Jason:
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, everyone, and welcome to the July 26th edition of Macro Minutes. We called it this week the Need For Speed. So old school movies like Top Gun, they've been rebooted into a successful sequel and central banks are full throttle on rate increases in a throwback to their early 1980's inflation fighting mode. The Bank of Canada, they've surprised with a hundred basis points, the ECB surprised with 50, and while the feds expected to hike 75 basis points, it could be naive to rule out a larger move or a surprise this week.
Jason:
So to help us navigate the OMC this week, we're joined by Tom, our US economist for US views on the bond market. Blake Wynn. Peter's going to tell us about the ECB and what looks like an increasingly dismal European growth backdrop. I'm going to discuss central bank surprises. Why a recession probably won't surprise anybody. And whether rate cuts in 2023 should be faded. Elsa in FX, she's going to tell us about the link between currencies and commodities and Lori in equities is going to update us on her bullish call on small caps. So over to Tom to kick it off on the FMC meeting this week.
Tom:
Great. Thanks Jason. And good morning, everyone. So look, I'll make a few quick comments here first on the fed. I think that this is obviously a, I think, a fairly anticipated meeting relative to the outcome. It looks like we're going to get a 75, as Jason said. We've been saying for quite some time, we don't think that you can completely rule out a hundred. But in fairness, they were going to do that, I think that would probably prep us a bit more. So I think the odds are incredibly low.
Tom:
There's still some element of [inaudible 00:02:07]. So brace yourselves for 75. I think what comes with that though is, Powell remaining pretty hawkish. I think it's going to be incredibly complicated for him not to be. Again, I think you all know my view. I think there's elements of the economy that are in recession right now. And I think when we get that GDP report later this week, I think it's going to sort of bear that out.
Tom:
And I'll say more about that in a moment. So, I think, Powell has to continue sort of push this idea that they're basically full steam ahead. We're obviously watching closely or listening closely for any commentary around what comes next. I think we're probably in line with what a lot of other folks are saying, which is to say a 50 at the September meeting. And then in the November, December meetings, right now we have 25s built in, but again, as we've said, let's see if they're able to get there, just given how some of the data will evolve between now and then.
Tom:
I think that we need to be mindful of sort of the mismatching timing. Again, we feel very comfortable saying that things are slowing down and that by the end of the year, I think we'll meet a very different place from a growth perspective. Again, I think you can easily make the argument that we're in recession right now, as I wrote so many times at this point. This is the most anticipated recession that we've we've ever seen.
Tom:
And so I think that it's something that is going to weigh on the fed's decision making process. The problem is, they're so close to the inflation problem now. Inflation's going to remain elevated. I have a decline built in from a month on month perspective for next month, at least at this point a working assumption as we always have.
Tom:
And even with that, the year and year still remains elevated. So I think so just from a data reporting perspective, I think it's going to be complicated for the fed to really back off, particularly any anytime soon. Watch that GDP report. I know everyone's probably focused on the fed. I think the GDP report is going to be pretty key, in terms of getting sort of sentiment in place for the week. I think it's going to look pretty weak, so something to watch and I think that's it for me. I'll pass it back to Jason.
Jason:
Okay, great. Thanks a lot, Tom. Next up is Blake to tell us about the US bond market.
Blake Wynn:
So yeah, just kind of picking up on the FMC where Tom left off. Markets are, as Tom said, it does look pretty clear that we're going to get 75 base points tomorrow. Markets are only priced several basis points above that, very clear indication for markets that's what we're getting. And also as Tom said, the fed did have plenty of chances post CPI to open up a discussion about a hundred. They basically punted on that. Didn't take the bait.
Blake Wynn:
This isn't like the last time when we got several inflation prints in the kind of blackout period and that leak, where they kind of moved market expectations. The CPI came with plenty of time for them to kind of pivot if that's what they were looking to do and they didn't. So it does seem very likely that we get 75 basis points, but without dots and assuming we get that 75 basis points, most of the post meeting price action is going to be completely dependent on Powell.
Blake Wynn:
And most of the focus there is probably going to be on any kind of near term Ford guidance, which as we've seen in the last few meetings, he's all too willing to provide that kind of numerical guidance around the next few meetings. So most of the focus is probably going to be on what he says about September and perhaps even November. Right now, September's only showing about a 30% chance of a 75 basis point hike still mostly priced for 50. If you go out to November, we're really only showing about a 30% chance of a 50 versus 25.
Blake Wynn:
I doubt he'd really explicitly discuss anything much beyond that. He's been pretty hesitant to provide guidance more than a few meetings out or kind of discuss any specifics around the terminal rate. And to that point, markets currently have terminal price for December at essentially the 325 to 350 range after trading as high as 4% during the intermediate period.
Blake Wynn:
So there's definitely room for that to move up. I just don't know that Powell's really going to say much to directly kind of push on that terminal rate. Again, I think he focuses mostly on kind of the next few meetings, which again, there is some room there where things could move up if that's the way Powell does want to push it.
Blake Wynn:
If he says something tomorrow to meaningfully kind of push up that kind of front end pricing or even out to terminal, I'm not entirely sure how the long end would really react to that. Given that the market response to CPI and other recent hawkish CD events has really been to rally, I wouldn't be surprised even if we did get some push up in the front end or even that kind of long tail risk of a hundred basis points.
Blake Wynn:
I really wouldn't be surprised at the long end actually rallies out of that after kind of the initial knee-jerk reaction subsides. For now, it's really just going to be hard for the markets to kind of break this recession minded trading paradigm, where we've basically taken any near term, any additional near term pricing of fed hikes and translated as more cuts, more risk of a hard landing in 2023 and beyond. And seeing that really push down lower long end rates.
Blake Wynn:
That being said, we are near the bottom end of the recent range in 10. So I think the willingness of the markets to compress that further, if we get a hawkish fed tomorrow, maybe somewhat limited. On the other side of the coin, I think there would obviously be a lot of focus on any concerns he highlights about the growth side, that could definitely drive a bit of a dovish response.
Blake Wynn:
And maybe markets are perhaps a little more sensitive to that than they would be to any kind of additional hawkishness. But I doubt those are going to come and assume he maintains essentially the same language that he and Yellen have both been using, that as they look around now, they're not currently seeing any signs of slow down and kind of refocusing the conversation back on the inflation side.
Blake Wynn:
But if we did get some kind of concerns or if they signal any kind of concern that they may be shifting back to the growth side employment side of the mandate, I think that would obviously be something where we could see the more dovish reaction, the kind of bullish steeping out of that, that ... I think is the flip side of this recession minded kind of trading that we've seen on any hawkish news.
Blake Wynn:
Lastly, last thing I would say is that just with kind of what we've seen the recent rally and rates, the retracement in equities from recent lows and kind of the easing in overall broader financial conditions over the last few weeks, if anything, I really do expect that they probably want to come out of this on the hawkish side. Again, I don't think they go a hundred, but I think Powell is probably going to try to focus his language, to provide some ... to kind of bolster that hawkish language, just given that we have seen financial conditions easing in the weeks heading into this meeting.
Blake Wynn:
Again, not a hundred, but any way he can use that qualitative piece of the Q and A to kind of reinforce their hawkishness, I assume that's the direction he's going to be trying to push things. And with regards to the market price action coming out of that, I do think there has been just anecdotally, I think still some modest positioning for that a hundred basis point hike, even though that's not anybody's real kind of modal expectation, just given surprises we've had with other central banks in the last few weeks.
Blake Wynn:
I do think there may be some slight positions on for that kind of stuff would have to get unwound on that 75 delivery. So we may see a slightly dovish reaction to the initial statement before we actually get Powell speaking. The delivery of that 75, maybe we get some very light odds of a hundred getting priced out of the market and see that kind of dovish price response is the first, the first leg, at least until Powell starts speaking. And I'll go ahead and leave it there and pass it on to Peter.
Jason:
Okay. Great stuff, Blake. ECB, so they surprise last week, but more interesting has been the price action since the meeting. So over to Peter to enlighten us on the European situation.
Peter:
So actually, Jason, what I'm going to do is first of all, I'll probably say something about this current gas situation then I'll speak about the ECB and I'll give a little bit of a segue into the Bank of England, which is also going to have its policy meeting next week. So, first of all, one of the reasons I think why the market has reacted quite forcefully lately to the bullish side over here in Europe certainly, is that we have an ongoing conflict of course, about gas deliveries. Everyone knows about that.
Peter:
We had dropped the gas supply from Russia, particularly into Germany through the so-called north stream one pipeline down to zero over the maintenance period. They switched it back on, but already there were sort of indications and that this wouldn't last the situation. And just last night, the Russian site has announced it from Wednesday onwards, they're going to reduce it further to about 20%.
Peter:
And so we have put a note out about two weeks ago, where we looked at this situation and just as a little bit of background and the Germany uses, is particularly used as a storage hub for other European nations as well, where it's re-exported. And one of the risks of course, is that there's not enough gas coming in, either for Germany or the surrounding neighbors, and then gas rationing would have to be in enforced. And particularly in the current environment, the current regulation in most European countries and EUI it stipulates that if a rationing is put in place, private households are going to be prioritized, which implies that industry is sort of second order. And that could potentially lead to quite a significant drop in production, enhanced GDP. That's why the market is so forcefully looking at this.
Peter:
Now in the note that we did, we modeled what kind of demand cut back ... sorry, usage cutbacks could be put in place. What kind of export cutbacks could be put in place to prevent a situation where there's an actual shortage. And that in my mind is the absolute drop. It's not necessarily only the price that's clearly negative, but if we get into a situation where there's simply not enough gas going around to fire up industries, that means shutdowns in a very significant drawback in GDP.
Peter:
So far, that doesn't seem to be the base case, but obviously the more this situation or the stronger this situation has been enforced from the Russian side, the higher the risk gets. And that obviously has implication on markets. So that was just as a precursor.
Peter:
Now, as regards to ECB, as you said, Jason, they have surprised the market rather than doing a 25 basis point rate hike, they did the 50 basis point rate hike. And they have argued that one of the reasons for that was the higher inflation and inflation expectations. And the other one was that they put in place the anti fragmentation tool that they have worked out. Now, they have coined this very specifically as being front loading and have said, what Lagar has said and that the end point that they want to get to broadly neutral without getting drawn into the debate where that level is, would not change.
Peter:
Now what the market has done out of this, which seems quite rational, particularly in light of what I said before of increasing risk to GDP through higher energy prices and potential shortages of gas in the first place, is that the money market curve has been flattening and the entire bond market has been rallying as a consequence. And thus, it seems to be quite paradoxical that even though the ECB surprised at the same time, the market has been rallying. I think the combination of higher gas prices, higher energy prices, potential supply shortages, as well as the more aggressive central bank in the here and now has led to that situation.
Peter:
We previously had a target of about 1% in tenure bonds that has been surpassed. We haven't taken profits. We now think that we could go back to probably in the area of about 80, 85 basis points and that the market has been pricing out a little bit more of the hikes that it has been particularly in 2023. Now last but not least before I let you go, after the fed is before the Bank of England. The Bank of England has in the past meeting said that they would act more forcefully if the energy price situation does not improve. It certainly hasn't improved. Inflation has not improved. And in the last big speech that the governor of the Bank of England in the so-called mentioned house speech gave, he very specifically mentioned a 50 basis point rate hike.
Peter:
So far, they haven't done that. So far they've only gone in 25 basis point steps. So it seems very likely that when the bank meets next week, that they would also go 50 basis points. The question is, how's the market going to take that? And particularly how's the market going to steer the ... how's the bank going to steer the market if at all, because they're very reticent in that. But when you look at sort of what is implied in the [inaudible 00:14:46] futures, particularly sort of going forward, and we're still sort of priced for a string of further rate hikes. And given what's happening internationally, I think it's quite plausible that we price out a little bit more here as well. And with that, I'll probably pause and hand back to you, Jason.
Jason:
Okay. Thanks a lot, Peter. So I'm going to discuss three topics, one Central Bank surprises. Secondly, wire recession, won't surprise anyone. And third, this issue of the rate cuts being priced into 2023. So on the first topic, Central Banks are clearly in surprise mode. And I think this is exactly the policy prescription that should be followed in order to show markets and the average person that they're serious about fighting inflation.
Jason:
So I think meeting market expectations just simply doesn't do the trick and micro forward guidance for each meeting is probably not the right kind of approach. The Bank of Canada ECB, they did have the fortitude to deliver a surprise. The feds, probably a little bit more sensitive to market pricing, but I think from an overall perspective, kind of no real good reason to kind of opt for a smaller move at this meeting.
Jason:
So, the market's giving kind of a mere 10% chance, a hundred basis point move, which [inaudible 00:16:07] paying the meeting is worthwhile. The second topic, a recession that won't surprise anyone. And this is evident in two separate areas. The first, when you look at the Google trends data, it shows that searches for the word recession in the US is even higher than when the US economy was actually in recession in 2008 and 2020. In Canada, searches are on par with what we saw in 2020 and higher than in 2008.
Jason:
So, the ultimate end game of current Central Bank policy will probably be recession, which we do forecast in the US and Canada in 2023. But you know, that arguably could happen earlier. As Tom pointed out, there's a lot of areas of the economy that are showing quite a bit of weakness at this point. But if this had happen it's clearly not going to surprise Wall Street and it's not going to surprise main street.
Jason:
Second, growth fears also visible in how the long end of the curve is behaving. So since the Bank of Canada hiked a hundred basis points, 10 yields are down almost 40 basis points. And since the ECB surprised with their 50 basis points, German 10 yields are down about 25 basis points. All of this is in reaction to the negative growth consequences of higher rates. So, the market's not going to be surprised by a recession either.
Jason:
Lastly, there's probably a pretty high bar to rate cuts in 2023. The markets currently discounting peak rates around January, give or take in the US and Canada and a full cut by July and a full 50 basis points by the end of next year could be some small kind of adjustment cuts from an over tightening scenario. But overall, Central banks just can't risk easing too early or too much.
Jason:
They obviously got the inflation cycle wrong right now and they probably won't risk getting it wrong again. So when you kind of look at the risk return, risk reward, trade offs, they probably rather have deflation at this point than missing their inflation targets on the upside. So, if the market does get the pricing, let's say 75 basis points of cuts, it's probably worth fading via either the [inaudible 00:18:23] futures curve or the fed funds futures curve, as far as looking for steepers in those markets from about January, February, as far as the receive leg to either September or December for the pay leg. With that, over to Elsa to enlighten us on the FX market and specifically the currency commodity linkages.
Elsa:
So I'm going to talk very briefly about the Canadian dollar and crude specifically. That we've gone some very similar work looking at the Norwegian [inaudible 00:18:56] and natural gas. Because one of the questions we received a lot from the start of the year was why isn't the Canadian dollar doing better, given the rally and oil? And then on the flip side, we started getting the question, why isn't the Canadian dollar doing worse, given the [inaudible 00:19:12] oil?
Elsa:
And I think the stem from the fact that obviously there are a number of confounding factors driving CAD at the moment. And if we focus a little bit on, what's been driving it since the start of the year, we can see that the reaction function has not been materially different to past experience, but we've had an impact from general risk appetite that's been working in the opposite direction. So we have a fitted framework for looking at CAD.
Elsa:
It breaks down movements in dollar CAD, according to kind of typical drivers. So two year rate differentials, crude general US dollar direction, and then a measure for general risk appetite, which we use with the S and P. And using that framework, we actually find that the residuals are kind of unexplained component is relatively small since the start of the year. When you look at it in that light [inaudible 00:20:08] has actually followed more or less what should have happened.
Elsa:
The rally in WTI from around $60 a barrel, just over that to 122 at the peak was only worth around three and a half percent move lower in dollar CAD. And part of the reason why the move has not been worth more, is because a lot of this is down to the crude market being in backwardation and CAD tending to trade more off the back contracts rather than the very front end contracts.
Elsa:
And then alongside of that, the fact that for a while, Canada was struggling to respond to the higher crude prices, particularly because of the increase in carbon taxation and a number of things that have been weighing on oil and gas CapEx. So we did a piece on this in total FX, a couple of weeks ago, just following on from the Bank of Canada's NPR. And you can see that even with the rallying crude throughout the last six months, and then the subsequent selloff, we've not seen material changes in oil and gas CapEx in the Bank of Canada's end projections.
Elsa:
All of that to say that CAD does still remain a commodity currency. If you strip away the effects of other things, it is going to trade on high oil prices. Of course [inaudible 00:21:19] is equal. So typically in a supply driven high oil price environment, you tend to see equity softening. And that tends to have the opposite effect on dollar CAD, where we like had [inaudible 00:21:29], so long CAD against the Swedish Krona, long CAD against the Euro long CAD against Sterling, are trades that we've been recommending all year, really, and trades that we still like even given the out performance that we've seen so far. I'll leave it there and pass back to you.
Jason:
Okay. Thank you very much, Elsa. So to conclude today's call, we have Lori from our equities team, who's going to tell us why she's gone back to an overweight on small caps. What economic risks she thinks are baked into small caps and other thoughts on the US equity outlook and positioning through year end. So over to you, Lori.
Lori:
So thanks for having me. I always love joining this call and I wanted to focus on small caps this morning. I thought it was really timely given a report we put out, but also, what number one on the economy. Small caps are fantastic lens to view how equity markets are digesting economic developments. That's something we've known for quite some time. I did cover small caps incidentally back during the financial crisis. And it was my exclusive area focus from '07 to 2014.
Lori:
The other reason I wanted to highlight it today is because we have a very clear, actionable trade idea associated. We want investors who take a multi cap approach in their portfolios and who can go overweight small cap to go back to an overweight. And another way to put that would just be simply, this is an area we want to be buying right now.
Lori:
So in terms of the call that we made recently, we had basically over the last few weeks in our marketing, really back in June, been telling investors that we wanted them to get off their under weights. We wanted them to get back to neutral. And as I was really marketing in June and early July, I found that equity investors were really asking me, what's closest to being de-risked? What should we be buying right now, if we have enough defensive exposure in our portfolio, and we want to be getting ready for the rebound?
Lori:
And we found that consistently, we were telling people to go to small cap, even over any sector in the S&P500. So what do we like about small cap right now? I would say first off, let's go back to small cap 101. Historically what we see is that recessions are a great time to, if you're a long term investor, at least to buy small caps. What we tend to see is that small caps really underperform ahead of the recession, in the early phase of the recession. And then around when markets are trying to find the bottom, we typically see small caps start to outperform large cap while the recession is going on.
Lori:
It's really kind of a mid recession pivot that you tend to see. So we know if with all the recession talk that it's rolling, that we need to have a laser focus on when's the right time to come back in and buy these stocks. So let's look at some of our other indicators. Valuations, if you look at the Russell 2000 forward, PE excluding companies with negative earnings, they typically bottom out in the 11 to 13 times range. And where you were back in mid-June was about 11.3 times.
Lori:
If you look at a relative multiple between small and large are at historic lows, basically as cheap as we've seen since the tech bubble. And we are finding that a lot of small cap investors that we speak with are starting to emphasize that point to their clients, if you think about kind of the long [inaudible 00:24:31] actively managed small cap funds.
Lori:
Positioning is something else that's quite striking in the small cap space now. If you look at the CFTC data on asset manager positioning and Russell 2000 future contracts, it's in deep net short territory, where it is actually starting to stabilize. But it is well below financial crisis lows. And that's much more bearish positioning than what we see in the big cap space, if you look at S&P 500 contracts.
Lori:
Let's also mention earnings. We're in the middle of earning season right now. And we're seeing a lot of downgrades to earnings expectations in large caps, small caps have already gotten a lot of that pain out of the way. And when we look at the rate of upward revisions in small cap versus large cap, we find that it's actually starting to flip in small caps favor. Small caps are acting much more resilient in terms of their earnings expectations right now.
Lori:
And then the last point I would make on small cap is they do look like they're already baking in substantial deterioration in the economy. If you look at ISM manufacturing, it tends to really move in tandem with a small, large relative trade. Small cap is underperformed dramatically since March of '01. And the way it's trading versus large cap right now, it looks like it's already baking in a decline in ISM manufacturing, the typical [inaudible 00:25:40].
Lori:
You see something similar if you look at the Russell 2000 year over year against year over year trends in jobless claims. Those two tend to track each other very closely, but small caps have already fallen pretty hard on a year, over year basis, and are really anticipating a big spike in jobless claims already. Not what we saw in the financial crisis, not those kind of jobless claims spike, but pretty much every other spike that we've seen outside of that.
Lori:
We also want to point out that small caps historically do start to outperform large caps when unemployment is starting to move up. And I know that sounds somewhat counterintuitive, but it's something we've seen very consistently over time. And typically what it means is that by the time, as Jason said earlier, everybody knows the recession is coming. It's already priced into the small cap part of the market. I would just give you one last thought on small cap, which is it's an easy place to put some exposure on to the US, either through the future's market or through an ETF.
Lori:
So when I see sort of talk of recession in Europe continuing to build, not that it's absent in the US, but it generally, it does seem to be the idea that Europe is a bit worse off than the US. Small caps are a way that people can play that geographical divide. And I'll say sort of the commentary, sort of on the other market outlook changes that we made recently for Q and A if we have time, but that's really what I wanted to emphasize to you today, that there is one part of the US equity market I'd be buying right now, it would be the small caps. And that's it for me, Jason.
Jason:
Okay. Thank you very much, Lori. So to conclude the call, I just want to remind our listeners of the title of our call today, which was the Need For Speed. But we know that speed kills. And in this case, it will kill growth, but Central Banks could very well be reluctant to resuscitate the economy.
Speaker 8:
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