Jason Daw:
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 Daw:
Hi everyone, and welcome to this edition of Macro Minutes called U-Turn. I'm Jason Daw, your host for today's call, which we're recording at 9:00 AM Eastern time on November the seventh. The trends in markets that we've seen since June, higher yields, lower equities, wider credit spreads. These pulled the Sharp U-turn over the past week, the US 10 year yield. It's down 40 basis points from the highs and has provided the impetus for a decent equity and credit rally. On today's call, myself and Blake are going to speak about our views on duration, which are not widely different, but focus on different aspects of fundamentals and technicals. Later, Michael's going to enlighten us on the US economy, and Lori is going to tell us what this all means for the equity market. So the bond market is the tail wagging the dog at the moment, so we're going to get into the weeds on duration with Blake kicking it off and then followed by myself.
Blake Gwinn:
Great, thanks Jason. So as you hinted in the opening there, I mean the narrative shift in price action this last week has really been kind of wild. What I want to do, I just want to really quickly hit on the three main developments in the US last week that were at the center of all this. First was treasuries refunding announcement, which was one of the most highly watched refunding announcements that I can remember, at least in my career. The tail risks around supply and demand certainly relaxed a bit on that announcement. Treasury came out with a slightly smaller deficit forecast than expected. They pulled back a bit on long end issuance, but we didn't necessarily see that announcement or that pullback as a game changer. As we noted in the piece that we put out after the funding announcement. Our modal view on true premium from here continues to be fairly benign, but we still see the risks around it is skewed to the upside To that point, there's going to be a lot of eyes on the three year tenure and 30 year options this week.
I think even if we have kind of priced in the overall stock of supply coming, there's still the possibility that these flows, flow effects as markets have any difficulty digesting the supply still puts 'em upside pressure on yields. So a lot of people watching those auctions this week on the FOMC meeting markets has interpreted the meeting as modestly dovish. But I think that interpretation mostly relies on this assumption that there was really any set of circumstances in which Powell would've come out and talked up the September FOMC dots. I think the Fed speak into the meeting, including Powell himself, who we heard extensively from were all pretty clear that the bar to hiking again was very, very high. So I think not confirming that additional hike in the September dots, which is really what markets were focusing on, especially with only one meeting left in that forecast horizon, really shouldn't have come as much of a surprise to market.
So we didn't really see that quite as dovish, at least relative to expectations as the market did. The third point beside the quarterly refunding and FMC was obviously the data. Mike's going to talk about this a bit more later, but I did just want to say that 150 K jobs isn't exactly the sign of an imminent recession that I think many commentators on Friday seem to be making it out to be. Just two quick observations I'll make again Michael talk about the data a little bit more later. The three month moving average for n fp is still higher than it was at the September FMC meeting. And remember at that meeting, FM c FM C members were all boosting their economic forecasts and dot pop projections. And the other thing as for ISM numbers both on service and manufacturing side, both of the prints this last week represented only the fourth lowest prints of last year.
So really the doomsday commentary that surrounded a lot of the data this week I think was a bit overdone. We're not trying to write any of last week's data off. I mean it was absolutely soft on multiple fronts and certainly going to provide some fuel to the Fed that clearly is looking for a reason not to hike again. But again, in our view that was already largely consensus, but I think everyone needs to take a bit of a deep breath. Only seven days ago, our client conversations were all largely hammer hand ringing over the back to back to back back strength in N-F-P-C-P-I retail sales, GDP, all this concern about supply and demand imbalances, questions about how we're possibly going to get to our year end target for tens at four 50 or challenges to our call for cuts in the back half of next year.
The way the narrative really seemed to be shifting on Friday, it almost felt like we were going to have to start justifying our calls from the other side over the coming weeks basically explaining why we don't have a hard landing or cuts priced into the first half of next year. I do think that's calmed down a little bit. The partial retracement in yield this week have taken a little bit of the pressure off of those conversations that were really taking up late on Friday afternoon, but still it's pretty clear that there has been a pretty sizable shift in the narrative. Just to sum up before I pass it on, we don't necessarily disagree with the direction of rape moves last week. I do think the violence of the rally was significantly exaggerated by stop outs, a very crowded short positioning. But for us it's really more the degree to which the narrative seemed to flipped from this kind of soft landing.
Even really re-acceleration back to hard landing that I think was a bit of the overshoot medium term we're pretty neutral on duration, maybe a slight bullish steepening lean. That's mostly because we're within about 10 basis points of most of our year end forecasts across the curve. Not only that, but at these current levels, the risks around our forecasts are much more balanced than I think they were even a week or two weeks ago. And it now seems very unlikely to us that we're going to challenge the yield highs that we reached several weeks ago, at least before year end. But I will say that in our view, the reduction of these upside yield risks hasn't really necessarily come with a boost to downside. We actually have just increased our conviction in those modal views, which again includes four 50 tens by year end, no more hikes from the Fed and cuts starting in June of next year with the economy continuing to show signs of slowing into 2024, I think outweighing any kind of these term premium issues. I do want to say here that obviously with a fair bit of humility, I do think we have already seen the peak in yields and expect for the rest of your end to mostly be trading inside of current ranges.
Jason Daw:
Thanks a lot, Blake. It seems that we agree on kind of the broad thrust of what's happening in the bond market in general. I guess from my standpoint, simplistically, the narrative in the bond market does seem to have changed. Prior to a week ago, it was all about one-way risks. Now it's definitely more balanced. It's not necessarily an uber bullish setup, but a better one than we've had over the past few months. And I think taking a step back, it's important to remember that the surge in yields that we had from June to early October was reinforced by almost a perfect storm of fundamentals and technicals. There was high worries about term premia, big worries about US supply changes to Japan, yield curve control and rapidly rising expectations for Q3 GDP. So this led to one-sided bearish bond market sentiment and a buyer strike from certain segments of the asset management community.
Now it seems like we're past the strongest points in US GDP, past the worst of supply fears possibly past the peak policy rate discussions past the worst of Japan YCC risks and probably past the worst of the term premium move. So now at a minimum it seems that the balance of risk for the bond market are very different than it was a couple weeks back. And I think this means that the chances of being 50 basis points lower in yields exceeds that of being 50 basis points higher from here. We might need to wait for some of this market to stabilize a little bit after what we saw last week, but I do feel the setup now is to play the market from the long side instead of the short side at least for the next one to three months. And to conclude, I do want to say a few things about Bank of Canada rate cut pricing.
There has been a material shift in what the market's pricing for the BOC. It was pricing another hike just a couple of weeks ago and now we have an inverted OAS meeting day curve. So the market has focused on the dovish aspects of the Bank of Canada communications and specifically the comments that the economy could be in excess supply this year and that they might cut rates before inflation reaches 2%. So we've had a violent swing in pricing. It's moved now closer to our base case of rate cuts starting in q3. There is some chance of the market now pricing in April or June rate cut. We think those are probably a bit too early, but we wouldn't fight the trend right now. The market is moving in the direction of pricing larger and sooner cuts in 2024. So at these levels relative to our base case, we're probably more neutral as far as the OIS curve in Canada. But if we did get to a situation where a full cut is priced by April and two cuts by June, then the risk reward would tilt in favor of paying. So with that now over to Michael on the nuts and bolts of what's happening in the US economy.
Michael Reid:
Great, thanks Jason. As Blake noted, do want to focus on some of the data we saw last week. It's worth mentioning that I think a lot of that is coming from the impact of the UAW strikes. And what I mean is if you look at the payroll gains in particular, it printed below consensus, but if you add in the impact from the u AAW strikes, which was estimated around negative 33,000, we get a print that's right there in line with consensus and still quite strong. And if you look at the details, we continue to see strong growth from healthcare. That's a stalwart that should continue to print strong gains. We're also continuing to see gains in leisure and hospitality and state and local government. I note those two because those still have not returned to pre pandemic levels and there are still around two to three months of gains for those particular sectors in terms of their average growth to reach that level.
So we do see a path forward here where the gains will continue to come in quite high. Yet we do see some weakness in the underlying details. If you look at the unemployment rate, and it's worth noting that ticked up to 3.9% just as a technical matter, BLS does not classify workers who are on strike as unemployed. So the rise we saw in the unemployment rate is coming from other factors. In particular, if you look at the flow of workers who are coming from out of the labor force into the ranks of the unemployed, that is continuing to rise. That just means people who are looking for work are having a harder time finding a job. Additionally, if you look at the continued claims data that also is continuing to rise and another sign that workers who are collecting unemployment insurance right now are having a relatively harder time finding work taking together those two certainly can be lagging indicators.
But one thing that stood out to me as well on this report was the share of workers who have multiple jobs and there that actually rose above the pre covid levels and says to me that consumers are really starting to struggle with some of the price increases we've seen on goods and services. If you look back at the past four months, we have seen real disposable personal income, lagging real spending and that's concerning and we're starting to see consumers continue to draw down savings. The savings rate is near an all time low and we're also seeing an increasing reliance on credit spending. So taken into context, what we are seeing is some underlying weakness, not in the payroll numbers, but in the labor market activity that is going on. And how that fits in with our view is we see continued weakness ahead. Certainly as we head into the holiday season, we expect that the consumer wealth continue to slow here we are expecting for a considerable slowdown in GDP growth, again led by the consumer pulling back.
And a drag that I have been flagging for some time now is the non-mortgage interest payments as a percent of disposable personal income. These are monthly flows that consumers are facing paying down their debt. That stands now at 2.7%. We have yet to see the impact of federal student loans both on consumption. That will continue also to add to that interest expense again, further solidifying our view that the consumer will slow down here in the final quarter of Q four and we do expect a contraction heading into the first half of 2024.
Jason Daw:
Okay, thank you Michael. In the U-turn theme equities were under pressure but have reversed in the past week. We've heard about the bond market and the US economy. So now over to Laurie to tell us what this all means for the equity market.
Lori Calvasina:
Alright, thanks Jason. So I'll leave the question of whether yields have peaked my fixed income colleagues, but I did want to recap conversations we've been having with equity investors about what's been going on with 10 year yields. And quite simply the biggest question in my meetings last week was whether or not yields have peaked, and if so, what should we buy? We've taken a look in the past at sector performance relative to the s and p 500 over time and then looked at the correlation of those performance with moves with 10 year yields. What the historical playbook says is pretty simple. It says you want to sell energy materials and other cyclicals and buy growth sectors, especially communication and consumer discretionary if you think that yields have peaked. When we talked about the growth sectors that are potential beneficiaries, communication services and consumer discretionary, we've really emphasized that between the two, we do see better valuations in the communications services sector, which does have a number of key internet names, media and entertainment as well.
It's worth noting that in these conversations, there was really an excitement among equity investors that I frankly just hadn't seen in a while. Equity investors have been telling me for the last few months that they feel quite stuck, unsure of how to proceed. And we really did have a renewed sense that they were ready to act. In terms of some of the other interest rate related pieces of analysis that have been getting traction in our meetings, I'd call out a couple things. First off, our equity risk premium analysis. We too keep a very close eye on the earnings yield of the s and p 500, less the 10 year treasury yield. And basically the two have been close to parody recently and this is really a reversal of conditions that have been in place since the tech bubble. But at the same time, it's also a return of conditions that really were seen throughout the 1990s when stocks did just fine.
We had a very healthy equity market. One of the things that really caught investors' attention was that we've run a back test against different levels of the earnings yield gap against 12 month forward s and p 500 returns. And even though basically the two are at parity, we're still in an environment where you get pretty strong 12 month forward gains in the s and p 500 over time. There are levels where the earnings yield gap will foretell negative returns in the equity market over the next 12 months, but we simply haven't gotten to those yet. Another chart we've talked about a lot recently looks at how equities do when yields are rising and we found that the s and p 500 continues to post strong gains when surges in the yield are 275 basis points or less, but stocks do tend to fall when the surges are more than that.
If we use post SVB as our starting point, it's been about 168 basis point move. If you look at the recent high, and that really contrasts with what we saw in 21, 20 22 when equities got hit quite hard. But the total surge in yield totaled about 305 basis points. So what we've been through just hasn't been bad enough to take stocks down historically. And one last thought for me, kind of getting away from the surge in yields a bit, I think the bigger picture context here is that this move in interest rates did really help equities out in a certain way and that it took equity investor sentiment down to oversold levels. So we have a lot of high frequency data points that we monitor. And last week, something quite exciting happened on the a i survey, we monitored net bullishness and we found that that indicator went one standard deviation below the long-term average on the four week average. That reverses a move we had seen back in August when that indicator hit one standard deviation above the long-term average. So we've gone very quickly from excessive bullishness to really, really deep pessimism and historically the s and p 500 has been up about 14% when you've hit that one standard deviation mark below the long-term average. So I think this is a really positive development for equities and improves the setup for 2024. So that's it for me. If anyone does have any questions on equities, the bond market, please reach out to your RBC representative.
Speaker 5:
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