take the overnight rate to the bottom of their neutral range, which is 2 to 3%.
Simon:
Inflation as with elsewhere has been more persistent and we do see it averaging 6.7% year on year in Q2. That should be the print in tomorrow's April report and that was the last print in March as well.
Simon:
In addition to inflation, we have seen the demand side quite firm in Q1, well above expectations are RBC economics at 4.5% in the latest forecast, the Bank of Canada at 5.6% in their April NPR, which matched earlier nowcasts from Stats Can. And also we have a very tight labor market, 5.2% unemployment rate in April, and that's as low as it's been in multiple decades.
Simon:
After hitting 2% in July, we expect two more hikes, but we expected them to ship down to 25 basis point increments, the more normal increment in September and October, and that would get them to 2.5% and that's where we expect them to stop is we expect inflation to have slowed and growth risk to become more prominent from higher inflation and also the tightening that it has already been done.
Simon:
Market pricing has come down, but is still above our forecast. So it has been as high as above 3%. It's more around 2 to 2.85% right now by year end. So again, above our forecast, but has come down from peak levels.
Simon:
As Jason noted, we think we have hit yield peaks and we do expect GOC term yields to kind of flatten, to move lower over the next six months ending the year around 2.6%. And we expect actually a perfectly flat curve at that time across term yields at that level.
Simon:
And with that I'll shift back to Jason.
Jason:
Okay, great, Simon, thanks a lot now over to Blake for his views on the treasury market.
Blake:
Yeah. Hey, Jason, look, I mean, my comments are going to mirror yours to a large extent. You know, I think basically some CPIs since the FOMC last week, we've continued to see the kind of hump that existed in the Fed pricing curve. If you look at OIS, this kind of big ramp up to kind of a 330, 340 type of terminal rate in early 2023, and then a sharp turn back down towards lower rates at the end of 2023 into 2024. That hump has started to largely grind lower and we've got a more smooth pathing priced in, since both of those events. Terminal's now hovering around 3%, we've got 50s more or less priced for June and July. September's more of a toss up it's around a 50/50 chance for either a 50 or a 25 and 75 basis point hikes have largely been priced out. There's only a very small probability remaining in the kind of June meeting.
Blake:
On the September meeting specifically, and what the question of whether it's a 50 or 25, I was having an interesting discussion with our inflation trader yesterday, who pointed out that the August CPI fixing, which is going to be the last one before that September FOMC meeting is still being priced somewhere around 8%. That's still a very high print and this is above what is likely implied by the Fed's March forecast that they published with the SEP at the March FOMC meeting. And also might argue that a 50 basis point hike in September should be priced with a higher probability.
Blake:
I do think this kind of opens up an interesting question specifically about the September meeting on whether kind of a 25 basis point hike in September's the base case and the Fed needs to see some kind of significant upside surprises on inflation over the coming months to prompt a 50. Or whether the base case is more continued to do 50s until they get overwhelming evidence that inflation is headed back lower.
Blake:
I kind of lean towards the former. I think right now the base case is probably that they will step down to 25 in September and that it's really going to take some outside inflation surprises here to get that conversation about a 50 or even speeding up to 75s going in any kind of earnest.
Blake:
Just kind of moving out the curve. I mean, along with this re-pricing and the Fed, we've got 10s pretty comfortably back below 3%, they seem to be relatively steady there. I still lean bullish from here on rates, as I wrote out of the FOMC meeting. I kind of maintain that we're at the end of this large paradigm shift where we essentially went from having nothing priced into the fed, a terminal rate of 1.25, 1.50 that wasn't coming until some sometime in the 2025, 2026 range to having this entire hiking path laid out before us, that essentially completes by 2023.
Blake:
With the end of that paradigm shift, I think what's currently priced for the Fed path is going to start to stabilize unless we get some kind of big surprises in the data. Again, if we see some continued big upside surprises in inflation, that will obviously be something that Fed has to adjust to, but that's something that's probably a couple month story. And I think there would need to be several prints that really kind of push the Fed in that direction.
Blake:
With clarity around the Fed back growing, I expect volatility to start to ease and become much less directional. Unlike the last four or five months when volatility has almost continuously carried us towards higher rates and that this stabilization should improve the carry environment and kind of encourage the return of a lot of the domestic and foreign real money buyers, who have essentially been sitting on the sidelines.
Blake:
On top of this, I think investor sentiment and investor attention has really started to turn away from this kind of bed story and kind of debating and trading around the shape of the hiking path and become much more focused on the potential for a slow down and recession into 2023.
Blake:
I was in Boston talking to a lot of investors last week, through all those conversations, I was kind of surprised at how little people actually seemed to bring up the Fed path whereas two or three weeks ago, that was all anyone wanted to talk about. That's basically taken a backseat and it's really more about expectations for slowdown or recession 2023.
Blake:
Importantly, the last thing I'll say importantly, I don't think that these concerns about slowdown recession are heavy enough yet that the markets really started to call into question the Fed paths currently priced in. I say that's important because as long as this current Fed path sticks and we get those recession fears starting to pick up that still tends to push the curve flatter versus if we really start to call a question [inaudible 00:11:18] back, priced in and start taking out those hikes and further pushing down terminal expectations, that's something that could turn into as deepener. So something to keep an eye out.
Blake:
And that's it for me and I'll turn it back to you.
Jason:
Okay. Thanks a lot, Blake. Now over to Peter for insights for Europe or the UK.
Peter:
All right. Thank you, Jason.
Peter:
So first of all, I think the first topic that I would like to raise is precisely that focus on either inflation or growth, because when we look at the two main central banks that we have over here, the ECB and the Bank of England, they currently seem to be focusing on slightly different things. So what do I mean with that?
Peter:
So when you look at the Bank of England who actually has raised grades, who has launched the QT program already, and has in their recent meetings, again hiked 25 basis points. When you actually look at sort of the way they're communicating that it seems to me that they're paying much more heed to the emerging growth slow down, and that's potentially coming through.
Peter:
Now, in contrast, when you look at the communication from the ECB who has not hiked, who has not really engaged yet in any quantitative tightening whatsoever. In fact, what they have only said is that they will stop accumulating bonds. They're still currently buying bonds. The rhetoric is extremely hawkish. I mean, just this morning, we had arguably from one of the biggest hawks and for the first time somebody raising the prospect of a 50 basis point rate hike.
Peter:
So as a result, what you're seeing is that the implied path in the Sterling market is not really rising anymore. Whereas in Euros, it keeps rising and rising. And that's particularly true, sort of in the very near term. What we think is at the helm of that is that the ECB is behind the curve and they know it and they're trying to up their game. And what you see is that they're also fearing probably that they're missing their window and therefore trying to speed things up. So that's the first thing I would mention. And in my last part, I mentioned some trades and it will come back to that theme.
Peter:
Now, the second topic and Jason alluded to it already is that there is quite a bit of widening pressure in credit markets. And that's certainly true here in Europe. And the one thing I would draw out is that we obviously have a unique situation in the Euro market in particular, where we, apart from corporate credit, we also have sovereign credit. We've seen quite a bit of widening here too. So the infamous BTP bond spread has been trading north of 200 at one point. We have recovered a little bit here, but keep in mind the ECB will stop the purchases and if we're going into a rate hike scenario, particularly if it's coupled with a growth slow down, I think there is further widening pressure here. And I think that's definitely something to keep an eye on.
Peter:
How does that translate into trades that we are recommending? So, first of all, the first one that I would mention is that we remain, we have been recommending short credit through Y Tracks. We want to remain there. I think the risk is not over. And I think we could see another leg lower or wider here. That's the first one I would mention.
Peter:
Secondly, on the Eriba curve in particular, and we think that the more the ECB pushes for quick rate hikes, when you look at actually how steep it is compared to the dollar curve, compared to the Sterling curve, we think there is flattening potential here. We have been recommending Deck 23 against Deck 22 and we think that still makes sense.
Peter:
And then lastly, when you sort of look at the two central banks that I talked about Sterling, and the Sterling market has outperformed quite a lot. And I think particularly if you look further out on the curve, I think there is probably something to be said about that recent out performance. And there are some trade recommendations that look at sort of some reversal of that.
Peter:
And with that, I'll hand it back to Jason. Thank you.
Jason:
Thanks a lot, Peter, always insightful now over to Adam to tell us if it's time to call the top in the dollar at 20 year highs in the best month in seven years?
Peter:
Thanks Jason. So bottom line for us is no it isn't. And just putting that into context. When I was last here with you a month ago, we talked about hypothetically about what the impact of parallel selloffs in bonds and equities would be. And the bottom line being that is the single most positive background you can have for the dollar.
Peter:
Didn't expect that to play out quite as quickly as it did and carry the dollar quite as high as it did, but that essentially the parallel selloffs in April, early May is what I think drove the dollar rally. And it's not what we assume drives the dollar going forward.
Peter:
So putting that into context, the dollar rallied in April and early May cumulatively about 5%. And we have about another 5% in our forecast, but spread over the rest of the year, rather than in the space of a single month. And what we assume drives that is a return to a more normal relationship between bonds and equities and in FX a returned to more conventional policy expectations as the main driver of currencies. And on our expectations related to where forwards are priced, the relatively short end rate expectations continue to move moderately in the dollar's favor against the aggregate of the rest of the world.
Peter:
So the strength of the dollar rallying in April was sufficient to get us clean through our end year targets, even though we were selling a qualitatively dollar positive story. The market leap frog, where we expected the dollar to get to at the end of the year. Bottom line is we changed those forecasts rather than going with the flow of the market and still embed an overarching theme of moderate dollar gains broadly into our expectations going forwards.
Peter:
Couple of trades that we like, particularly as a way to express that in relatively medium term context, long Dolly Yen where we think that there's been very little, if any, local Japanese in involvement in the Dolly Yen rally so far. And we think there will be going forwards, so sufficient to buy another leg higher. And then short cable short Sterling against the dollar where as well as all the short term cyclical effects we've been talking so much about. There is valuation argument with Sterling sitting right at the top of its 20 or 30 year range in valuation terms on the most important measures of the real exchange rate. So broadly stronger dollar in two ways that we like to express that view in a medium term context.
Peter:
Back to Jason.
Jason:
Okay, great. Thanks a lot, Adam. Next up is Amy to tell us about the equity volatility landscape.
Amy:
Good morning, everyone. Thanks for having me on. So in the options market, things have normalized to a degree. So I think when I was on last month, we discussed the huge disconnect between rates volatility and equity volatility a proxy we use is the ratio of the move index to the VIX index to look at short term implied volatility. That has dropped from an all time high back into its 68th percentile. So the rates versus equity volatility ratio has kind of gone to slightly above average historically over a five year period.
Amy:
The biggest question we get is why is the VIX not climbing when the marketing sells off and why has skew underperformed so much? So several key reasons why this is happening. First, there's just simply left the hedge as the market goes down. And second investors have kind of chosen to take their ball and go home. We see a lot of de-grossing and de-risking which decreases demand for hedges. And third, although March 2020, we did see the VIX touch 80, we're actually in a much more uniquely persistent high volatility regime than we were during the pandemic. So volatility has already been higher for longer, and it's very difficult on a go forward basis to price in more market risk that characterizes more volatility even longer than that.
Amy:
So what are the key takeaways from here? The first is one of the tail risks investors see in our position for right now is actually on the upside. So when you have a situation which we're seeing now, where many investors have de-grossed and de-risked, they're actually concerned about there's some sort of upside swing and they aren't participating in it. So back to the flash of the FOMO fears from the past 10 years and so we do see a lot holding low Delta call options, which partly explains the skew dynamics in the market right now. And upside tails that clients have talked about is if we actually do manage to engineer a soft landing, or there's lower inflation reads, or better than expected recovery in China, or a sooner than expected resolution to the Russia-Ukraine war.
Amy:
Another big question that I get is if volatility is so persistently high, should we be selling it? And I would answer this question with a big it depends. There was a recent note where we looked at two groups of companies and it's got relatively good feedback. The first are your negative cash flow, highly levered companies that really need to come to the market for financing.
Amy:
So a prime example of this is the situation that happened in Carvana, but others are Lyft, Rivan, Uber, Beyond Meat among others. Now, obviously you're seeing very, very high, historically high, multi-levels in these, but I would definitely still recommend owning til protection in the rather than selling volatility. But there are other companies that are very high quality in terms of balance sheet, have positive cash flow, extremely low leverage. A lot of your high quality tech names are on this list like a Google or Apple or a Microsoft and a lot of these companies are actually doing corporate buybacks, which historically does dampen skew.
Amy:
But the argument I've been making is since we're in such a persistently high overall level of volatility, it really doesn't matter that's dampening skew because you're essentially getting a put from the treasury of the company itself. And while yields are slowly climbing, yields still are overall quite low. And the yield that you're carrying from the options market is quite attractive. So if you are going to sell volatility, I would look at skewing these names as opposed to other names.
Amy:
And I'll just say one tidbit about crypto. So during the whole situation with Luna last week, we actually did get a lot of inbound about crypto. And there was concern about other stable coins like Tether and the fact that they actually hold real US dollars and treasuries, et cetera, and what that would mean. And it was interesting to me because I do think a lot of hedge funds, which have started to do institutional adoption of digital assets, you're really seeing that when crypto sells off. Because it is, to some degree affecting their de-grossing and their risk there.
Amy:
And I'll leave you with one more data point from my colleague Mia on the derivatives' desk, when the market is up more than 8.5% into options X per week, which is this week, the S&P ends up 2.7% up on the week. But when the market is down more than 8.5% into X per week, the S&P is actually down 6.7% on that X per week. So we're watching this X per week carefully. But right now I would say that the skew characterized into this week is still quite low and I think that, again, is an impact coming from de-grossing.
Amy:
And I will leave it there. Thanks, Jason.
Jason:
Okay. Thanks a lot, Amy. To round out today's call. We have Michael Tran to enlighten us on the auto market.
Michael Tran:
Hi everyone, thanks for joining us today.
Michael Tran:
Look, we remain pretty consistent in our structural bull oil view. And look, I'm sure we're all feeling at the pump these days, where you have retail gasoline prices and diesel prices punching in at record levels. Look, oil prices have been really choppy, just like most macro markets out there, but really let's not lose sight that we're caught in a structural cycle right now in the global oil market where it's pretty hard to not remain constructive over a six to four month timeframe. I'll highlight the two major oil market themes here that really warrant some deeper thought.
Michael Tran:
First on price. When you think about some of the short term biases out there, that's led a lot of casual oil market observers to forget that this global oil market was the tightest in at least a decade or longer, even before the Russian invasion. So let's not make the mistake to think that Russia catalyzed the fundamental framework.
Michael Tran:
In fact, I could even make the argument that the invasion may end up deteriorating the sentiment around the path forward because of the FPR, the release from strategic reserves, from the government, and the sticker shock of these surging gasoline prices. I think we'd all probably, in the bull camp, rather a slow grind higher than what we saw back in March, right after an invasion.
Michael Tran:
Now, look, if you think about sentiment liquidity and navigating some of these major headline risks out there, I think we generally think that prices will likely remain volatile, but we have been pushing the $115 barrel or higher narrative by peak summer for quite some time now. Because regardless of headlines and policy, the fact of the matter is that the major problem in the oil market is that we've become increasingly tight on both crude and refined product inventories globally.
Michael Tran:
Now, historically, when you have a problem like that, that one is a really difficult measurement to solve without prices going higher. Now over the summer, I think the market will be searching for a degree of demand destruction. That's a really bullish framework.
Michael Tran:
The second theme is the incredibly tight refined product markets. This is your gasoline, your diesel, your jet fuel, cetera. I think what's important here is that gasoline and diesel prices, like I mentioned, are hitting records at the pump. When you think about a barrel of jet fuel in New York Harbor this morning, that's pricing in at $273 a barrel right now. I think the problem the world is facing is that refined product inventories are low across the globe. And since refiners are effectively running near full capacity this summer, the market is effectively trying to solve for optimize.
Michael Tran:
How do you rebuild inventories? And if you can't do it through increased supply through the refining process, the only way to replenish inventories is to price so high that you rebuild inventories because you hit a point of demand destruction and more barrels get left behind in that way. That's a really, really bullish framework and I can't say that I've ever seen that set up before in my career.
Michael Tran:
Now, the last thing here is Russia. Now, despite all the talk about self-sanctioning and not buying Russian oil, the amount that they have sold in March and April are very similar to what they sold pre-invasion and the loading schedules for what they're selling this month in May are also quite similar. So Russia's still flowing barrels at the same level as pre-war. So all this talk about self-sanctioning, to this point, is just a lot of virtue signaling right now.
Michael Tran:
Now, what we do know is that the EU is actively negotiating a deal to embargo Russian oil. We do believe that over the course of this year, the expectation is that Russia will have an increasingly difficult time placing their barrels and major countries like Germany have already suggested that they'll wean their way off of Russian oil over the balance of the year.
Michael Tran:
Now, in closing I'll mention that we do think that there is asymmetric risk with China at this point, but we think it's actually to the upside. So what I mean by that is China's been really weak. I mean, data released yesterday showed Chinese refinery runs, which is effectively crude demand, fall to the lowest level since the early days of the pandemic and the market has been taking it completely in stride. So I think it's tough to see China really getting that much worse at this point, but I think any incremental improvement in COVID, even if it's just an increase of a couple hundred thousand barrels a day, which is a market tightening event compounded by a market that we already think is going to be tightening into the back half of the year globally.
Michael Tran:
I think that if you follow our work you'll know that the metric that we used to watch for physical tightness or looseness is Atlantic base in global marginal barrel. So whether China improves, whether Russia deteriorates or both, we'll see it in the Atlantic base in marginal barrels in real time. So as the market absorbs these SPR barrels, I think we're going to see a structural tightening of both the physical and the financial market throughout the summer. I expect us to be in a protracted period of stronger time spreads, backwardation with just strong structure over the foreseeable future through the balance of the year.
Michael Tran:
So with that one, I pass back to Jason.
Jason:
Okay, well, thank you everybody for joining the call, that'll conclude the May 17th edition of Macro Minutes.
Speaker 9:
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