Jason Daw:
Hello, and welcome to Macro Minute. My name is Jason [Daw 00:00:07] and I'm the head of North America Rate Strategy and your host. During each episode, we'll be joined by RBC Capital Markets experts to provide insights on the latest developments and financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Jason:
Hi everybody. Welcome to the March 22nd edition of Macro Minutes. The past two weeks have been characterized by growing inflation worries, an uber hawkish Fed, bond yields at the front end and long end of the curves skyrocketing higher, unabated curve flattening and fixed income volatility while off the recent peak, still very elevated on a historical basis. The dollars remain strong, and until the very recent bout of tightening, corporate spreads were displaying an unusual tendency by moving wider alongside higher bond yields. To help us navigate the fixed income and currency landscape today we have a full slate of experts.
Jason:
Tom's going to tell us if the new Fed dots that are now calling for substantial hikes this year can be realized. Blake will be talking about what the Fed means for the US bond market. Peter will provide insights on whether the hawkish Fed stance applies for the ECB and Bank of England, as well as the treasury sell off feeds into European markets. Simon's going to delve into GOC net bond issuance ahead of the federal budget and the expected BOC move to quantitative tightening next month, Adam on whether after an extended rise in US rate expectations, if it's time for the dollar rally to end, Robert on his updated RBA call and relative value trade ideas and Jason Mendel on high yield credit and whether the spread tightening we've seen recently can continue.
Jason:
To begin, I'm going to kick it off with some thoughts about curve flattening and the long end of the curve, which broadly applies to both the Canadian and US markets. First we're clearly in a phase for bond yields where upward moves in the front end are transmitted in a non-linear fashion to the long end of the curve. And this is just a fancy way to say that for every X basis point move up in short rates, that long rates move less and curves flatten. And I think importantly, this is a normal pattern that occurs when central banks are in a tightening mode. And it's really difficult to fight this trend, even if you think the curve is tactically overextended, or if the majority of structural flattening has already occurred. For a steepening trend to develop, it'll probably require the policy cycle moving from tightening to rate cuts, which is probably a long way off. And higher inflation, balance sheet reduction or flows, these are unlikely to push curve steeper in my opinion.
Jason:
Second, while the bond market's showing similar directional patterns relative to the past for this point in the cycle, there are some aspects of current market pricing that bears close attention and debate. Various parts of the curve are inverted. The Euro-Dollar backs curves at different points, one-year and two-year forward swap curves and various forward swap tenors related to policy pricing. Now, inversions, they're very rare occurrences, and these even started well before the hiking cycles in Canada or the US kicked off. Without discussing kind of what the drivers are of this, or whether it'll be more or less predictable recession, the higher conviction takeaway is that as long as the market continues to behave in this way, it should reinforce flattening trends in cash bonds and spot starting swaps.
Jason:
Third, I think there's probably a limit on how high long term yields can go. And I think this is especially the case now considering the significant amount of rate hikes being priced in, and on the US side, what the FOMC dots told us last week. If we assume that central banks can bring inflation down if they want to, which I think at least I agree with, to very tight monetary policy, then this should translate into a situation where the more that gets priced in or delivered, there should be greater stability and inflation expectations and weaker future growth expectations. This should cap how high long-term yields and even real yields can go. Unless of course, growth expectations can turn around or terminal policy rate pricing goes substantially higher from here. So while there's a lot of risks and ifs, if the choice is between following this big move that we've seen across various parts of the bond market, or starting to position for some stability or reversal, the latter seems like a better tactical risk reward option in my opinion.
Jason:
And finally, in Canada last week, we recommended a fives tens flattener trade. That encompasses both things that I discussed today, flatter curves and limited upside at the long end. And aside from these reasons, the five-year screened is very rich on the Canada curve. The Canada curve at this part is steep versus the US, and the risk reward profile seems quite favorable overall. The fives tens curve, minimal negative carry compared to other flattener expressions. And in swaps, we target a move to zero basis points. And for a cash expression, we like shorting the September 26s and long the D31s. So with that, now we over to Tom to tell us about the Fed and their increasingly hawkish language and what it means for policy rates.
Tom:
Thanks, Jason. I would just pick up on a thread that Jason left out there on the curve. The one thing I would say about the curve, particularly as it relates to forecasting recessions, and I think this is almost always missed in the conversation, is that the curve inverting in and of itself is not enough to say that there's a recession. There's another ingredient that's almost always necessary for a curve inversion to portend a recession, and that's the Fed being true neutral. And I think given some of the hawkish rhetoric that we've heard from Powell, that certainly seems like a possibility, although I would hasten to add that we're not quite there yet.
Tom:
But I think I've found it interesting over the last couple of speeches by Powell that he is seemingly, he outdoes himself every time on the hawkish front. I thought that the pressor was pretty hawkish. And then yesterday he comes out and really tried to drive home this hawkish approach. I think on some level, it's almost like he wants us to have these extreme conversations. This is what I was writing in The Daily Deck yesterday. It's like he wants us to wonder, "Hey, is this 75 basis point hike possible? Hey, is an inter-meeting hike possible?" Again, it's not that we place high odds on these outcomes. It's just that I think that he's completely comfortable with those conversations happening. And one of the things that we highlighted in The Daily yesterday is if he's really very, it could clearly, he's hypersensitive to the inflation dynamic right now, so it sort of begs the question, what could get him to get pushed over the edge to doing something, say like an inter-meeting hike?
Tom:
There's going to be [inaudible 00:07:06], because it would almost always require some trigger. But there's a trigger, the coming CPR report. It's going to be another firm one. At a minimum, and we don't have, our numbers aren't finalized yet, we still need a bunch more data, but our working estimate right now is the month-on-month on the headline rises 7/10 of percent. If that's true, that keeps the, which is again, let's be clear, 7/10 month-on-month is pretty extreme in and of itself, but it keeps the year-on-year at 7/9, which is itself pretty extreme. So it's like, if they need evidence for some extreme approach, they'll have it. But I think at a minimum, he's really trying to drive home that fifties, I stress plural, fifties are in our future.
Tom:
I think seems like certainly to us a foregone conclusion that they're going to do it at the coming meeting. I think it's, again, as we wrote in yesterday Daily Deck, I think it seems like a foreground conclusion that they do it at the meeting thereafter, which is fine. And look, we'll happily forecast that. The thing that we wonder about though, is will they actually, will these numbers actually be realized. And we've said this many times, there are a lot of challenges in the economic backdrop right now, whether it's the plight of the low end consumer, whether it's the potential for a negative wealth effect for the upper end consumer.
Tom:
If you're going to layer on top of all of that an aggressive Fed, I think it's fair to wonder if these forecasts are realized. Look, we've obviously taken down our growth estimates, as we highlighted recently. And at this point it would certainly seem that the risk is that you continue to take these numbers down. And anyone leaning on the Fed for some sort of, I don't know, hope that, hey, but look, if you look at the SEP, that they have the unemployment rate holding stable over the next two years, that's a laughable forecast. Again, as we wrote the day of the meeting, it's a laughable forecast in the-
PART 1 OF 4 ENDS [00:09:04]
Tom:
... forecast again, as we wrote the day of the meeting, it's a laughable forecast in the context of the Fed has funds going well through neutral, but you have the unemployment rate holding stable over those two years. There's no reasonable economic model that would ever spit out that output. We would state that idea and certainly not take much comfort in that idea. So with that, I'll turn it over to Blake, or back to Jason.
Jason:
Okay, great. Thanks, Tom. Fascinating times. How quickly central banks are changing their tune, and Blake, over to you for what this means for the treasury market.
Blake:
Yeah. Thanks, Jason. Just kind of picking up where Tom left off, the rate response to both the Fed and Powell's comments yesterday has been pretty straightforward, given how hawkish he was on both counts, massive front-end-led sell off. This has pushed the curve flatter. We've seen several different sectors of the curve go inverted, which has brought a lot of attention. I put out a note yesterday kind of discussing curve inversions and how we're hearing from the curve and what it's signaling in this cycle may be considerably different from what it's signaled in past cycles and what it's kind of been reflecting about market expectations for economic outcomes and for the path of policy. So please check that out. I won't belabor that here, but just wanted to mention that that note is out there.
Blake:
As far as how Fed pricing has moved, how implied Fed pricing has changed since both of those events, we're now pricing in about a 70% chance of a 50 basis point hike in May. We've got about 130% chance of a 50 by June, so whether you want to call that essentially full pricing of a 50 in one of those meetings, plus 30% chance of another 50% hike at one of them, clearly markets have gotten around to this idea that there are going to be 50s, perhaps both of the next two meetings. We're also hiking in an additional 7.6 hikes this year. That's not including the one we just had in March. So that's also a pretty significant rise in total hikes for 2022, in line with the move in the dots.
Blake:
Kind of interesting that what we've seen there is that market expectations at first following the FOMC meeting, kind of seemed to be taking the hawkish dot plot and the comments from Powell, seem to be taking that as some confirmation of what was to be priced in.
Blake:
But since then we have moved massively in some of the prior sessions and gone towards pricing in a lot more, such as there's still a wedge between where markets are priced and where the FOMC dots are showing you.
Blake:
To that point, we also took on board the fact that the dot plot is now doing a terminal rate above neutral, and one that is reached as early as 2023. As I said, markets have taken that on board. We're now pricing a terminal between 250 and 275, hitting that by early 2023. Then after that point, it does look like markets are expecting some kind of corrective cuts back down to 2% level where it kind of settles in for '24, '25 and '26.
Blake:
I think going forward, I mean seven hikes for this year, seven remaining hikes really seems to very likely be established as somewhat of a floor, any hawkish, dovish news basically pricing in back and forth above that level. Also think pricing for 50s will continue to be a feature for the next several meetings. That'll be very sticky and I think very unlikely to get completely priced out.
Blake:
One interesting thing, inflation markets have not taken a lot of comfort in the hawkish Fed and the shift in Fed pricing. [inaudible 00:12:51] initially did move down after the FOMC announcement, but since have moved back up with the rise in oil prices, to the point where we're basically higher on a break even basis than we were prior to the meeting, so really not much relief on the inflation side there.
Blake:
Looking ahead, I still think rates will move higher. I still think curves will continue to move flatter from here, but I think it's going to be very tough at this point to out-flatten the forwards. We're now showing two tens at almost negative 30 basis points by year end.
Blake:
That's a very aggressive level. So even if I do think that we can continue to flatten on an outright basis from here, outperforming those forwards is going to be very difficult. I think it's also tough to really get short or put on flatteners here after such sharp moves in both of those directions over the last few days, leaves very little upside. And I think you're still at some headline risk around Ukraine, any positive headlines, and we saw a little bit of this last week with some headlines that were very quickly discounted about potential peace talks. But I do think there's some risk there of positivity from that situation leading to some kind of relief rally.
Blake:
Also in this volatile environment, I think RV and carry trades are very difficult. So basically even though I still think rates move higher, curves continue to grind flatter, I'm fairly neutral here and would be very wary of putting on large positions, given how much we've already moved and those risks that are still outstanding as I discussed. So until we get some clarity on Ukraine, Russia, it does seem like things are more or less, fairly priced from here, and kind of waiting for new signals about direction.
Jason:
Okay, great. Thanks Blake. We'll move on to Peter now on ECB, Bank of England, and the impact of US rates on the European markets.
Peter:
All right. Thank you everyone for laying out the groundwork. Well look, the way we are trading over here, I would characterize that as being certainly massively influenced by what's happening in the US, and particularly in the dollar front end, actually more than you would expect. Now, what do I mean with that?
Peter:
Well, first of all, after many, many years of ultra low rates, particularly in the Euro area, but also in the UK, we've seen the front end moving quite a lot. That's arguably due to the Bank of England, in the case of sterling already starting hiking before the Fed even, but also of the recent hawkish shift by the ECB when you look at the Euro market.
Peter:
Now the interesting thing, if I jump the gun a little bit in terms of market impact, is that one of the hallmarks that you typically see in a bond market sell off is that the US market under performs the European market, certainly the Euro market, typically also the sterling market, certainly in nominal space that has not really happened.
Peter:
And we held our ground, almost matching the US one-to-one when you look at the 10-year spread, not in the front end, but in the back end, when you look at the 10-year spread, what you see is that the 10 spread has barely moved neither in euros, nor in sterling, obviously at the shorter end of the curve it's slightly different.
Peter:
So what is really going on over here? Now, as I mentioned, and I mentioned this on the call that we had the last time round shortly after the ECB meeting, the focus has clearly shifted, certainly for the ECB, from growth to inflation. I mentioned this already, the downward revision to growth from the ECB was relatively mediocre, just 0.5, which we think is too low. And they have, despite everything that's going on in Ukraine, they have very clearly shifted the focus towards inflation.
Peter:
We now have a soft end date for the asset purchase program, and it seems likely that they either hike at the end of this year, or as we think in very early '23, which in historical context is not too far behind the Fed for the ECB.
Peter:
Now, the situation is slightly different when it comes to the Bank of England; the Bank of England in the last meeting has actually turned out to be a little bit more dovish than what the market was expecting. We had one member of the MPC voting for no change, despite the majority voting for a hike. And they've also changed the language a little bit around what was going to happen in the future meetings.
Peter:
That all being said, in both markets the market still is expecting a very aggressive path. Just to give you some reference, in case of the ECB we're pricing the peak at round about 1%, or just under 1%. And in case of the Bank of England around about 2%, both of them should be seen as levels not too far away, at least from the lower end of the corridor, that should be considered as neutral. So we are already seeing both of these central banks over the next two years hiking into, at the very least, neutral territory.
Peter:
Now, when it comes to us and our expectations, we would probably still see that the market is pricing this as slightly on the aggressive side. But having said that, we would not recommend in the current environment where the Fed is very aggressive, where the path through into our markets is larger than is usually the case, going against the grain of the market. We would expect towards the middle of the year our-
PART 2 OF 4 ENDS [00:18:04]
Peter:
...the grain of the market. We would expect towards the middle of the year, our economies to start slowing down. But if that's the case, and if that is a catalyst, maybe for the market to change the dynamics a bit, that's probably the time to enter any kind of trade that would be playing the market more from the long side. But for the time being, we think that's a difficult proposition. So we find ourself in a slightly difficult spot as analysts, as strategists, because we do think the market has made a lot of room for pricing already, but clearly sort of the dynamic in the market is towards higher rates and the path through is relatively strong.
Peter:
I probably close just as Blake did with one last bit on inflation and inflation market, because that's clearly a very important part of the market segment. And what you do find is that both in euros and in sterling inflation markets are pricing relatively high inflation levels, not only in the near term, but also over the more medium term and that's certainly most noticeable in the recent push higher in inflation expectations in the Euro market where previously the five year forward or the 10 year spot rate should have been considered as low, which has no longer been the case. So the five year and the 10 year, they're now sitting at levels that have clearly been in the past levels where the ECB was at the very least comfortable is not probably already tended to the hawkish side. And that's clearly, probably also one of the reasons why the central banks are talking like that.
Peter:
Now over the last couple of days, ironically, inflation expectations in sterling have drifted lower a bit, but then again, they're already high to begin with. So I think it's fair to say that the inflation impact that we've seen from the Central Bank has been relatively muted so despite sort of the hikes in the UK, despite the hawkishness of the ECB, we have not seen a significant retracement in high break-even levels that we're seeing currently. So most of the move came through in real rates, but not really in break-evens. That's probably something that the Central Banks will continue to monitor very closely and probably also look to address at one point.
Jason:
Okay. Thanks, Peter. Simon, over to you on the outlook for issuance and the bank Canada is expected move to QT.
Simon:
Yep. Hi everyone. Thanks Jason. Yeah. As Jason said, I'll focus for Canada on issuance side, there are several important upcoming developments. The first of these should be this Thursday with the quarterly bond schedule for next quarter. Unlike most years, but similar to last year, we don't have the budget ahead of this. So that usually provides a lot of guidance for what to expect in the upcoming quarter for the first fiscal quarter. However, we do think the current quarter, where we have 55 billion in gross issuance should be pretty informative, and we're not expecting a lot of changes across the sectors where we think the number of auctions per sector should be the same as the current quarter.
Simon:
We do think you should watch ultra longs. There's a risk that these are discontinued, although we are expecting them to stay. And we do think a new maturity, so between December 2072 to 75 is likely, and also the five year sector where we think the March 27th are done being issued and should roll to benchmark but there is the potential for one more auction. Beyond that the federal budget is upcoming. We don't have a firm date on it yet. There has been a Bloomberg report that it's the first week of April, but that's yet to be confirmed, but it should be in the coming weeks. Nevertheless, some interesting factors around issuance this time.
Simon:
One is the high maturities, 182 billion that's because this is the first time pandemic issuance will be maturing. And so they need to refinance. However, on the other side, there is a very elevated GOC cash balance approaching a hundred billion, which we think is too high and can be reduced. Uncertainty around spending initiatives and loan repayments also adds to uncertainty overall on the budget number. But we do think that as the next quarter, the current quarter is pretty informative for issuance overall. We think it should be in a 50 to 57 billion range per quarter. So 200 billion plus overall for the upcoming fiscal year. T.
Simon:
He big difference on issuance side and we've seen this already in the bank's move to the reinvestment phase starting in November, is they expected to move to QT on April 13th. And so what should happen here and what the Governor [inaudible 00:22:50] has noted is an end to secondary market purchases, currently about 4 to 5 billion. But they should keep some small auction purchases. So we are expecting that to remain around 4%. Though it is possible that they are eliminated altogether.
Simon:
So the key here and what we focused on throughout the pandemic is on net issuance and with the bank backing off so aggressively, both in the reinvestment phase and expected in QT. This means net issuance continues to rise. And for example, that move from around 34 billion in Q4 of last year to close to 50 billion in Q2 of this year. And this is especially the case in tens and longs where issuance has been focused during the pandemic. One final thing to emphasize for the bank, given that the BOC has a lot of short term holdings, so less than five years passive rundown is very much expected rather than active selling. And that the bank can very much reduce their balance sheet footprint very effectively just through this passive rundown. And so we continue to not expect them to engage in active sales.
Jason:
Okay, great. Thanks Simon, Adam, over to you on the dollar and is the first hike a cell signal.
Adam:
Thanks, Jason. And that really is a critical question for us at the moment. We've been constructive on the dollar for more than a year now. Number one, on our thematic trade for 2022 was broadly long dollars. Question is, should we, having had such a severe repricing of rate prospects in the US, should we call a top? And in particular, there is a very widely bought into thesis, which does the rounds at the beginning of most fed rate cycles, that the first rate hike from the fed marks the peak in the dollar and the right trade is to sell dollars at the first rate hike and stay short through the rest of the tightening cycle. Question is, should we join that consensus for dollar weakness and call a peak as we pass the first fed rate hike? And the answer is we don't think we should.
Adam:
So if you look back at the last seven rate hike cycles from the fed, it is indeed true that on average, the dollar has been lower one month, three month, six months after the first fed rate hike, but the average hides an extremely diverse range of outcomes. So the second month horizon, after the first trade rate hike, the dollar was ranged from on a DXY basis, everything from up 11% to down 9%. And the reality is the average token is very little and every hiking cycle is different. And the observation that really pulls that average down is in the immediate wake of the Plaza Accord and the dollar collapse that follows it.
Adam:
So the reality is that every hiking cycle is different and outcomes depend as much on what's happening in the rest of the world as they do with fed policy itself and as much on why the fed is hiking, rather than the simple timing of the turning point. So with the forward curve now looking very similar to the dot plot, should we become a bit more balanced maybe? I don't think that's probably fair and a bit more opportunistic in expressing of positive knowledge [inaudible 00:26:42]. Should we simply jump from being dollar positive to being dollar negative in the way the consensus is and buy into this thesis of first hike marks the peak in the dollar? Then the history really doesn't support that view. And our bias continues to be towards a-
PART 3 OF 4 ENDS [00:27:04]
Adam:
Yes. Continues to be towards a moderately stronger dollar. Though the way we express that becomes, from here, I think a little bit more opportunistic having had the bulk of that repricing take place. Back to you, Jason.
Jason:
Okay. Great. Thanks, Adam. Now over to Robert for insights on the RBA, when they'll tighten, any cross market and relative value trade ideas.
Robert:
Thanks, Jason. So as published, we've changed our RBA call as of last week. Brought forward our timetable for them hiking from August previously to June now. A couple of key reasons for that, even quicker erosion of labor market slack than we had been expecting. Core and headline inflation, plus wages, all spend to lift off a bit more quickly and sharpen we expected.
Robert:
And arguably more importantly, obviously the Fed and others are not sitting on their hands and the RBO is ultimately a follower in this [inaudible 00:27:57] cycle. But again, to backdrop broadly speaking, our long term horizon remains about the same, the where rates get to. So our terminal expectations remain reasonably lowered around one and a half, one and three quarters for this cycle. A couple key reasons there, first of all, still much softer inflationary forces than many other parts of the world. Despite things started to pick up. And then secondly, very high house on leverage here and a largely variable mortgage market. Which means that we're very sensitive to cash rate hikes more so than especially the US market, for instance.
Robert:
So in this environment, we've essentially given up on outright longs. It's honestly too hard to hold and things are all headed one way, as Peter mentioned earlier, instead though we like going along the belly of Aussie dollar interest rate curves on a cross market basis, a 3% terminal rate pricing for us. It just looks too high. And especially relative to other parts of the world. Many things compare us perhaps a bit too frequently to New Zealand where things really have taken off. We are a very different market. We don't think terminal rate expectations should be as high here. So we like structures like [inaudible 00:29:05] versus both the US and Canada. The former we like entering above a hundred basis points. Which sounds high, but we've been close pretty recently.
Robert:
And the ladder of 45 basis points or so. Aussie has only about 10 basis points away from entry of the US 40 basis points. But the difference is by design, Aussie has a bit more risk neutral, especially significant concerns about flight to treasury type dynamics. As we see in Aussie market quite frequently hurting us. Or even energy complex similarities, especially now given Russia and Ukraine. We did have an Aussie [inaudible 00:29:39] one trade, we put on and took off quite quickly in the last week, which worked well. So the gist of this is moving our preference upper curve inches barely to more specifically targeted terminal rate relativity. Thanks back to you, Jason.
Adam:
Okay, great. Thanks Robert. Now we're to Jason Mandel from our credit team to tell us about what's happening in credit market, other managing the higher rate environments and whether we can get spreads tightening further from here.
Jason:
Sure. Thanks so much. So in high yield in 2022, we've moved about 200 basis points on yield to wide to 6% now. Spreads are around 370 after touching above 400. A notable move for sure, but still nothing like the March, 2020 period. When we saw spreads out at 700 to a thousand plus. And still less than the [inaudible 00:30:29] 2018 when spreads hit 500 at the wides. So that said, we've widened past investment bogies of many clients and several have started buying, while some have just backed them up a little bit further.
Jason:
Many clients have expressed more uncertainty and discomfort over the geopolitical situation than Fed rate hikes. Which are perceived to be reasonably well telegraphed and thus largely priced in. With wider spreads, a greater share of high yield comes from credit versus interest rates. And investors appear to be most keenly focused on the consumer, on the economic impacts of food and energy price inflation.
Jason:
As for buying, the ability to find size and high yield is critical and often high yield market drops are accompanied by liquidity declines, and thus reduced ability to find any real size at the wides. Enter the new issue market in high yield, which has been incredibly quiet so far this year, as most opportunistic refi's got done in 2021. And there are a few M&A fueled needs right now. So market participants are greatly anticipating what new issue opportunities will look like, and hopeful for strong new issues spread concessions, and willing to buy back to you, Jason.
Jason Daw:
Thank you for joining us today or on Macro Minutes. We'd like to thank you for tuning in. I'm Jason Daw, and I look forward to seeing you next time.
Speaker 2:
This content is based on information available at the time it was recorded and is for informational purposes. Only it is not an offer to buy or sell, or a solicitation, and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.
PART 4 OF 4 ENDS [00:32:05]