Yo-Yo Yields - Transcript

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 August 9th edition of Macro Minutes, and we called this one Yo-Yo Yields. So the bond market overreacted to inflation fears in June and yields overshot on the top side, and July was a complete reversal and some, as growth fears escalated and yields overshot on the downside. Since the low on August 1st, bond yields have snapped back higher. So, for today's call, insights on rates will be provided by myself, Blake, and Simon. And to help us navigate currencies, we're being joined with Adam and Daria.

Jason:

I'm going to kick it off today and mention two publications from last week that should be on your radar screen. So last Tuesday, we put out a piece saying that the bullish move in Canada fixed income was over for now. This was the day that yields got below 2.6% on the downside in the 10-year. So we shifted to neutral on duration, and this was compared to our previous bullish stance that we held since late May. Recall our positive view on the belly and long end yields. It was quite out of consensus at the time. But we do feel that last week, the pendulum swung too far in the growth fear camp and the market seems to have forgotten that more rate hikes are probably needed, that inflation's high, price pressures are broadening, and the Bank of Canada seems quite resolute in bringing inflation back to target.

Jason:

So the skew to policy rate's still to the upside versus market pricing and the market pricing rate cuts in early 2023 seems quite premature. It might be a situation where higher for longer policy rates might be necessary to bring inflation under control, especially with a situation of deeply negative real rates. So central banks, and especially the Bank of Canada, they need to be absolutely sure that inflation will get down to target. And they'll probably err on the side of deflation or a deflationary outcome, instead of having a situation where we have sticky inflation, let's say, 4% to 5% a year from now.

Jason:

Tactically, I think the freighting setup has probably shifted to favor looking for yield declines to get short or pay instead of yield spikes to get longer receive. Over the next month or two, the 250 area and tens that should mark a broad bottom. Obviously, there's some margin of error given heightened volatility and assuming that there's no major risk off event. And we'd be inclined to be short in the 230 to 260 area between 260 to 290 neutral, and if tens got back north of 290, we would consider a bullish or received exposure.

Jason:

Secondly, we published a piece on Thursday last week, looking at fair value models for 10 year bond yields in the US and Canada. Basically, inflation and policy rate expectations can account for the majority of the movement in yields since 2015. And we've had a situation where yields have moved in line with fundamentals in the past two years and at current levels are pretty close to where they should be based on this simple model. So for 10 year yields to rise materially from here, either consensus inflation expectations need to rise, which might be unlikely given that we're probably at least at the peak of inflation fears or terminal rate expectations need to edge up, which is a more likely possibility.

Jason:

This is plausible given the skew and tightening outcomes, that yields do go higher from here. But even then, the effect is going to be increasingly non-linear. So, a smaller move in 10 year for a given rise in policy rate expectations, which also means that the curving versions could become a lot larger than what we've seen, so far.

Jason:

With that, over to Simon for some additional details on Canada.

Simon:

Thanks, Jason. So today, I'll discuss one about the September 7th policy meeting, the next one for the Bank of Canada, and also go into some economic details. So, for the upcoming meeting, we did say after the July meeting that really the Bank of Canada left their options open for anywhere between 50 basis points and 100 basis points for the hike in September. Market pricing is generally between 50 and 75 basis points, about 65 basis points currently. But we do think there is some underappreciated risk of 100 basis point follow up after they did that in July.

Simon:

Definitely one of the most key releases and probably the most key release ahead of that is the July CPI report next week. As with what we should see from the US this week, lower gasoline prices will be a significant attraction for Canada. We're looking at probably about eight tenths on headline year on year rate, just given the decline in the month and base effects.

Simon:

Elsewhere, within the shelter category, we're seeing some pretty significant moderation and components tied to resale housing. So definitely, over the past three, four, five months, we have seen a moderation there. And so components tied to it which include home replacement costs, other home expenses, definitely some moderation, and the year on year rates moving lower, though still elevated while mortgage interest costs tied to the bank's interest rate rises have moved less negative, and definitely likely to move into positive territory very soon.

Simon:

However, generally, we have seen a broadening of price pressures. So some notable categories for this, household operations and furnishings, which is a very general consumption category, clothing, footwear, and especially travel related prices. So travel services, airline prices, things like that have definitely moved higher. And this is part of the broadening and price pressures that we have seen. What that means is that alongside elevated wage growth, even though it didn't accelerate in last Friday's report, still elevated 5.4% year on year in the LFS on Friday, and also inflation expectations remaining very high, it's clear, as Jason said, the bank has more to do to bring inflation back down to target.

Simon:

And we do expect them to move interest rates. Again, like we said, anywhere between 50 and a hundred basis points in September makes sense. And they definitely left the door open to a sizeable hike. In addition, the other main release ahead of the September 7th meeting, so this is still four weeks away now, so definitely some time, is the Q2 GDP release on August 31st. So we're expecting that to come in around four and a half percent. That's what the monthly GDP reports are indicating. And also note that at that release, we will get an initial July now cast as well. So initial look at Q3. And that's it for me. I'll push it back to Jason.

Jason:

Okay. Thanks a lot, Simon. Next up, Blake, to tell us about the treasury market.

Blake:

Yeah, thanks Jason. So yeah, we're not quite as hawkish on the Fed over here. As Jason was kind of mentioning with the Bank of Canada up top, still have a 50, 25, 25 for September, November, December as the base case, as well as a 325 to 350 terminal range, which is more or less the terminal arrange that was priced into markets about a week ago. But, even we had updated some of the post FOMC move had swung too far in the direction of this dovish move and wrote to Pete last week, discussing what we saw as a pretty justified swing back in the other direction as markets bare flattened earlier this week. So, please check that out. But I will say at this point, post NFP, that almost seems like ancient history. NFP, last week, clearly changed the game.

Blake:

I wouldn't say it necessarily was a massive game changer for the Fed, but I think from the market perspective, a lot of people looked at that and started to take away some of the recession risks that had been priced in. We saw terminal move higher for the first time without really seeing this corresponding increase in cuts at the back end, which was a little unique from the way things had priced over the preceding weeks. I think, part of the reason I see this as not a huge game changer for the Fed themselves, anything from slightly below consensus to what we got on the actual print, really what that probably meant for the Fed was just that the focus stayed on inflation in the near term. But I think there's probably some thinking that this gives some cover to going a bit more aggressively at perhaps the next meeting or even two, but they're still going to be almost entirely focused on the inflation side and very dependent on how these next prints come in, which really brings us to CPI this week.

Blake:

Market's entirely focused on the number there, also a lot of focus on the Feds Speak leading into it, puts the NFP pre CPI Fed Speak. We've heard both cases to some degree, daily, noting that her base case was at 50, taking a bit more of a dovish tone this week than her hawkish comments last week. Bowman came out on the very hawkish side. I'm really saying 75 was a base case. And even noting that, perhaps 75s were justified until we start to see inflation come down in a meaningful way. So certainly thinking out that hawkish ground there. As I said, we're still at this 50, 25, 25. At this point, that's probably on the dovish end, 325, 350 terminal. We have priced up into the 360 to 370 range host NFP, but the risks around our view that 325, 350 terminal are certainly skewed to the upside.

Blake:

And I think we really need to wait and see where CPI comes in tomorrow to really get a handle on what the next couple of meetings might look like. And also, I would imagine that the Fed Speak that comes out after that, will give some clue as to what we're looking for in September. Regard the market reaction to CPI playbook seems pretty simple here. Any beat of headline or core remaining elevated, the curve likely continues to bear flatten. We see that September pricing probably push closer to 75. November start pricing in more of a solid 50 basis point expectation with some risks, both towards 75, but also down to 25. But as has been the case recently, I think that's probably coupled with more cuts getting priced into the late 23 into 24, and that in the end, we see tens pretty significantly outperform.

Blake:

We've been pretty adamant in our flattening view, long duration bias this summer, but both of those are a bit difficult to get involved with, at this point. We've got tens near the middle of the range, at least what we see is the likely range for this summer, and getting pulled along to some degree, should we see any further repricing of a higher terminal. So if we get a big CPI beat or further hawkish Fed Speak, a very good chance that tens do get pulled, to some degree, back towards the top end of that range. So, it's a little tough right now to be in those long positions. Still over the more medium term, we do expect the hawkish, dovish divisions on the Fed, start to reemerge and do eventually see the Fed pulling back and likely ending the hiking cycle by the end of this year.

Blake:

So, that leaves tens for us somewhere around that 290 range, really not that far off from where we're currently pricing. So, when you take into account these very near term bearish risk, but a couple of those with the medium term bullish view that we have, there really isn't a whole lot to do on duration here as we're hanging out in the middle of the range. And even on the curve, I mean, I think with two tens near the flats, we reached into the 90 and 2001 cycles, you've got punitive carry and I think somewhat crowded positioning in flatteners, entering into new positions there. It doesn't really seem to have a great risk, reward, either, even if, for our view, we really see a continued grind flatter in two tens as the path of least resistance, but it's just a very difficult position of bond, right now.

Blake:

So for now, we wait for CPI, hope that brings a bit of positioning clean out and hopefully some better entry levels where we can start to look to get engaged in those trades. The last thing I would just say, for anyone interested in treasury supply or continued imbalances in the front end, we had a treasury funding meeting last week. I'm not going to discuss it in any depth here, but if you want to see our updated forecast and analysis on what we found out last week from treasury, you can check out the piece we put out last week on that topic. And that's it for me and back to you, Jason.

Jason:

Okay. Thanks a lot, Blake. Now, over to Adam. He's going to talk about the puzzle of the yen plunging while Japanese investors are selling foreign bonds in record size.

Adam:

Thanks, Jason. Yes. I'll take a couple of minutes to think about dollar/yen, today. And the yen is the worst performing currency in G10 space, this year. Down of, well, dollar/yen is around 15% higher. And on the face of it, it's difficult to time the news we get on what Japanese investors are doing in foreign bond markets. So yesterday's June data showed pretty much the biggest liquidation of foreign bond holdings we've ever seen. Japanese investors sold about $40 billion worth of foreign bonds and brought the capital home in June alone. And in the first half of the year, that's about a hundred billion of foreign bond sales. And on the face of it, that's a bit counterintuitive, if Japanese investors are liquidating their foreign assets and bringing the cash home. It's slightly surprising their currency's going down, not up. And as is often the case with Japanese investor flows, the way you square the circle is all about hedging.

Adam:

So, we can't measure it directly, but I think it's very likely that the bulk of the foreign bonds that Japan has been selling so far this year, have been bonds that were held on a currency hedge basis, where hedging no longer makes sense, that the cost of hedging has gone so far north as a result of the Fed rate hikes that it's no longer economic to hold bonds on a hedge basis. And the investors are just unwinding those holdings entirely. That of course, is an FX neutral flow. If they're selling the bonds and unwinding the hedges simultaneously, there's no net FX impact. Where the FX impact comes from, I think, is another flow alongside that whereby the bonds that are not being liquidated are increasingly having the hedges taken off as again, hedging no longer makes any economic sense when the cost of hedging exceeds the yield on the bonds, as is frequently going to be the case.

Adam:

So, what I think we are seeing, or we have seen in the first half of the year, are these two simultaneous asset reallocations selling hedged foreign bonds by JGBs and taking the hedges off existing holdings of foreign bonds. The net effect is that you see this combination of capital repatriation, yet local investors selling their own currency. And looking back at their behavior historically, it seems to be the case that their hedging behavior moves pretty much exactly, coincidentally, with the cost of hedging. There is no evidence that they anticipate changes in the cost of hedging and the flow moves in advance of those changes. For that reason, we think there is potentially a lot more of this flow to come and dollar/yen can keep rallying, despite the fact that it's the written so much in the first half of the year. So we put out a revised forecast deck last week for all the currencies we covered.

Adam:

The only major change we made was to push our target for dollar/yen even higher. So we had previously had 140. We've shunted that up to 145, and that will make the yen, again, in the second half of the year, the worst performing currency in G10, the same as it was in the first half of the year. Just a couple of references, if you want to look at this in any more detail, our chart of the day yesterday looked directly at those capital flows data. And we look in more detail at the whole issue of Japanese investment abroad and Japanese investor flows in the current total FX, which came out just over a week ago. So we'll refer you back to those and pass back to Jason.

Jason:

Okay. Thanks a lot, Adam. Finally, we have Daria to tell us about EM currency performance and what to watch going forward.

Speaker 6:

Thank you, Jason. So one of the main questions that we've been asking from a broader EM perspective, has been the question of we've seen EM sell off this year date, and there's this question of, is there more space for the selloff to run or is there space for a rebound to happen in EMFX? And part of the answer to that question depends on a range of different factors. And one of those factors is what happens with US financial conditions? So, if we have a scenario where US financial conditions continue to tighten more aggressively from current levels, then yes, that's a downside risk to EM. But if we have a scenario, which I think is more interesting, is what happens if US financial conditions are close to flat, is that sufficient for EM to rebound? Or is there another factor that we should be taking into account?

Speaker 6:

And if we look at it in isolation, then yes, maybe, if US financial conditions are close to flat, then yes, that could potentially stem the decline in EM. But there is another factor that we think should be taken into account for EM performance, going forward. And that factor is China's currency. And we think this risk is underappreciated by the market. And on our forecast, we have our strategist on China, has been bearish on the currency and he has dollar/CNY going to 6.95 by year end, and then 7.00 by early next year. And in that kind of environment, if CNY is depreciating, then from a broader EM perspective, we think that's a risk, a downside risk, to the broader EM complex.

Speaker 6:

And specifically, if we were to extrapolate that view to Latin America or also SEIA, then we think that the two currencies that are probably going to be more vulnerable in relative terms, are probably going to be the South African rand and also the Chilean peso, given that both of those countries have a large trade exposure to China. And with that, I will hand it back to you, Jason.

Jason:

Okay. Thanks a lot. Thanks everyone for joining the call today. So bond market volatility should remain high until there's better clarity on inflation, central bank terminal rates, and how deep the impending recession will be. And this will continue to impact all asset classes and we'll continue to address these issues in upcoming Macro Miniatures.

Speaker 7:

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