Speaker 1:
Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Jason:
Hi everyone and welcome to the February 7th edition of Macro Minutes called What Now? I'm Jason Daw, your host for today's call, which we're recording at 9:00 AM Eastern time on February the 7th. So, the big news has been the US payroll report. It's sent shockwaves due the fixed-income market. The market has shifted fairly aggressively to pricing in a new peak in the US terminal rate, which is now close to what the FOMC dots were suggesting. There's also been contagion to Canada. The market's now pricing around a 50/50 chance of the BOC hiking again by June after being convinced they would be on hold. So to unpack what this means for global fixed-income markets, we're joined today by myself, Blake on the US, Peter on Europe and the UK, and Su-Lin on Australia. And for the implications for FX, we have Elsa, and for equities we're joined by Lori.
So to start off today's discussion, I'm going to answer the question of what now for Canada? So as a general concept, I do think the Canadian market has overreacted to the US payroll report. For the Bank of Canada, we do continue to believe that the BOC is probably on hold this year with a greater risk of cuts in the second half of the year compared to them hiking further. Now what would change our view is if there was slower progress on inflation and wages coming down, but this will be a multi-month process if it did unfold rather than a one data point event. So looking forward to the March meeting, the OS market is pricing around five basis points of hikes, which seems excessive given the message that we heard from the Bank of Canada recently, which was a firm hold, and two, that there's limited key data points between now and then.
So we only get one CPI report and one labor market report. So receiving the March meeting and picking up anywhere from four to six basis points makes a lot of sense to me. For term yields, I think the move in the last two days is probably overdone, but I wouldn't fight it yet. If we got 10 year bond yields in Canada closer to the 315 to 320 area, I think risk/reward in getting along does improve quite significantly. We're probably in a range trading environment for the next few months. There's no strong consensus from clients on growth, inflation, or the Bank of Canada path. And when you couple this with offsetting dynamics of macro fundamentals generally arguing for lower yields, but valuations quite rich on a number of metrics, I think it does prevent a big move in either direction in the short term.
But with that said, a downward drift over the balance of 2023 is our base case scenario. And lastly, for the curve, we continue to believe there is limited potential for steepening in twos, fives or twos, tens. History does show that these curves only steepen meaningfully when rate cuts are happening and even then it will be hard for the curve to beat what's priced in. So with positive carry of around 10 basis points a month, we think flat or still offer good risk reward, even at these levels. With that, next up to Blake to tell us about the Fed and the US bond market.
Blake:
Yeah, thanks, Jason. Yeah, so normally I'd probably get on here the week after an FOMC and kind of recap Powell's comments last week. But those were broadly interpreted as dovish and I think given that 500,000 plus shocker on NFP, those are largely dated at this point. So markets have basically unwound all of the post FOMC price action that we saw, and I think for the last few sessions it felt a bit like a return to the environment we had in November of 2022, late last year, when markets were still thinking about these upside risks to terminal, the curve was still bear flattening and this huge sensitivity to data prints with those risks being skewed towards higher rates led by the front end. March meeting, we've now got fully priced for a 25 basis point hike and we're even flirting with some tail risk of a move back to 50 basis points. Pricing just a little bit above that 25 basis point level.
We think the bar to that is extremely high at this point. The Fed has very clearly stepped down to a 25 basis point pace, and I think for now they're really going to push hawkishness via the terminal rate rather than moving back to a front loading pace. But still, markets are pricing in some risks of that possibility. The biggest mover's been the [inaudible 00:04:52] meeting, which is now showing about a 40% probability of a hike. Prior to the NFP release that was basically just a basis point or two, so a pretty big move there. Markets starting to think about this hiking cycle extending all the way out into June. And all of this has taken the terminal rate to 5.14%. I point out the specifics on that because it's actually about six basis points over the fair value of what we would expect given the Fed's median dot in the 2023 SEP.
So we've kind of moved to where we were pricing below the Fed for most of this period since the December FOMC meeting to now actually the market outpacing the Fed to some degree. For all this, I think markets still seem a bit resistant to questioning the cuts in late '23 and '24. The total cuts we have priced by the end of 2024 have really only come off about 14 basis points since the NFP release. The whole curve's obviously shifted higher, but the actual downward slope has really only corrected by about 14 basis points, which really, given the normal day-to-day volatility around those levels is not a really massive move there. I think part of this, again, is this return to the late 2022 mindset that if the Fed keeps pushing still higher, the risk of hard landing increases.
So good news for the near term, essentially, bad news in the medium to long term. [inaudible 00:06:16] their range for the last month, but we still have a ways to go before testing that 390 high we reached in December. Given the massive movement of the front end that we saw over the last few sessions, twos, tens, rocketing back down to those December flats of negative 80 [inaudible 00:06:29]. That move's cooled a bit this morning. As to the direction from here, we're actually a bit short on conviction, but to that point, we will hear from Powell this afternoon. We have to assume he's going to come out swinging a bit, both because I think markets took that devilish interpretation of his comments, which I think was probably a bit accidental, so he's pushing back against that. But also kind of incorporating this new information from NFP. I will say that I think the next few data prints, I think there's going to be a massive amount of market sensitivity to those prints, including CPI next week. I think that will be skewed towards higher rates, still flatter curves because markets will be looking for some type of confirmation of this theme that kind of got introduced with this NFPB. So, I'll leave it there and hopefully our next call we'll have a bit more information, a bit more conviction on where we're going from here.
Jason:
Okay, thank you Blake. Now over to Peter to tell us about policy rates or the rate outlook in the UK and Europe.
Peter:
Thank you, Jason. Well, clearly if I look back at the last week and leaving the nonfarm payroll number and what it did to markets aside, the message actually couldn't have been better for fixed-income markets out of Europe. Inflation came on the low side, growth was better than expected but still not significantly higher. So overall, it was a relatively benign picture. And the Central Bank meetings, they did produce the market expected outcome. And when you listen to what they were saying in the following press conferences, in both cases of the Bank of England as well as the ECB, the rhetoric cannot be really described otherwise as downshifting a little bit. In the case of the Bank of England, the labor market was seen as the key thing, but the subsequent talk definitely stressed risks of over tightening, for instance. In the case of the ECB, it was pre-announced, de facto, that a 50 basis point step is also going to come at the next meeting, but then all the indications for the meetings to follow after that have largely been dropped.
So overall, before going into the nonfarm payrolls number, the fixed-income market has taken relatively positive notes out of the European zone. Overall, we still think that the market over here is pretty much priced across a very broad continuum of outcomes. One of them being that inflation is stickier and we've seen that in the core inflation numbers in particular. And on the opposite side, of course, that a larger recession could be manifesting itself, and you see that in the cut pricing. And then obviously there's a very large part in the middle where things of both of these extremes pan out to some degree and a bit of a off softer landing could be panning through. So, we think that the market for the time being, at least as far as Europe is concerned, cannot really make up its mind.
We think the market is probably going to continue trading sideways, although after the nonfarm payrolls numbers, just as we've just heard for the US or for Canada, the implied terminal rate is roughly at the peak where we've been over the last couple of months, but not necessarily significantly higher than that. And we think that for the time being, the investment strategy remains as it has been, no strong duration calls, but much more risk at short-term credit, trying to reap the benefit of relatively widespread still. And they have come in a little bit, but only a little bit. And trying to create P&L that way. We also still like asset swaps where we think that the massive European bond issuance will come through and will put further pressure on these asset swaps, and we think that's a long-term story that hasn't changed for us either. And then we'll try to ascertain what the data brings in going forward and whether the bigger market moves or the bigger market narrative will change. And with that I'll hand it back to Jason.
Jason:
Great stuff, Peter. So to round out the view on global fixed-income markets, we'll hear from Su-Lin on Australia.
Su-Lin:
Thanks, Jason. The RBA's also inching closer to terminal, but lagging the rest of the dollar block. Partly because it was a bit late to start hiking and only began in May of last year. It delivered another 25 basis point hike today at its first board meeting of the year, taking the cash rate to 335. We had expected this, but the statement erred quite hawkish, and three things stood out to us today. Firstly, the very high recent Q4 CPI and its details has clearly unnerved the RBA, and its focus has shifted back to almost solely getting inflation back within target sooner rather than later. There's new and particularly strong language around the economic and social consequences of high and entrenched inflation.
Secondly, there was very little new discussion around some early signs of moderation in consumption or ongoing housing weakness with its growth forecast largely unchanged. And thirdly, the final paragraph hints at further rate hikes. Our own inflation forecast remain higher than the RBAs and we've noted the risk of some resilience in household consumption. So we're happy leaving a 25 basis point hike in March in our profile, and we're adding one more in April to seek terminal now at 385. Our short Feb and IB trades have performed well today and we have even more conviction in our short march IB trade, which will continue to run. Market pricing for another 25 basis point hike in March has lifted to about 80% from 60% prior to today's meeting.
Jason:
Thank you, Su-Lin. Now over to Lori on what all this means for the equity market.
Lori:
All right. Good morning, everybody. Two quick thoughts from me. First, I just wanted to comment on what we're seeing in terms of sectors. I think the key takeaway as we're digesting all this Fed speak is really to think about how recent sector leadership within the S&P has been consistent with what we've seen in the past following final Fed hikes. Comm services, tech, and consumer discretionary have all outperformed year-to-date, though they were hit on Monday as markets digested Friday's job report. We took a look back at median S&P 500 sector performance following final Fed rate hikes since 1995, and what we found is that these are really the three sectors, again, comm services, tech, and consumer discretionary, that tend to do best in the six-month period that follows. So what does this all mean? It really tells me that at US equity markets have really been starting to discount the end of the current hiking cycle well in advance.
I sensed in December that people in US equities were ready to move on to new themes and we really think that it manifested itself within the S&P in terms of sector leadership. So I would keep a close eye on these sectors in the weeks ahead for clues on how US equities are thinking about the Fed path. And then my final point, we do see a case for valuation expansion in US equities this year as inflation moderates. In our meetings last week, the thing that really jumped out to us is that investors remain interested in debating what kind of PE multiple the S&P deserves to trade at in light of higher for longer interest rate assumptions and inflation that stays above the Fed's 2% target. So we did, on Monday, update our S&P 500 trailing PE model, which is based on data going back to the '70s.
We plugged in consensus year-end 2023 forecast for all four variables in the model as of Friday. That's PCE at 2.8%, Core PCE at 3%, Fed funds at 475, following a move to 5% in the first half of the year, and 10 year yields is 34. Based on actuals, the model suggested that the S&P deserved to trade at around 16.4 times as of December 31st of last year. It actually ended up in the mid 17 times range. So the model isn't perfect but has done a very good job at telling us the right neighborhood the multiples deserve to be in. Based on current macro assumptions for year-end of this year, the model is telling me that the index deserves to trade at around 22.4 times on a trailing PE multiple at the end of this year. And again, that's trailing not forwards. And if you do the math and you look at current consensus estimates of earnings for 223, that could take the S&P up to nearly 5,000.
My earnings forecast is much more conservative at 199, and if you do the math there, it could take you to 4,500 in a bull case scenario. So given our consensus outlook for 2023 earnings, I think 4,500 is the way to think of a reasonable gauge of upside risk to 4,100. 4,100 is my current year-end target, so we're baking in something more like a 20 times trailing PE multiple. But we've been finding just because there's been such a deep consensus that it's not going to be a great year for equities, people want to explore what the upside and downside risks are and we think that 4,500 is the right way to think about the upside risks. That's it from me, Jason, and I'm happy to pass the call on. I think Elsa's going to be next.
Jason:
Okay. Thanks, Lori. Very informative. So to conclude today's discussion, we'll hear from Elsa on what the situation in fixed income and equities means for currency markets.
Speaker 7:
Thanks, Jason. So from our perspective we're at a critical juncture, and the way we like to look at FX at the moment is through our quadrant of bond and equity performance. Having spent most of the last 10, 20 years in a world where bonds and equities moved in opposite directions, the last year and a half has been characterized by the co-movement of bonds and equities, which I think is catching a lot of people out in terms of currency reaction. Having spent all of 2022 watching bonds and equities sell off together, the tail end of last year and the start of this year has been all about bonds and equities rallying. Lori just touched some of the upside risk potential for equities, and it would have to be a combination of upside inequities and further rallying bonds that would create an environment for the dollar to sell off through the course of the year as the market consensus expects.
We're a little bit more hesitant to jump onto that dollar-down bandwagon. We think that we're likely to spend this year a little bit more uncertain, flipping between the top-left quadrant of our framework. So bonds and equities rallying together, and the bottom right, bonds and equities selling off together with some risk that we move into the bottom left, which is bonds rallying, equities selling off if economic activity turns out to be much slower than expected. Until then, we're focusing a lot more on relative value trades and people that follow our weekly trade of the week will have seen that. And outside of that, we will just caution that when it comes to the Yen in particular, the way it trades in this kind of environment is going to be very different to what people are used to. The correlation with equities that one might expect, particularly on Yen crosses, has broken down completely. And for that, I'd say look ahead to some upcoming research from my colleague Adam Cole. Pass it back to you, Jason.
Jason:
Okay, great. So thank you, everybody, for joining this edition of Macro Minutes. I'd like to reiterate one of the messages we had from late last year that 2023 should turn out to be as challenging as 2022, but for different reasons. And this is because investors are debating the path of policy rates on hold, cuts or more hikes. And this stage of the policy cycle should show significance cross-country differences and have impacts on relative asset prices. So, stay tuned for our publications or reach out to us directly in the interim for any additional insights.
Speaker 8:
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