Presenter:
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.
Blake:
Welcome to the May 2nd edition of Macro Minutes, which we're calling Too Much or Not Enough. We have a number of major central bank meetings the next two weeks, including the RBA last night, FOMC and ETB later this week, and Bank of England next week. While each of these institutions may be facing slightly different circumstances, it's likely that all are nearing a decision point within the next meeting or two where they have to decide whether to keep pushing against high inflation or trust that they've already delivered enough tightening to sustainably redirect inflation back to target levels.
That debate may be framed by the tension between backward and for forward-looking frameworks. Or more specifically, do you rely on backward-looking data, which generally has shown that inflation's still uncomfortably elevated and labor markets will remain tight, or do you trust more forward-looking model-driven forecasts that would suggest the pent-up lagged effects from already delivered hikes and tightening in credit conditions due to banking stress are already enough to pull inflation back to target?
Well, that's that. Let's get the call started. We have a great panel today. It includes our Head of Bank Equity Strategy, Gerard Cassidy, to talk about the banking sector. Head of North American Rate Strategy, Jason Daw, to talk about Bank of Canada and bond yields. European macro strategist, Peter Schaffrik, to talk about the ECB and Bank of England. Global Head of FX Strategy, Elsa Lignos, to talk about how our policy views map into the currency space. Finally, we're going to wrap up with Chief Australian Economist, Su-Lin Ong, to talk about the emerging peak in global policy rates.
But first, I'm going to kick things off with a very brief overview of the Fed. We have the FMC meeting tomorrow. 25 basis point hike is our expectation. It's also fully priced by markets, so we really have no reason to suspect that the Fed's not going to deliver on that. Without the Fed providing an update on the SEP dots of this meeting, that means all the price actions likely going to be driven by changes or probably, more specifically, lack thereof, in the statement, and Powell's characterization of June.
With regards to the statement, I think his consensus is that they remove or at least pretty heavily change the passage about some additional policy firming remaining appropriate. As such, I think if they don't remove or change that statement, that may be one of the more hawkish potential outcomes we could get at tomorrow's meeting.
Markets are also going to be very highly attuned to any signaling Powell does during his press conference. As to their thinking about June, the degree to which they're expecting credit conditions to pull back, pull inflation down and any indication of a pause. Our base case is that he leaves that door open to June as much as possible. We've still got two NFP prints, two CPI prints, a lot of data to go before that June meeting, and we really doubt that they'd want to tighten up their options this soon into that process. We'd be very surprised if he communicates or in any way signals that a pause is coming.
However, if he were to say something like their base case is currently a pause or if he validates the March SEP minutes, which showed five and eight terminal, that would likely be one of the more dovish outcomes as it would be a pretty strong signal that a pause is coming at the June meeting, even if he tries to counter that by saying that they're going to remain data dependent.
Overall, I think the market risk around this meeting pretty fairly balanced between hawkish and dovish outcomes, but I'd also add that compared to the meetings over the last year or so this is probably one of the least amounts of market risk I've seen headed into an FMC meeting. That's largely because terminal has a lot less room to run in either direction. June's basically already pricing in the middle of that zero to 25 basis point range, and being this close to terminal and with that pricing kind of in the middle of the range, really just not a lot that we could see terminal move, whether Powell comes out and signals a pause or whether he comes out and really leaves that door open, just not a lot of place for markets to go from here.
Lastly, just very quickly, I'd be remiss if I didn't briefly mention the debt limit given that's been an intense spot of focus for markets, particularly over the last 24 hours. That's largely because yesterday Secretary Yellen sent a letter to Congress outlining an early June timeline for a potential X date. Whether this was because treasury has better insight in the outflows than the street who's generally been focused on a late July timeframe for that X date or it's because Yellen was simply being very conservative to keep the pressure up on Congress, it may not really matter that much.
Her setting this timeframe really sets the deadline for Congress and I think puts the wheels for markets in motion. That's largely because in the past we've seen price action mostly in built space really start to exaggerate once Treasury formally narrows that deadline into a few weeks or a couple of days like she did last night.
Indeed, we've already seen this morning June bills have taken a massive hit. We've got bills maturing around June 1st that have been trading as higher than 90 basis points up this morning. So really pretty extreme price action as people start to dump out of those potentially at-risk bills and react to this news from Yellen last night.
For our part, we had seen a much later X date than Yellen. But even still, we're not really sure she's bluffing and just trying to keep the pressure up on Congress. That's largely because if we do get to June 1st, they don't have a deal and the X date has to slide till late July, she would definitely face some political blowback. My guess is the early June is actually a best faith modal estimate of the X date for them and they simply have better info on cash flows in the street.
But the last thing I would say is that the X date doesn't really slide smoothly by a week or two in either direction. It tends to jump based on major cash flow date. So if we do survive to June 15th, it's not like the X date's going to go to June 20th, it's more likely to jump to late July or early August.
With that, I'm going to go ahead and turn it over to our Head of Bank Equity Strategy, Gerard Cassidy, to talk about the banking sector.
Gerard Cassidy:
Thank you, Blake. I would suggest that when we look at the banking sector, it's very important to take a look at what happened yesterday with JP Morgan's acquisition of First Republic at a receivership from the FDIC. The importance of this transaction is it finally ends the deposit flight issues for the banking industry amongst the largest banks and takes it off the front page.
As we all know, the Silicon Valley signature bank failures, and now the First Republic, were all driven by what we've referred to as the right-side of the balance sheet. The funding mix for those companies were very short-term funded as well as the fact that many of their deposits were over the $250,000 insurance limit and that money left very quickly once the problems became apparent at Silicon Valley back in the middle of March.
Moving over to what we've seen with the earnings season, which just ended for the largest banks. Believe it or not, the earnings season and the conditions of the banking industry are good. Unfortunately, the cloud of these bank failures has been weighing on these stocks, which is why the stocks have performed poorly since the news came out on about March 8th when Silicon Valley had its first news on the problem with the unrealized losses in their bond portfolio.
As we go forward, the big focus now will be on the changes in the regulatory environment that are expected as a result of what we just came through with the deposit problems. Most of the regulatory changes will be focused on banks with asset sizes of 100 billion to upwards to 700 billion. These are the regional banks. The money center banks probably will not see much change. The regional banks who have been more lightly regulated than the money centers will see their regulations most likely go up to more of a money center type bank regulation, which of course will lead to lower possibility for those banks. We're thinking possibly a 100 to 150 basis points of lower return on equity numbers as a result of these new regulations.
But I should emphasize as Vice Chair Barr, Vice Chairman of the Federal Reserve for Safety and Fairness, in his letter and critique of what happened at the Silicon Valley Bank failure, he was very emphatic in this letter that the changes when they're coming will be phased in over time, which is the normal course of business for the Fed.
So we anticipate their notice of proposed rulemaking probably comes out by the summer. Then they'll have the 90-day comment period. The Fed will answer those comments, and we'll probably get some type of regulation set for the end of the year, first quarter of next year, with a phase-in period of two to three years, which will also include TLAC, which was separate from what we've just seen with the deposit issues.
The regulators or the Fed had already put out an NPR on TLAC. That's the debt that the banks have to carry to give them extra protection for their depositors. Right now, the biggest G-Sib banks all have the TLAC, total loss absorption capacity is what TLAC stands for, they already have that debt in place. The regional banks now will likely have to carry some of that and there'll be issuance of this debt, in our view, over the next three years once that becomes finalized.
The outlook is now all focused on the economy. It's focused on the commercial real estate markets. Those are, of course, challenged. The economy is slowing down, and the banks are anticipating a 25-basis point increase that Blake just referred to from the Fed. Then most of the banks that we talked to believe that the Fed will be close to being done and are anticipating that the federal will start cutting rates possibly as soon as by year-end, if not in the first part of next year.
With that, Blake, I'll pass it back to you.
Blake:
Thanks. With that, we'll throw it over to Jason and talk about Canada.
Jason Daw:
Thanks, Blake. Two items I want to discuss today. The first is the Bank of Canada's increasingly hawkish rhetoric. This started at the April 12th policy meeting. It was reinforced by Macklem at the April 14th discussion at the IMF, and it was further reinforced with the policy meeting minutes that were released last week.
Our takeaway on their communications is as follows. Their last hike was in January. I don't think they want to hike, but their patience is limited, and if trends, especially in core inflation don't cooperate, then they could indeed hike again. That's what they're telling us.
Ultimately, they don't want financial conditions to ease so they are trying to jawbone the market away from pricing cuts as early as September. Now, obviously, the hurdle to cutting rates this year is quite high in our opinion, and that is reflected in our base case scenario that they are on hold for the remainder of the year. I would say that's probably the most likely, unless we get a more serious shock to financial markets. The market's been pricing a rate cut as early in September. That does not seem to make sense based on what we're seeing from the macro data, and it obviously is not aligned with what the Bank of Canada's been telling us.
The risks to when they start cutting interest rates, we've had them penciled in for Q1 of next year, but the risks are clearly slanted to that being in Q2 of next year instead of it happening earlier. So when you look across the OAS curve, October, December meetings, there still is value in paying those, in our opinion.
The second topic I want to talk about is the valuations in the Canadian bond market. We put a piece out on this last week. Now, we have been bond bullish for quite some time. From our lens, it is hard to argue with fundamentals capping any meaningful and sustained rise in term yields, and that the direction of travel is probably skewed to lower yields this year given downside growth risks and disinflation and 2024 rate cuts, along with the historical precedent that bonds have performed well in the 12-month period following the last Bank of Canada rate hike.
But looking at it from a valuation perspective, that does kind of help provide a bit of a compass to assess value and what the market's been pricing. What we wrote last week was that with yields in the fives, the thirties, tenners, at the lower end of the range of the past year, and bonds screening slightly rich compared to monetary policy expectations, there was little value in adding risk at those levels.
We have had a bit of a balance recently, about 15 basis points over the past week, but we still think that yields are still too low to get involved at these levels. So we would recommend waiting, and if yields did go up another 10 to 15 basis points from here, the value proposition for adding long risk would become much more compelling.
Blake:
All right. Thanks a lot, Jason. With that, we'll turn it over to Peter to talk about Europe and Bank of England.
Peter Schaffrik:
Thank you, Blake. What I'd like to talk about is, A, as you mentioned, the two central bank meetings that come up before we meet next, the ECB this week, the Bank of England next week. Then secondly, a little bit about the outlook, particularly as it pertains to lending because our bank lending data has been challenged as well. Just this morning we had the latest bank lending survey out as well.
But first things first. This week we get the ECB meeting. We expect, and that's totally in line with the market, that they will raise raise by 25 basis points. The time of 50 basis point increments should be over for now, and that they will also continue to entertain a hiking bias. Inflation in Europe, and we had the latest iteration also this week at the end of last week, is still at uncomfortable levels for the ECB and they have communicated that more tightening is required.
The market is currently implying a peak of round about 375 and change. That's roughly where we see them ending up as well. So our endpoint forecast is 375 over the course of the next three meetings, so 25 basis point increments over the next three meetings. We expect that they will indicate that this is roundabout where they will be going without obviously mentioning a concrete target. But we know from various speeches, and that even some of the hawkish members, have indicated that roundabout that level 4% sometimes has been mentioned is where they probably see ending up.
With that, we think that the market is probably fairly priced for the time being. The medium-term is something different, and I'll talk about that in a second. But let me just quickly also speak about the Bank of England, which is going to meet on Thursday next week. We also expect them to do a 25 basis point rate increase, but I think here the balance of risk to us is slightly different because they have obviously started earlier, they have hiked more. We know that inflation still remains a little bit on the high side and above their own forecast. But what we also know is that the adjustments, as far as energy is concerned, is a bit slower. So transition into the retail prices is slightly slower in the UK than it is, for instance, in the continent of Europe. That's coming at one point.
We reckon that there is a decent chance that there's not going to be much more tightening needed, certainly not as much as the market is implying because the market is now expecting that they will end up around about at 5%. That's very close to the levels that we've seen or that we are seeing in the US. Also, where the market is seeing them in the US. From a historical point of view, that is very rare. We tend to be in Europe, both in the UK as well as in your area, somewhat below the levels that we're seeing in the US. We actually think that the balance of risks in the UK market is slightly skewed to the downside, not massively so, but ever so slightly.
That leads me maybe to my third point. When you look at the market on how we're priced, we've been trading in a sideways range now for quite some time. Most recently we've been trading around about 250 in 10-year bonds, about 385 in 10-year yields, which have been historic, have been most recently, so the top end of the ranges. We think that there is probably, in terms of expectations, a little bit of an exaggeration, or not an exaggeration, but a little bit of the topside built-in in terms of where the economy can go.
One of the things that we would point out presents a downside risk is lending. When you look at the bank lending survey, lending standards have tightened quite considerably over here. That was already the case before the whole SVB and First Republic drama went through because we've been tightening credit standards now for the better part of a year. We do think that this will have an impact going forward on lending in particular.
We reckon that consumption can stay relatively decent as the labor market remains tight, but some part of the GDP growth aspect is probably going to suffer. With that, we think that growth is probably going to undershoot where both the market as well as the, say, the ECB is expecting them to come in, and that should moderate the upside to yields and both at the front-end and the back-end of the curve for the time being. We reckon also probably in relative terms to other markets.
With that, I'll probably hand it back to Blake, but I'm sure we're going to return to that subject in future calls.
Blake:
Great. Thanks, Peter. Let's head over to Elsa to talk about the currency space.
Elsa Lignos:
Great, thanks. From my side, I'm just going to try and wrap up the central bank outlook and how that might play out in currencies. Just starting with the yen that we've not said much on yet. We had the Bank of Japan last week, and I think heading into that meeting there had been a widespread expectation that the Bank of Japan may not normalize just yet, but certainly lay the path for normalization. That certainly didn't come to pass.
If you look at investor expectations, or even more so, sell side expectations, dollar-yen is one of the most consistent themes out there that everybody expects it to end the year lower than spot. We actually had the opposite view, taking a long Swiss-yen position into last week's meeting. It worked. We hit our target. We've now closed that position. I wouldn't be rushing in to put on Yen shorts right now. I do think we'll get opportunities again to reposition for that longer-term trade.
The second point is around Eurozone and US relative performance, and I think Peter and Blake already touched on this respectively. But there's an interesting market narrative looking for the Euro to effectively pick up steam just as the US is slowing. It doesn't seem to be playing out though in the data. I think the danger at the moment is there have been a number of Euro bulls out there positioning for top side either in spot or in options, and having initially traded above 110 and threatened to break higher, euro-dollar is now back below and struggling to make momentum to the topside.
From my perspective, I just note a couple of things. You've had the risk of recession in the Euro area go from being roughly 80% priced in the next year to down to 45%. Sure, that could come down further, but the risks now look a lot more asymmetric. 45 down to 10 seems a lot less likely than 45 back up to 70 or so.
On the US side, the risk of recession has stayed roughly flat around 65%. Again, not that we are massive dollar bulls the way we were last year or the year before, but we do think it's worth being a lot more cautious on the very strong consensus calls for dollar under performance. Certainly heading into this week's FMC, we'd prefer a much more neutral view.
What do we like as a trade? Well, we had the RBA overnight, they came in with a surprise hike. I do think there's some room for lazy Aussie shorts to get squeezed a little bit further. My preferred way of expressing that would be long Aussie against Swedish krona on the other side. It had a pretty rough run from February through to April. We've bounced a little bit in recent weeks, but I think that has further room to the top side. So, long Aussie, short Sweden would be our pick from FX. With that, back to you, Blake.
Blake:
Great. Finally, we're going to head over to Chief Australian Economist, Su-Lin, to talk about the emerging peak in global policy rates.
Su-Lin Ong:
Thanks, Blake. The RBA hiked by 25 basis points today following its May board meeting. That takes a cash rate to 385. After it falls in April following 10 consecutive hikes, they're dovish for a lot of the last few months and the domestic data has been pretty mixed since it last met. The decision to hike today has added to the challenge in interpreting RBA communication.
Its reaction function looks to have shifted. It's noted on a number of occasions, including the governor's last speech in early April, that it was prepared to tolerate higher inflation, a rather slow return to target, not until mid-2025 to protect the labor market. It seems to have shifted with the RBA now suggesting policy needs to be set to ensure inflation returns to target within a reasonable timeframe. Mid-2025 may be too long.
We have sympathy for that view, and we've argued for a more restrictive setting monetary policy, that we pulled our May hike largely on the dovish RBA communication of late. The RBA's changing reaction function makes us wary that the door is clearly open to further tightening.
From a rate strategy perspective, our bias remains to be strategically long, and the sharp selloff following today's unexpected hike may well prove up too. But with greater uncertainty around the RBAs communication and its reaction function, we're going to be a bit patient here and we'll look at three years nearer to the 200-day moving average on three-year futures at 96.75. Back to you, Blake
Blake:
All right. Thanks, Su-Lin.
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