Jason Daw:
Hello and welcome to Macro Minutes. During each episode, we'll be joined by R B C Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Elsa Lignos:
Hello everyone and welcome to this edition of Macro Minutes, the title Sticky Core and Right tails. We're recording on Tuesday, the 30th of May at 9:00 AM Eastern, 2:00 PM bst, and I'm your host Elsa Lignos. So jet ceiling negotiations turned out to be a lot less dramatic than many had anticipated. Still to come, of course, all the congressional votes, but once the smoke clears were left facing down the back half of the year with many of the questions that investors had in January, not that much closer to being answered. It looks like we've seen peak headline inflation, but core is proving to be stickier than many had anticipated, and that has led to reassessment of the policy outlook for the back half of the year with me today. To discuss this and more, we have several of our top rate strategists, starting with Peter Schaffrik, our head of European Macro Strategy, Izaac Brook Brook from our US macro team, Simon Deeley, who will be covering off our Canada rate strategy. Rob Thompson joining us from Sydney. Looking ahead to the RBA next week, I will be looking at the currency perspective. And finally we've got Amy Wu Silverman tackling the right tails in the equity market. And with that, I'll hand over to Peter.
Peter Schaffrik:
Thank you Elsa. Uh, so I'll probably pick it up, um, just where you started. Um, inflation is a topic that has dominated markets, um, basically since the end of last year and hasn't really gone away now. Um, when you look at, as you said, headline inflation, it's start to come down. Uh, but when you look at core inflation, it still bumbles along at relatively elevated levels. Core PC in the US is still 4.7. If you look at, uh, the ure area for instance, uh, we've just started, um, to see potentially a deceleration, but we're still at 5.6%, which obviously is significantly too high. And I think this is really the rub of the question because it was always clear that headline inflation more in Europe than in the US but still also in the US, has been dominated to a great, um, extent, um, by energy.
And as energy prices have come down after we more or less successfully averted the crisis, um, from last winter, it was always clear that the base effects alone will drive headline inflation down. But then obviously there is more to the story than just the energy prices. Um, and we see that pretty much everywhere. Um, and there is a very good argument to be made that the relative tightness of the e economic activity, labor markets in particular are driving a core inflation or rather preventing core inflation from coming down, um, at the speed at which the central banks would like to see that. And this is really where I would like to zoom in on Europe, when you see the expectations that are currently being priced in and then compare it with a torque that comes particularly out of the ECB in my mind, is one specific thing that over the last couple of weeks is starting to emerge.
First of all, what you're seeing is that even the more hawkish council members seem to be, um, rallying around the view that around about 3 75 to maybe 4%, which is roughly speaking where the market is pricing and the ECB at the moment, um, the peak might indeed land. Um, and there's hardly anyone who sort of really tries to push this significantly further out as we had seen at the end of last year or even at the beginning of this year. Um, and um, and that seems that that seems to have landed well with markets where the peak expectations are now been trading more or less sideways for I'd say the better part of two months. Now, however, um, what is less clear is what's going to come thereafter. And what you see most lately, what you hear most lately, rather, and Mr quite a lot of the central bank speakers point out that rates might have to stay at these elevated levels, um, for much, much longer, um, in order to quell the inflation troubles ended up brewing underneath the surface and are quite visible, um, in the core inflation or put it differently that it might take much longer to bring headline and core inflation back to the target at a, at a, at a, at a meaningful level that the central banks will feel satisfied.
And of course we need compare that with what is priced into the market. We still have, um, the, a relatively quick turnaround from rate hikes to rate cuts being priced. Um, and I think that is where the thrust of the central banks will lend shortly after the peak has been reached, essentially arguing and talking to Mark, talking against the implied market moves. Now, I would like to single out, however, one, um, market that in my mind sort of stands out and is unclear at this stage whether this is, um, uh, an, an anomaly or whether it's a bit of a canary in the coal mine and that is the uk When you look at what happened in the UK is first of all, core inflation has not, um, has not started to peak yet. Uh, in fact quite at the, at the last, um, inflation beating that we had, um, it accelerated further despite, um, headline inflation coming down with a bit of a delay because of the way how energy prices are being transmitted.
The market has pushed the envelope quite significantly for the Bank of England and we're pricing now more than a hundred basis points more than what we currently, where we currently are for bank rate. Um, and um, it, uh, it seems to be on an ongoing process. Furthermore, when you look at across, uh, the rates universe, the UK market has underperformed pretty much every market out there, certainly the burden in the treasury market by a meaningful degree. So that pretty much every fair value level that you can look at now seems out of place. And for me, the big question going forward is, is that something that needs to be opposed as a lot of people including ourselves, have tried and failed for the last couple of weeks, or is the UK a canary in the coal mine? As I was saying earlier, um, that is leading the way and inflation is not coming down as markets, um, um, as markets expected eventually to happen, um, and uh, therefore require much higher rates to begin with. I'm still leaning towards the former, um, but I think time will tell and whether that view is correct. And with that I'll hand it back. Thank you.
Elsa Lignos:
Thank you Peter. Up next we've got Izaac Brook who will be covering off our change in Fed call and the outlook we have for the second part of the year.
Izaac Brook:
Thanks Elsa. So running with the theme of sticky inflation, we're talking about this spring. Uh, we put out an update to our fed call at the end of last week. Our base case had long been a five eighth terminal, but given continually strong data and a fair bit of hawkish fed speak, we're now calling for 25 bit pike at either the June or July FMC meeting and a higher terminal rate of 5 3 75. Given this extension in the hiking cycle, we've also pushed back the timing of when we see cuts starting. We now see the cutting cycle beginning in Q4 or Q1 2024 rather than light 2023. Given the historical gap between the last hike and the first cut and the feds hold hold for longer communications, getting cuts before then would require significant deterioration in economic data or or surge in systemic risk. And neither are developments.
We foresee we're adjusting this call for a few reasons. We had expected economic data to reflect more of a slowdown by this point in the year. Progress on inflation has been made, but we still don't think it's at a level the Fed is comfortable with post banking stresses. The fed's reaction function remains more singularly focused on inflation than we had originally anticipated. And lastly, those banking stresses haven't widened out or spilled over. While expectations for credit tightening have risen, we think that tightening and its impact on labor and inflation need to be realized before it starts influencing the Fed's policy decisions. As for weather, this hike falls in June versus July. Markets are currently pricing a greater chance of June, but we lean slightly towards a June skip and a July hike. While a debt limit deal seems assured, there's always a chance of a last minute volatility inducing rug pole and waiting until July could be a good compromise between the hawks and doves.
With another six weeks worth of data, the Fed will be able to make a more informed decision on the need for another hike. Of course, Friday's NFP and June 13th, CPI could push June price year enough to 25 that the Fed opts to deliver on it instead. And one last thing we'd like to note. We do think that if the Fed delivers a 25 bed Pike in June or July, then the balance of risk shifts towards another hike at a later meeting this year. But given their extreme focus on data dependence, it's too soon to add that second hike to our current call back. Over to you Elsa. Thanks again.
Elsa Lignos:
Thanks so much Izaac. Up next we've got Simon Deeley from our Canada rate strategy team to talk about the Bank of Canada head of their next meeting on Wednesday, June 7th.
Simon Deeley:
Thank you. Also, uh, yeah, in Canada Beat Bank of Canada price hiking or hike pricing has accelerated in the second half of May. Uh, following a strong C P I report, which included acceleration monthly gains for headline and the core measures. Now in Canada, we do have the year on year rates, uh, moving down. So for core measures, uh, we've had those at 5% as high as 5% and they're at 4.2 currently for the CPI trim and CPI median. However, that uh, CPI report did see, uh, up four tenths for each of the core measures and three month annualized calculations bumping higher in the month as well. So kind of these short term metrics definitely show not definitely showing what the Bank of Canada would not want to see. Uh, however, governor Mcle was not any more hawkish in the financial stability review press conference days later than he had been since their hawk hold at April meeting, which included strong emphasis on re returning inflation all the way to the 2% target.
Next week's meeting is now about one third price for a 25 basis point hike with July, about 80% priced and a peak of 32 basis points total, uh, priced in by October meeting. We think the risk of another hike or even hikes is real inflation had been cooperating, uh, and was contrasting with continued strength in the labor market, uh, which is evidenced by continued low unemployment rate at 5% even and elevated wage growth with inflation more sticky. The onus is on activity. Data does show some slowing. Uh, so entered tomorrow's Q1 GDP report and plus an April GDP now cast. The headline gain should be strong about two and a half percent annualized is our estimate, but with clear signs of slowing in the monthly data. So for example, the earlier March now cast was down one 10th, uh, confirmation of this slowing momentum, uh, beyond the now settled public sector strike that should detract in April.
Would definitely be supportive of the bank remaining on hold at upcoming meetings. That is our base case that the bank remains on hold for the rest of the year and seeing that they have hiked enough in our view to slow the economy and bring inflation back to target. We do think if they are to hike again, it's more likely to be sooner rather than later, though with the unsustainability of current or higher policy settings being increasingly clear as the year goes on, the yield pop we saw last week has left us more favorable to duration longs here with the 10 year point preferred as it will be less sensitive to any further bank moves than the front end or belly. Uh, and that's it from me. I'll turn it back over to Elsa.
Elsa Lignos:
Thanks Simon. Up next we've got Rob Thompson joining us from Sydney to discuss the rba.
Robert Thompson:
Thanks Elsa. Down here in Australia we're grappling with many of the same themes elsewhere. Uh, very tight labor market, albeit with some very slight early signs of easing, uh, and sticky inflation, particularly in core terms. Uh, over the longer term we're still subscribers of the view that term yield should had lower, um, but the dart at the moment are keeping the front end of the curve very choppy. Uh, in the short term. We're focused on the r b meeting next week, uh, and would note that by international standards in particular in pillar block space, uh, Aussie core inflation is still very high at 6.6%. So the risks, uh, for the RBA are clearly skewed towards more hiking. Uh, despite our base cases, they stick with 3 85 cash rate from here on, um, there's only 15 basis points also priced into the curve from here. So we actually think risk reward, they was lead leaning, uh, further in this direction despite a base case being their stay on hold.
Uh, just to finish, I'll note that before next week's meeting, there are three key Aussie events to navigate. First. Um, so number one is senate testimony from the RBA governor himself. Uh, the second, the April monthly inflation reading both those Australian Australian time Wednesday morning, uh, and then third and critically the annual minimum wage decision that's due on Friday morning. Um, the minimum wage decision is probably the most important of those three. The decision has to be made by independent com, uh, commission and but the government has publicly backed an inflation, uh, inflation matched increase, which would be about 7% in the background. The r b's been warning about rising wage growth matched with low productivity growth. Uh, SOLO might choose to warn again on that front in the testimony Wednesday morning. Um, and on the inflation front that new monthly series is still quite new. It's incomplete and experimental. Uh, so despite inflation being the key issue both here and globally, we actually wouldn't place as much weight on this data as the other two events for this week. Uh, the quarterly series remains the benchmark. It's much more important and that next print isn't due until the end of July. Uh, with that back to you Elsa. Thanks.
Elsa Lignos:
Thank you Rob. And now I'll briefly cover off the currency perspective. We've heard from our rates colleagues how rates are likely to remain elevated into the back half of the year, particularly given stickier than expected core inflation with cuts getting priced out. And one thing we think is interesting as a theme is how that plays through into G 10 effects. If you look at the outperformance in the currency space year to date, a lot of it is done to carry an EM effects leading the way, but we think that should be spilling over into a broader G 10 story. Our current total effects piece looks at the com divergence in rates, which has basically taken us back to pre GFC levels. T 10 policy rates are more widely dispersed than at any time since 2008. Now, the face of that it would seem at odds with this environmental of ethics ball that's pretty low and in line with its long term average.
And yet looking into the historical evidence, it's hard to see any argument that dispersion in rates should necessarily lead to higher vol on the face of it that would support more attention to G 10 carry trades alongside em carry trades. And a couple we like in particular, long dollars we've been tactically and selectively long dollars throughout the year. Um, but more interestingly perhaps long kiwi. We've entered that as a tactical trade for the week ahead, thinking that the Kiwi softness on the back of last week's Z was somewhat overdone. Um, and it's a trade that we've liked with some time with the Swedish kronner on the other side of it. And finally, um, we have covered a lot of ground on sticky core inflation. The other side of the story is a very buoyant equity market, which is seemingly impervious to hikes getting priced out. Now that may be puzzling or frustrating for macro investors, but with us as Amy Wu Silverman are equity derivative guru to discuss how the underground right tail signals more pain perhaps to come in the equity market. Over to you Amy.
Amy Wu Silverman:
Hi. Hello everyone. Thanks for having me on. So I thought I'd kind of turn this over to the high level aspects we've seen in the US options market. You know, look year to date it's been quite interesting. I've kind of called this, uh, a paddling duck market from the perspective of volatility, meaning it, it seemed resilient on the surface both from an s and p performance perspective, but also from a volatility perspective with Vic's sort of in and and around teens not going over that psychological 20 barrier. But when you look under the surface that duck is paddling and is paddling hard, we've seen violent sector rotations, we've seen extremely narrow breadth in the market that looks like it's only going to get more narrow and you've actually seen the demand for hedging return. This is actually the opposite of what we saw last year.
One of my favorite stats from 2022 is the s and p drew down 20% and you managed to lose more money being long. The s and p as well as systematically buying puts the P put index actually managed to be down 21%. Now, at the beginning of this year, we saw this start to shift away. We actually started to see tails the demand for tails enter the market. We started to see skews steepen. And I think part of the narrative as it relates to the debt ceiling was a lot of investors were mapping Vic back to 2011 to what seemed to be very similar in terms of fractious Congress in terms of something that could generate future volatility. And if you mapped back to 2011, what you saw was evict at very similar levels as it is now. But we actually didn't peak until 48 or 50 on the Vics.
There was substantial volatility in the summer months and there's been a lot of soul searching the weekend just because we actually did get a US debt ceiling resolution. Now there's, you know, four days left until we get to that X date. Obviously the night is young. But look, I think at this point it sounds like a deal will happen. And one thing we've talked about in the context of that is the right tail has been seemingly underpriced investors have gotten very good at thinking about the absolute worst things that could happen. Um, but not thinking about what could be the good things that happen. And one thing we talked about in the context of that debt ceiling is, was a resolution simply underpriced. Now piggybacking off that was we got these blowout in NVIDIA earnings and the reason that matters is we're starting to see signs in the options market in terms of call buying, call exuberance.
That really reminds me of what we saw in the YOLO meme craze, um, GME and A M C in January of 21. And in 20 you're starting to see skews and vert. So essentially the demand for calls in these names like Nvidia, a M d as well as the other mega cap tech names are starting to get so high. They're, they're actually subsuming the puts and what can happen and what has happened in the past is it creates gamma dynamics that essentially exacerbate the moves even more. So a lot of conversations I've had with investors are, if you have been underallocated to what is the most narrow breadth, but the highest contribution of return to the market, so meaning, you know, seven to 10 names that are your mega cat tech names or perhaps your AI beneficiary story names, what do you do now? And that's the biggest question because if there is a reallocation to these names, I think we could see a further exacerbation of those call exuberance that we've seen during the pandemic in other parts of the market.
If that is the case, then I do think that right tail again is something that investors should really consider and really think about. One final thing I'll say is as we entered this market, we essentially ran sharp ratios on every single stock in the s and p and every single stock in the Russell. And the reason we did that is we said, look, your cash yield is now real. It it's around 5%. And so arguably you should think that every single sharp should decline across the board. And we did see that except in two sectors in healthcare and energy. And my question is now is will that expected return in tech have to be rerated? And if that is true, then could we actually see rising sharps in the tech sector? And again, that matters more. That's the only game in town because that's the biggest breadth of the market and I will leave it there. Thank you.
Elsa Lignos:
Thank you so much Amy. And thank you to everyone for dialing in.
Speaker 8:
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