Speaker 1:
Hello, and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Simon:
Hi everyone. Welcome to the August 30th edition of Macro Minutes entitled, The Bears are Back in Town. Despite a hawkish Powell being expected at Jackson Hole, we have seen yields push appreciably higher in recent days. Curves are more mixed, however, and recent ECB speak has been leaning towards a 75 basis point hike at next week's meeting. To provide some insights on this landscape, we have a full lineup of RBC experts. Peter will discuss energy price increases and the forthcoming implications for the economy and markets in Europe. Blake will give a full wrap up of Jackson Hole, and I will look ahead to the BOC September 7th meeting. Michael will discuss cross trends in the oil market and how policy and fundamentals are shaping the outlook. And finally, Elsa will provide the latest in FX space. So over to Peter.
Peter:
Thank you Simon. So what I'll try to do is, I'll obviously take a European lens, and I want to speak first of all about the economy a bit and about the recent increases that we've seen in natural gas prices, and particularly in power prices, and the implication on the economy, and then secondly, feed it into the bond market and speak also particularly about the ECB meeting that's upcoming next week. So first of all, what we have seen over the last couple of weeks is a fairly significant increase again in gas prices, as well as in power prices. So over the last month or so, we've seen about a 250% increase in power prices in particular. And yes, of course, power makes up only a small percentage of the consumer basket, but given the increases that we've seen on the continent of Europe in particular, this is going to be meaningful. At the same time, we've also seeing gas prices accelerate once again, and we've had that debate before, that's obviously going to be a negative for the European economy, because we are net importers.
Now, I want to throw out a point that I made on a previous call, but given the development I just outlined, is very pertinent. In our view, there is a significant distinction between the current situation where both gas and power is readily available, although at very elevated prices. What this situation is likely going to do is, it's going to eat fairly significantly into disposable income of consumers and drive the economy lower because consumption for non-energy related products will have to suffer. This is essentially our base case scenario. That's what we have priced in. And for the Euro area in particular, we have Q4 and Q1 this year and next year respectively at negative quarter-on-quarter growth rates. Now, given where power prices have gone and energy prices more generally have gone, the risk is probably still to the downside, but this should still be a situation that is on the one hand manageable, and on the other hand is also one that one can recover from relatively smoothly, I would say, once we go into the next spring and summer when energy consumption eases again.
Now having said that, the risk remains that we get into a situation where rationing would have to come in, as the availability at any price is simply not guaranteed or not sufficient. Now, this is a downside risk, is not our base case, is a tail risk, but this could potentially lead to GDP drops that are much larger and would be more reminiscent of the pandemic where essentially companies, plants or entire industries would have to either partially or entirely shut down. And again, this is not our base case, but it's clearly something that we keep on our radar screens and would review accordingly if we change our mind on this. Now, against that backdrop of a weakening growth outlook nevertheless, what we've seen is that central banks around the globe, and particularly also in Europe, have increased their hawkish rhetoric, because obviously this is also inflationary, and without stealing Blake's thunder, following the relatively hawkish comments that we've seen from Powell, quite a lot of ECB speakers chimed in and some of them have demanded a 75 basis point rate hike at next week's meeting.
Now, we think that's a little bit premature to speak of 75 basis points. We think that they will go 50 again. And in fact, we have penciled that in for a while, and we have penciled in another 50 basis points to come in the October meeting, because they have to weigh the weakness of growth on the one hand, and higher inflation levels on the other hand, and we think that this path will probably suit them well. Having said all that, however, what the market has clearly done over the last two weeks, it has pushed implied front end rates higher once again. That's particularly true for the UK where the data that came out was relatively strong, and also in the Euro area.
And we think that generally speaking in this environment, it is very difficult to go against the grain of a market that wants to push central bank rates higher, and where the central banks have remained on a hawkish war path with inflation for the time being. So therefore we think this is an environment where we can see European yields being shifted higher. As just one example, our year end target for 10 year bonds is 180, which compares to 145 with the current rate, and we therefore think that selling into upticks is the preferred strategy. With that, I'll probably let it go, but clearly the message from Europe is that the inflation picture is not yet tamed. Thank you.
Simon:
Thanks for those insights, Peter. Now we'll shift to Blake for takeaways from Jackson Hole.
Blake:
Yeah. Hey guys. Thanks. So first, I guess, wrapping up on Jackson Hole, in isolation, in and of itself, the speech was definitely hawkish in that Powell was very clear and succinct in his commitments to continuing to raise rates further, and noting the view that both some economic pain will be necessary and tolerated, and also that he expects rates will be held in restrictive territory for some time. But whereas that might have been, I think in isolation hawkish, if it's measured against what we already knew coming into the event and some of the hawkish expectations of the market, I actually thought it was fairly neutral, and it was really more just a distillation of themes that we've already been hearing from both Powell and other Fed speakers for the past several weeks.
Indeed the reaction in rates was initially relatively modest if you look at what's priced in for the Fed over the next year or so. Even out further the curve, we had relatively modest moves. I think looking across to things like equity markets is where you really see more of that hawkish interpretation coming out of the meeting. But as I said, nothing I heard Powell say in that speech really shifted my view on the next few meetings, and in fact, Powell was actually very clear to maintain optionality there, pulling back from any type of commitment on 50 or 75 to the next meeting. And even out on the longer run path, nothing there kind of shifted my view. I still think one to two cuts being priced to late 2023 seems reasonable. That's not because I doubt the Fed's conviction and what they've all been saying right now, or doubt Powell saying that rates would remain in restrictive territory for some time, it's really that they're going to be data-dependent, and when the time comes, if the economy's looking soft in late 2023, they will respond accordingly.
They're not going to hold rates artificially high to abide by some vague forward guidance they provided a year prior. So part of our view on further out the curve and some of those cuts being priced in is not, again, that we think the Fed is just all of a sudden going to become dovish, it's really more about the data that's getting fed into that reaction function when that time comes. As for September, we still think they step down [inaudible 00:08:45] basis points, but think markets are essentially going to keep it as a toss up between 50 and 75 into the meeting, and that's part and parcel of the Fed really deliberately backing away from this meeting-to-meeting forward guidance at the last FOMC meeting. Not only that, but I think the data during the blackout, most importantly, the August CPI, is very likely to serve as a decider and the Fed really wants to take a look at that and have that optionality open if the data leans one way or the other.
So right now, we see 50. Again, we would also like to look at that data coming, perhaps that we see something there that pushes us more into the 75 camp, but for now, basis 50. What I will say, pulling back from that discussion though, is that we care a little bit less, I think, about whether it's 50 or 75 at this point, because we're kind of moving out of this period of very heavy front loading. I think in Q3 and Q4 of this year and into 2023, it's going to be more about how long they keep delivering 25s than the size of each individual hike. So for the first half of the year, I think everybody was very, very focused on how big is each individual hike going to be. Now it's really about how long are they going to continue to do these kind of more modest hikes, how far are they going to take it in restrictive territory.
So whether or not they go 50, 75 at the next meeting, that either way still leaves open this path where they could keep delivering 25s well into next year, and that's really the more important part that I think markets should be focused on. Lastly, I just wanted to real briefly touch on QT, because there have been a lot of questions coming in. The Fed officially steps up the caps to full pace in September. So we've been getting a lot of client questions coming in about that. I want to stress that this really has no real impact. This date has long been known. We knew how this mechanism was going to work for months now. On the treasury side, the way that QT really matters is that, it changes the amount that treasury has to fund in private markets.
But treasury knew this was coming as well. They met back in August, had their August refunding announcement. They already knew that this step up was going to happen. They factored this into their issuance plans. And we already know what those issuance plans are for the next quarter. So the official start of these higher caps have already been accounted for in the issuance pace. So this really shouldn't be something that has a major market moving impact. Even on the MBS side, the sharp rise in mortgage rates that we've seen over the past months have really slowed prepayments on the Fed's portfolio. So even there, they're very unlikely to hit these new larger caps. So very little impact on that side. And lastly, as far as reserves, we're still in a position of massive liquidity overhang.
We don't see any real signs of funding market pressure starting to bubble up. So the faster decline in reserves that comes along with these larger caps is still something that I think is going to be months and months before we really see it starting to bite in markets. So just wanted to make that note, because I think this has drawn a lot of attention. It showed up in the media in some pretty prominent headlines, and wanted to address that this official step up in the caps for QT doesn't really have any kind of near term major impacts. And with that, I think pass it over to Simon.
Simon:
Very useful, Blake. Thank you. Now I'll discuss what to expect from the BOC next week. Market participants have for some time look towards the September 7th meeting with three legitimate policy options. So 50 basis points, 75, or 100 are all on the table after the bank retained flexibility at the July meeting. The 100 basis point hike at that meeting saw them hit the midpoint of their two to 3% neutral range. Our clear base case next week said they hike by 75 basis points, which would take the overnight target just into restrictive territory at 3.25%. Market pricing has leaned towards 50 and 75 basis points at different times since July meeting, with more recent levels showing a 75 basis point hike almost fully priced. Our risk lean from 75 is definitely towards a 100 basis point hike, given a still concerning situation for an inflation targeting central bank, and a strong desire to ensure they reach the 2% target over the medium term.
So err on the side of too much, rather than not enough tightening. Developments since the July meeting have not provided a strong skew in either direction. Inflation, front headline, CPI moved down to 7.6% in July, but that was due to lower grass prices, while CPI-common spiked and core measures are generally elevated around the 5 to 5.5% range. For the labor market, back-to-back declines in the main jobs report look a bit suspect, maybe due to [inaudible 00:13:38], and the unemployment rate remains historically very low at 4.9%. The [inaudible 00:13:44] payrolls report last week, so the secondary jobs report showed a huge 115K increase in June, and wage measures more broadly remain elevated around 5% year-on-year. Looking at the product market, so GDP. Q2 GDP actually released on August 31st is tracking roughly in line with the July NPR. Slightly above, so 4.5% versus 4% annualized, with growth momentum slowing to close the quarter and into Q3.
Indeed the strong headline number reflects the first fully open quarter after Omicron restrictions were in place early in Q1, and we do expect growth to slow in the second half of the year with the timing and follow through from [inaudible 00:14:23] consumption something to watch particularly closely. Looking beyond September meeting, we expect a final 25 basis point hike at the October meeting and NPR, and a terminal rate of 350. The risk here is clearly higher with 375 or 4% more likely than 325%, given continued inflation risk from elevated core inflation and wages, and only the earliest [inaudible 00:14:50] in headline CPI. So still too early there.
The labor market remains tight, and an expected growth slowdown is only likely to materialize in the coming months. Nevertheless, the bank is likely to eventually signal a pause in the rate hiking cycle, which we think will come at that October meeting alongside updated forecast. The messaging around a pause is likely to emphasize that more hiking could be coming and that they do not envision any rate cuts in the horizon. So policy rate to remain restrictive. And with that, I'll turn it over to Michael to discuss oil.
Michael:
Hi everyone. Good morning. So look, I'll say that oil prices clearly have been very, very volatile in both directions this summer, and liquidity and positioning, we think, have been really big drivers of this volatility. So a few quick thoughts here. Now, if you look over the summer, so since June, spot WTI contract volumes have been trading at mere 57% of seasonally normal levels seen over the course of the past five years. So in other words, liquidity is about 43% below normal so far this summer. The other point is that the recent two month slide in oil prices has really been met with the sharpest collapse in positioning for the investor long to short ratio since the 2018 attack on Abqaiq in Saudi Arabia when oil prices came off after that spike. So an incredible amount of length has come out of this oil market in a very short period of time.
Now, the macro pressure that we've seen in terms of selling on recession fears was effectively done into a liquidity gap over the summer, really hence amplifying the recent oil price weakness in the financial market. I will say that commodity hedge funds, trading houses, energy specialists still remain quite constructive on the fundamental backdrop, but there's been an incredible amount of volatility. We're still holding in the mid 90s for WTI, even though liquidity is thin. But away from the short term noise here, I'll say that the structural multi-year constructive oil thesis does remain intact, particularly when you look through the winter and beyond, so call it three months from here and beyond. But over the very near term, I think that we'll just continue to see very choppy trading, and the market is very much in search of near term upside catalysts. And the choppy trading so far over the course of the summer, I thin, is very fair.
I mean, the five biggest needle moving catalysts for the oil market right now are all policy-driven. So when you think about things like the Saudi put option, or the OPEC potentially threat to take barrels off the market of course is bullish. If you think about the potential for an Iran deal, that's bearish. Russian barrels rolling over, that of course is bullish, with December 5th the end focus when the EU embargo comes into play, things like strategic petroleum reserve, and then of course the resumption of Chinese demand also is bullish. But when you think about these five drivers, all of these are policy related, and really despite having various different odds of coming to fruition, and of course timing matters for all of these things, they all have quite asymmetric outcomes. So I'll just unpack just a couple of these over the next minute or so. Number one is, when you look back to weeks ago, the Saudis put a floor into this oil market by saying that there's a disconnect between the physical and the financial market.
They suggested that they could potentially tighten the market by taking barrels off if the market gets looser, and this shook a lot of the shorts out of the market. And so when ABS wants $100 a barrel oil, you've seen that Brent price of course moved right up to $100 a barrel and basically been pinned to that price point for the course of the past two weeks. On strategic petroleum reserves, the US now has sold 155 million out of the 180 million that they vowed to sell. So we have another 25 million barrels that we need to sell. Originally, its supposed to be wrapping up in October. We think that this SPR sale is going to drag into November, but you're going to be done after that. The other point I'll make here is, a lot of people talking about the likelihood of an Iran deal.
We still think from a host view that the odds are quite low. The sticking point here is the same as it's always been. The Iranians are looking for assurance that whatever deal that they do with the Biden camp, that will get grandfathered through to whoever is in the White House next, whether it's a Democrat or a Republican. So recall Obama did the original Iranian nuclear deal, Trump came in shortly after and ripped up the deal, and now Biden is trying to put the pieces back together again. So this is a very logical ask from the Iranians, but it is a promise that Biden can't make. Now, even if the deal is done, barrels hitting the market is likely a 2023 story at best. You need time for certification. You need time for a congressional review, et cetera. This is a low likelihood, but high impact occurrence.
The second last point I'll make is on China, and the entire oil market is waiting for this one. I'll say that the Chinese oil metrics have been just truly atrocious lately. And remember, China's historically been the world's largest oil demand growth center, but when you look at refinery runs, which is another way of saying crude demand, demand has not been this low since the early days of the pandemic. And then when you look at Chinese crude imports, they've recently hit the lowest since 2018. Now, this of course is not specific to energy markets, given China's zero COVID policy, but the data just continues to trend worse. Now, I'll wrap with a few bullish indicators. Number one is crack spreads just continue to price at economically attractive levels for refiners to continue to run hard. Particularly the diesel track is very strong all across the world.
When I talk about refineries running hard, that's a fancy way of saying crude demand will remain strong. I will also say that refined product [inaudible 00:21:22] rates continue to be very robust. This is a clear sign that demand destruction is not as bad as the market may have feared, given that people are still bidding up the transport needed to get access to that fuel. And lastly, when I say that Chinese demand has been very weak for obvious reasons, there's other countries that are similar to China that are punching in at near record high demand, and India is really in focus there. But with that, why don't I wrap there and pass it back to Simon?
Simon:
Thank you very much, Michael. We'll finish up now with Elsa on FX.
Elsa:
Thanks, Simon. So I'll keep my comments very brief. And a couple of implications from the comments made before by Peter, Blake, Simon and Michael, first for currencies more generally, as we think about central banks trying to keep up with the pace of tightening, and the ECB, we've heard a lot of more hawkish rhetoric, it's important to note that there are still quite large differences between the absolute level of rates in say the Euro area against the US and Canada, and that for all the global forces at play, we have ended up in a situation where carrier is actually coming back to matter within G10 when you talk about rates getting to 3.5% say in Canada, with the risk that they end up higher versus the Euro area, where with all the best will in the world, the ECB is likely to be probably 200 basis points below that.
The other factor to mention is the longer term crude outlook just mentioned by Michael, and that really points to constructive environment for CAD, not necessarily against the US dollar, but certainly on the crosses. If we tie that in with some positioning metrics that we look at, the market is generally very long US dollars against a broad range of currencies, but you can't really see any material differences between say dollar CAD and the likes of dollar stocky or Aussie dollar, Kiwi dollar. And even [inaudible 00:23:21] and Euro dollar, that we love to hate, do have more crowded short positioning, but certainly not extreme by any means. So we do see some potential for CAD outperformance on the crosses, particularly over a long term horizon, bearing in mind the comments made by Simon with the Bank of Canada looking to get ahead of the curve on inflation and keep rates in restrictive territory.
Speaker 7:
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