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 everybody and welcome to the November 8th edition of Macro Minutes called Wears Terminal. So all year market pricing for terminal rates in most countries has been moving target and one directional higher. Last week the Fed signaled a slower pace of rate hike, but a terminal value that was higher than their previous forecast. Luckily, the market was already pricing in more hikes compared to the fed dots and most asset markets took the surprise in stride. So IG credit spreads, they're narrower, high yield is a little bit wider. Equities have recovered most of their losses from FOMT day, and bond yields are just a touch higher. The one asset class that moved the most and maybe unexpectedly was a dollar, which sold off quite sharply at the end of last week. To make sense of what's going on in macro and financial markets, I'm joined today by Simon to discuss the Canada outlook and the terminal rate in Canada. Peter, on the potential terminal rate in the UK and Europe, Daria on the FX market, and Lori for views on the equity market. So with that, over to Simon to kick it off on Canada.
Simon:
Thanks Jason. Hi everyone. So almost two weeks ago the Bank of Canada hiked 50 basis points, that was in line with our expectation, but versus consensus of 75 and market pricing leaning towards 75 as well. Emphasis was on slowing growth in the associated NPR. So for example, the bank sees zero growth, roughly zero growth from Q4 this year through Q2 2023. And this even led them to suggest that negative growth is as likely as positive growth. So really as close as the central bank will get to forecasting a recession before you're in one. And really this slowing in growth they see leading to a better balance between aggregate supply and aggregate demand, and moderating inflation pressures down the road. So for example, their Q4 2023 headline inflation forecast in their projection went from 3.2% in July to 2.8% just two weeks ago. A lot of attention on a dollar in the lead up is partially because the governor was speaking on it earlier in October.
Generally, CAD has definitely depreciated against the US dollar but performed better on the crosses. And currently the level for CAD is about 74 cents US and that's right what they had in the NPR. So currently it's factored into their latest projections and we'll kind of see where it goes from here. On inflation as well, just in terms of the near term drivers for policy decisions. So for example in December would highlight that their headline inflation forecast is 7.1 for the quarter as a whole for Q4, and that's versus 6.9 at September. So they're not projecting a deterioration or slowing in inflation very near term. So we don't think that they're highly sensitive to headline inflation there, although they will be sensitive to inflation pressures of course. And really the governor left things very open-ended on the December meeting. Emphasized that there was more tightening to come, so implying more hikes to come, but keeping it very clearly no bias between 25 and 50.
The market initially was more leaning to 25 basis points, but has shifted more towards 50 following the jobs data last Friday, the strong jobs data on Friday. We noted going into the October meeting that anywhere from 4% to 4.50% likely with a 50 basis point hike in October. I still think that makes sense. Our base case remains a final 25 at the December meeting and 4% terminal. So at the lower end of that four to four and a half range.
For the jobs data specifically, large gain really unwind. So it was a plus 108, largely unwinds job losses over the summer. Unemployment rate was steady at 5.2%, so very low historically as the participation rate did recover from a decline. Recently wage growth remains an issue, so around five and a half percent in the latest data, though that's above the kind of 4% to 5% we see in other measures. And the overall message really that we're getting is that labor market is tight. And also just to highlight, we will look for more details on the bank's view on this with Governor Macklem speaking on the labor market on November 10th. And with that, that's it from me and I'll flip it back to Jason.
Jason:
Okay, thank you Simon. Always informative. Next up is myself and I'm going to discuss three topics. The Fed, Canada US spreads, and the curve. So as I mentioned in the intro, Powell told us last week that the feds are prepared the hike in smaller increments but that the terminal rates are probably higher than their last round of dots. If you recall back in September, they were looking for 4.4% this year and 4.6% next year. So even though the markets peaked, Fed pricing was already 50 basis points higher than what the Fed was thinking. Terminal rate pricing has urged up about 10 basis points and the peak has been pushed out from May to July. Based on what we heard from Powell, we have revised our Fed funds forecast higher. Previously it looked for 50 basis points in December and 25 in January and the terminal rate around 4.50 To 4.75. And our new forecast now looks for 50 in December, 50 in February and 25 in March. So a terminal rate of five to five in a quarter.
Lastly, the higher terminal rates does increase our conviction that the Fed could undertake corrective rate cuts in the second half of 2023. So this would not be a traditional large scale easing cycle. But rather a function of possible over tightening whereby rates could be reduced from a very restrictive level to a less restrictive but still above neutral setting. The other noteworthy development last week was Canada underperformance versus treasuries. So the underperformance ranged from 15 to 18 basis points across the curve. And during this period, Canada terminal was actually repriced higher by 20 basis points on the back of the payroll report and that was more than what occurred in the US. So the moving cross market bond spreads is roughly consistent with what happened to terminal rate differential pricing.
And currently we're sitting at a Canada/US terminal rate gap in the market of around 60 basis points and we think it could be anywhere from 50 to 100 going forward. Our point forecast is closer to the 100 basis point area. So from a fundamental perspective, I'm inclined to chase the move over the past few days and instead I would look for opportunities for Canada/US spreads to drift closer back to the lows.
Lastly, I wanted to touch on the curve. It seems like the market is biased to getting into steepener trades at some point. I do want to stress that historically steepeners in two-fives or two-tens, these only work when an easing cycle is starting to unfold. So it seems way too early to have this trade on now, as the risks are still skewed to more flattening as growth and inflation starts to weaken. And with central banks probably keeping rates on hold at least through the first half of next year. But based on our forecast, we do think the Fed could do some corrective cuts in the second half of next year. But we also think that the Bank of Canada is probably on hold in 2023. So a lower beta and possibly a better risk reward trade could be US steepeners paired with a CAD flattens. With that over to Peter to tell us about the UK and Europe.
Peter:
Yep, thank you Jason. As you said, what I plan is I quickly want to speak about the ECB and the Bank of England and the respective terminal rates there, how it's priced and how to trade it. I would start with the ECB and maybe the first thing to say is that obviously the ECB, two weeks ago, hiked rates 75 basis points again, and the message that was given in the press conference was relatively dovish. However, after the press conference, the hawks on the ECB council came out in quite significant force to push back against the implied market pricing. And what happened is that the terminal rate, which at the time just after the meeting stood roughly speaking between 2.50 and 2.75 was pushed back higher to stand currently north of 3%, just a tad below 3.25. And that's actually the good indication for the range where we've been in over the last three months. Somewhere between, let's call it 2.50 and 3.25. So a 75 basis point range.
Now for us, the question has always been where is the ECB going in terms of neutral? Because that's the only communicated point that they have given that they want to go to neutral. And it's very unclear where that is. The only numerical figure that was given by some of the ECB speakers is 2%. So clearly significantly below where the market is pricing. And then any indications that they might go beyond that. And we have very little. The only thing that we recently had, just over the weekend, was from one of the ECB centrists French Banque de France governor, Villeroy, who said that the ECB should keep hiking until core inflation starts falling, which he expects would happen somewhere in Q1 next year. So how does that square up? What is priced in? What has been communicated with our view? We think that the ECB will slow down just as the Fed will, to 50 basis point steps in December and then 25 basis point steps early next year.
We think that they will probably get to somewhere around 2.50 by the end of Q1. By that time we should have seen headline inflation peak, probably core inflation as well. The ECB then being at a level that probably is at the top end of neutral, potentially even beyond that, and the economy most likely going to be in a pretty deep recession, at which point we think the ECB will start to wait and see how the economy's unfolding. That means in our view that if you are roundabout current levels 3.25 ish implied at the terminal rate, you can start receiving again. But really, I mean given that we are not too far away from where we think we ultimately end up, there's only about a 50 basis points range that you can really play. And therefore we would probably think that this is a sideways market in which you have to position both ways.
Now turning over to the Bank of England. The Bank of England has also hiked interest rates by 75 basis points, but has given a very different message. They have said very clearly that they would not expect to hike grades to what is priced or was priced in at the time when they'd done their last forecast route, which was 5.25. So they have implicitly told the market where they would see a cap on the terminal rate. Now the market is currently implying something that's below that, somewhere between 4.50, 4.75 ish, and has been relatively steady ever since the meeting. So what we think that implies is first of all, we are below even the current market pricing. So we think that the Bank of England will only go to about 3.75 and therefore we have shifted our exposure a little bit further down the curve where there's quite still a very steep hiking path priced in.
So we are along March '23 SONIA futures to benefit from reduced terminal pricing and in a reduced speed. But also what we think is given that effectively a cap has been announced that implied volatility should be coming down quite a bit. Which has happened to some degree already, but we think there is probably more to go. So overall, therefore we think that both the Euro market and the Sterling market and the latterly more so is probably still priced on the high side, which lends itself for small long positions at the front end. And also we expect that eventually the two central banks will be plateauing. We don't expect any cuts as we do for the Fed, but at least plateauing as we head into '23. And with that I hand back to Jason.
Jason:
Okay, great. Thanks a lot Peter. Great insights as usual. Next up today is Daria to tell us why they're still bullish on the US dollar.
Daria:
Thank you Jason. So there's two topics that I want to talk about. The first is our view on the dollar and then also address some comments about China giving all the headlines that we recently have had about a potential reopening. So if we start with our broad dollar view. We've seen the dollar outperform this year against the rest of G10 and also against most emerging market currencies with a couple of exceptions. And that outperformance in the dollars come against the backdrop of higher US yields and lower US equity. And given the extent of the rally that we have seen this year so far, and given that we've seen a little bit of a selloff from a pretty significant selloff from the dollar recently, I think there are two questions that we should be asking. The first is does the broader rally and the dollar have further room to run? And then second, what do we need to see to have a sustainable turnaround in the dollar to downside?
So for the first question, we still remain bullish on the dollar into next year, and we think that it's premature to be calling a top in the dollar this juncture. For the second question, we think that the first condition for a turn in the dollar is that we would need to see a peak in US yield, but that's not the only factor that we should be looking at. So we need to take a look at it at the US from a relative perspective. So when we look at the US from a relative perspective, even when the Fed finishes hiking rates next year, the US is still likely to have a yield advantage against most other markets in G10 states. And if that is the scenario that materializes, that would be still supportive of the dollar and that effectively means that we would need to see more than just a piece in US yields for a turnaround in the dollar. And in effect, in order for us to see that turnaround, we would need to watch for any signals that the Fed would be cutting materially.
So the second factor on China, so there's been a lot of, I think, focus on whether China's going to be reopening, whether they're going to be easing the restrictions on COVID. So the view that our strategist on China has is that even though it's fair to expect an easing at some point because of the negative implications that the code restrictions have on growth, caution is still warranted because it's not clear when it would happen and how it would happen. Which I think is important to keep in mind, especially given that recently we've had, I think the market has been trying to find reasons to be bullish on risk. We first had the market focused on the potential fed pivot and then also on the story around China reopening. And with that I'll hand it back to Jason. Thank you.
Jason:
Okay, great. Thank you very much. Last but not least, Lori will be updating us on what the US midterm elections and higher fed terminal rate means for the equity market.
Lori:
All right, thanks for having me everybody. Happy midterm election day for those of you in the US. So I'm going to start out with a quick comment on the Fed and US equities and then I'll talk a little bit more about the election. In terms of the Fed, I will tell you that last week didn't change too much for me personally in terms of how we're thinking about PE multiples for the S&P 500. And the idea we've been talking about is really the higher inflation, higher interest rate environment multiples should be lower than what we've been accustomed to, but we don't necessarily need to look at rock bottom kind of levels, and the levels even frankly that we had back in the seventies. So we have built a model that uses PCE, core PCE, tenure yields and fed funds are really using the fed fund effective rate to forecast where the trailing average PE for the S&P 500 should be at year end 2022 and year end 2023.
And that data is based on data going back into the seventies. So we really are able to capture the intense inflationary pressures and aggressive fed back from that time period. Generally what we have found every time we update this model is that we're looking at a 16 times PE for the end of this year and an implied PE a little north of 22 times 21 times by year end 2023. Current version of that model we've got right now has the fed SAP projections on PCE and core PCE. We did for the sake of argument, just plug in 5.25% on the Fed at year end for this year and four and a half for this year. So kind of baking in the idea of higher terminal and a few corrective cuts that Jason mentioned at the end of last year. And then we also baked in a 10 year yield of around 4.25 for the end of this year and 4% for the end of this year. And we're still coming up with 16 times and around 22 times at the end of next year.
So to the idea that Jason mentioned, that a lot of this had already been baked into the markets, we had been running that model on consensus, economic and fed assumptions for quite some time, and really the data's just not changing that much.
So let me just wrap up with the midterm elections. We've done a lot of work here over the past few months. We did put out a survival guide yesterday. And really what we said is if you're looking at it from today's perspective, we think the midterms are a modest positive for Republicans to take back the house only, but it's a bigger positive for the market if Republicans take back control of both chambers. So why only a modest a positive if Republicans just take the house?
Well, frankly, I think a lot of this is priced in. What we saw at the high recently off the mid-October low is that we were up about 9%. Your typical midterm bounce is about 7%. And we also had been seeing big shifts in polling data and betting market data really since late August. And we think that's really responsible for a lot of that move off the October low. So why a more constructive view if Republicans take back both chambers? Well, even though the data's been improving for the Senate, it's generally been viewed as a higher risk type event, lower odds than what the market participants were seeing in terms of taking back the house. But we do think also that if you have a really big Republican wave today that it's going to be seen as giving strong momentum for Republicans heading into the presidential race in 2024.
There is also some precedence for US equities to see a stronger midterm bounce than what has already occurred. Now what's interesting is that 2022 in the S&P 500 is tracking with a 76% correlation against 2002, which was also a midterm year, also a year of messy normalization post a big crisis and initial rebound. And what we saw back in 2002 was that the S&P rallied back more than 20% off its pre-election day low through late November, and then it started to fall sharply again. So we'll see if that correlation continues to hold up. Now under either scenario, I do think investors will find a reason to be optimistic about 2023. If Republicans take back something as the S&P 500 does tend to rise 13 to 14% on average in years that have a democratic president and a split or Republican Congress.
I'm also frankly going to be watching very closely what happens with consumer sentiment, which has been tracking much lower for Republicans than Democrats in the University of Michigan survey. I wonder if we'll start to see Republicans feeling better post-election, assuming they do well today. We did look back at 2020 and found that democratic sentiment was very low in the Michigan survey. It rallied back heading into that election and after when Biden won the presidency back and that ended up carrying consumer sentiment broadly even though Republican sentiment was falling at the same time. In terms of sector implications, I think this is really more about the broad market impact than sectors, but our analysts have highlighted communication services, energy, industrials, as well as certain industries like biotech and regional banks that could benefit from Republicans taking back some control. And that's it from me, Jason. I'll pass the call back over to you.
Jason:
Okay, great. Thank you very much. Thanks everybody for joining this edition of Macro Minutes. While terminal rates have been edging higher, especially in North America, the market might take some solace in having a better grasp of where terminal rates might end. But the thing I'm worried about is that the growth downturn in 2023 could be larger than what consensus expects. Maybe prevent risk assets from rising significantly. And everyone is bearish on fixed income at the moment, but I don't see 2023 shaping up to be a poor year for bond returns. So we'll address these topics and more on future Macro Minutes series.
Speaker 7:
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