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 Dah:
Hi everyone, and welcome to this edition of Macro Minutes called, Sunburnt Bonds. I'm Jason Dah, your host for today's call, which we're recording at 9:00 AM Eastern time on August 22nd. Ouch! A sunburn never feels good and this is probably how fixed income investors are feeling after a disastrous year for bonds in 2022. The total return for treasuries has slipped into negative territory year to date recently, and it seems as though investors added duration exposure 25 to 50 basis points ago in this up move and there's little appetite to increase exposure right now.
This is leaving the low liquidity dog days of summer market susceptible to trend following and inflicting more pain on the longs. So today to opine on whether these moves in the market are justified will be myself, Peter Schaffrik, and Blake Gwinn. And Alvin Tan, is going to round out the discussion on China, which also has direct implications for global bond markets.
So I'm going to kick off the discussion with a few observations and opinions expanding on what I said earlier. First, the severity of the bond bear market cannot be understated from a total return lens. Prior to 2021, there was only small losses on a total return basis over any 12 month period back to the mid 1970s. But US treasury has lost 2% in 2021, they cratered 12% in 2022. And in recent days, the total return in 2023 has dipped into negative territory.
So as I mentioned before, investors generally jumped in and added long positions maybe midway through this run up in yields. And this is leaving the market with trapped longs, positions getting stopped out and susceptible to the machines and trend followers. Now granted, there is fundamental justification for at least some of the move given how the macro data has evolved recently, we've had resilience growth. There's also been higher real yields and the sharp reduction in 2024 rate cut pricing has been another big factor in this move up in term yields.
So if indeed there's not a lot of money to be put to work in fixed income, it might take a more sizable string of weak macro data to push yields materially lower. Now, the markets move further than I thought it would, but at least over the next few weeks summer trading, I'm unwilling to jump in and get long. I am more convinced however that eventually we will see a notable slowdown in growth. I don't think the growth cycle is as strong as some people are making it out to be, and I think the narratives are too positive at the moment. And I would say that at least in the US, there's nothing in the current data that precludes a downturn from happening in the future.
And again, it's probably just a matter of timing. Before I turn it over to the next speaker, some closing comments on the Bank of Canada. The market's pricing around a 40% chance of a hike at the September meeting, and that's not unreasonable ahead of the GDP data next week. Our motor forecast for the bank is no change in September as the preliminary signs of slowing should offset concerns about sticky inflation and be sufficient to keep them on the sidelines. So with that, next up is Blake, to discuss the US bond market and Powell's Jackson Hole, testimony later this week.
Blake Gwinn:
I think my comments are going to pretty closely mirror what you set up top there. I think in the US the selloffs basically had three parts, I think at the very end of July into the first week of August, I think there was some fundamentally justified part of the selloff that came around the change in YCC. We got information around the refunding process that put some questions around supply, brought term premium back into the forefront. And also at the same time the economic data was really supporting this soft landing narrative. So some of this was justified.
Then I think there was the second leg where we started to get into some positioning pain. We moved through some technical levels, long end ball was spiking and there I think it was more driven by this forced selling and some of these more technical factors.
Now over the last week or so, I think we've entered into almost a third section, which is that we're really just wondering higher because there's no one around to buy. I think a lot of the long-term buyers, as you mentioned up top, already bought 15, 20 basis points ago. They bought dips that occurred either late last year or pre SVB and there's very little dry powder left to put to work even though these levels are probably a more attractive entry point.
I also think to that extent there were prop shorts. I think a lot of those got cleaned out as they took profit 10, 15, 20 basis points ago. So there's really not a lot of that to take place yet. And then also I think there's no real technical levels up here from a chart perspective, we've entered into this no man's land where I don't think there's really any clear signs of support that the markets are looking to.
So that just allows us to continue drifting higher. And lastly, I would say, I always hate saying this, but late summer trading conditions, you have to give some respect to the fact that a lot of people are out on vacation and liquidity is probably poor. So you have to throw that in there.
In the very short term, I think we can probably stay in this higher range, perhaps even continue to drift a bit higher over the next few weeks, at least until we've got NFP on September 1st and then we've got the long Labor Day weekend right after when people were really becoming back to the desk in full. But away from the short term to a more medium term basis after we get past that Labor Day holiday. I do think that this level of rates is a bit unsustainable. I think for one, data's going to come back to earth a bit.
Right now we've got, if you look at the Citi Economic Surprise Index, we're at the highs of the entire hiking cycle. So that's got to swing back at some point, even if we're not getting outright bad data, at least getting some misses to what our expectations that keep getting marked up and marked up, so we will see some disappointment there. I think the pricing out of cuts is probably close to topping out. Right now, we've got Z3, Z4, a proxy for the cuts in 2024 getting very close to 100 basis points.
I think anything less than that as far as pricing of hikes is a bit unsustainable just given the asymmetry of the risks over the next year. Not necessarily our call, but that's a lot of time for something to potentially break and force the FED into a very significant cutting scenario. The market has to respect that asymmetry and the risks. And I think a very similar story with our star, which has been getting a lot of play the last week or so heading into, Jackson Hole.
Right now we've got five-year, five-year rates around 380. That's essentially the level with October 22 highs for this cycle. And moreover, I think we're 50, 60 basis points away from the highs reached in the taper tantrum of 2013. So very, very elevated levels there. I put out a piece that goes into more depth on this yesterday. I do think FED estimates are going to start drifting a bit higher for that long-term neutral rate. But I think the changes will be fairly marginal and I don't see them going back to those pre GFC highs.
It's largely because a lot of the secular factors that push down our star to begin with over the last decade are still going to weigh on our star going forward. So I don't really see expectations for a higher star as a really strong thesis by which to get structurally short rates here, at least not on its own merit. It's a very long slow burn type of thesis and I don't really think it's going to be worth as much as expected.
So if I can sum all this up, I think fundamental developments late in July and into August do increase the probability of soft landing, bring term premium back into the forefront and probably justify a higher yield range for Q3, Q4 than we've been forecasting coming into the summer. But I think we've overshot that range a little bit over the last week or so and expect us to dip back into something closer to say a 375, 425 range by mid-September.
And I expect that if we get there over the next few weeks that that's a range that should hold for the remainder of this year. Now as to what could move us sustainably outside of that, either the top side or low side, I think that's going to take some real big shifts in the paradigm, but we'll save that for another call. And with that I'll pass it along.
Jason Dah:
Okay, thanks a lot, Blake. Over to Peter, on the European markets.
Peter Schaffrik:
Thank you, Jason. Thank you, Blake. Well, first of all, the first thing to note is that for a good part of this year bond markets selling pressure could be traced back to events in Europe at the beginning of the year when European Central Bank hiked rates faster than previously expected. And when the overlooking data turned out to be quite strong. And what we've seen is that at this part of the year when the bond market was under pressure, treasuries were actually outperforming.
This is not the case this time round and the latest wave of selling pressure we've seen should very clearly indicate, or very clearly indicates that it's emanating not from our shores. But nevertheless, obviously these are international markets and we're all related, so we tag along. But you could see Blake, was highlighting to the technical factors in neither buns nor in gilds we have broken through the previous highs that we've seen or established earlier in the cycle. We're bumping along very close to the peak, but we haven't broken through.
Equally, we haven't had the same kind of selling pressure emanating out of real yields. Over here in Europe, real yields have been going much more sideways, which is another indication that we've been following the US rather than leading it. And when you look at the data releases that have been coming out, they weren't spectacular but they weren't particularly weak either. They pretty much came in line with expectations of both Bloomberg Consensus as well as the respective central banks.
And the message that we've gotten from the central banks was a mild hawkish buyers. So I think the market is essentially sitting here waiting for the next data points to arrive, waiting for guidance from international markets, waiting for guidance from central banks, which over the summer period hasn't really been forthcoming.
Now having said all that, I still want to stress that so far what we haven't seen out of Europe, despite the forward-looking indicators, particularly the PMI having turned significantly lower, is that the hard data has followed. And in particular I stress an element that we have been stressing for many, many months now is that labor markets remain exceptionally strong, much stronger than you probably would expect at this turn off the cycle. And that, of course, means that the underlying dynamics are such that central banks will have to guide the market focus.
And I want to return to something very briefly that Jason, mentioned at the beginning of the call. One of the drivers of the latest selling pressure that we've seen was that we have been pricing out rate cuts in the 24 forward space. And this of course is something that particularly the ECB, to a much lesser degree and Bank of England, have been indicating. They have been indicating that they get very close to the peak and we can have a debate about whether that's going to be at the current 375 or whether they're going to go to four ultimately in case of the ECB and how many more rate hike we'll be getting from the Bank of England.
But the key is that the message that we're getting is that even if we are reaching the peak, the market should not expect a quick turnaround, and central banks particularly over here in Europe to cut quickly. And I think that's something that we'll hear more and more as we approach the next meeting and as we come out of the summer period, when central bankers would make more appearances and it would remind everyone that Lagarde, is also speaking at Jackson Hall. So we might hear that message already from her there.
So therefore my summary at this stage is our markets have been selling off as well. I totally agree at this stage, I wouldn't necessarily be buying straight away into this on the market sell off, there are probably still lopsided positions over here in Europe as well. And I think the question that ultimately remains to be answered is how long will these policy lags be? How resilient will the economy be? And I think for the time being, the only answer for that can be probably longer than we thought and totally more resilient than we thought. And with that, I'll hand it back.
Jason Dah:
Okay, great stuff, Peter. So Alvin's up next to tell us what's happening in China and with the renminbi.
Alvin Tar:
China's growth rebound following the pivoted away from zero Covid is fast losing momentum. And we got important data to confirm that the slowdown has accelerated into the third quarter in the past fortnight. So last week for example, we got the key growth indicators for July, and particularly industrial production and retail sales showing the loss of economic momentum into the start of the third quarter. And before that we got the credit growth data, which also shows decelerating credit growth in China.
It's important to note again that China never had the pandemic fiscal handouts that were common in the developed economies. And so households and firms have become very cautious in their spending and borrowing behavior. And this has led to a fundamental lack of demand in the economy. And to add to this exports growth has also tumbled recently, which is of course exacerbating the downside growth pressures emanating from the domestic demand deficiencies.
And on top of all this, the property sector downturn, which has been a major drag on the economy, appears to be worsening. So in particular recently we've seen that the credit problems within the property developers have definitely intensified. So country garden, which is by some measures, one of the largest private property developers in China, is now at the brink of default. Two years ago when all these property credit problems first emerge culminating in Evergrande's default in 2021, Country Garden was actually seen as a safe haven. But now as mentioned, it is itself on the brink of default. And so this is of course exacerbating the ongoing economic slowdown, adding a financial dimension to the current macro risks in China.
And finally, credit demand by private firms and households have shrunk considerably. Though I think it's important to emphasize that a Japan style deflationary spiral is still not evident, which I'll talk a little bit more about that later. So all in all, the overall GDP growth target of "around 5%" for this year is now at risk despite the assist that it should be getting from the lower base effects due to last year's depressed economic activity from the various Covid lockdowns.
Now, more recently the PBOC has indeed stepped up defense of the renminbi, particularly after dollar CNY reached the 730 level in recent days, which matches the high that was reached in the autumn of last year. So I think it's becoming clear that the authorities are trying to at least defend this line for the time being. And we are seeing a combination of persistence lower than expected dollar CNY daily fixes. And also more recently funding squeezes in the offshore renminbi market to try to defend this 730 level.
Now, I think it's also important to emphasize that despite the news being rather gloomy as it is that it is not entirely all negative, as mentioned. China has not entered into a Japan style deflationary spiral in my view. So credit growth is very weak, but credit by and large is still growing. So credit growth has not turned negative at an overall economy wide level at this point. It's weak but still growing.
And also recently there was a lot of headlines about the fact that the headline CPI inflation rate in China fell into negative territory on the year-on-year basis. And now that is true, but at the same time when the data came out, the core CPI number actually ticked higher and core CPI is still in positive territory.
I think it's fair to say that there are significant base effects that is driving the negative headline CPI rate in China. And it's not yet clear that we are in a persistently deflationary cycle in China at this point.
So again, it's important to emphasize that despite all the negative news and all this talk about the Japan style deflationary spiral, China is not yet at that stage. And I will end it there. Thank you.
Jason Dah:
Okay, so thank you everybody for joining this edition of Macro Minutes. The narrative in financial markets is fluid, and right now the trend is your friend, but we think that might change in the coming weeks and months. So stay tuned to our publications or reach out to us directly for additional insights into what we're thinking on the direction of yields and curves.
Speaker 6:
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