The latest resilience in the US has kick started a debate about how much other regions that appear to not show the same kind of underlying strength can diverge from the Fed and cut rates regardless. We see the best chances of that happening in Canada, but also provide updated views on the BoE, ECB and RBA. Meanwhile, the gyrations in the JPY keep investors on their toes and we add our voice to the mix of what lies in store.

Participants:

• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Jason Daw (Desk Strategy), Head of North America Rates Strategy
• Cathal Kennedy (Desk Strategy), Senior UK Economist
• Su-Lin Ong (Research), Chief Australia Economist Blake/Izaac: FOMC
• Elsa Lignos (Desk Strategy), Head of FX Strategy

Research Analyst opinions are their published views, independent of those expressed by Desk Analysts

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.

Peter Schaffrik:

Blake Gwinn:

Hey, thanks Peter. Well, I guess my question is really what's really left for Powell to say at this upcoming FMC meeting. It was only just two weeks ago. He kind of put an exclamation point on the clear shift in Fed communications we saw after the March CPI release, he said that basically the FMC lacked the confidence on inflation needed to start cutting and that it's now likely going to take longer than expected to achieve that confidence. Since that speech two weeks ago, I think very little has actually changed on the data front and I'm expecting Powell is largely just going to come out and kind of repeat or maybe elaborate a bit on that lack of confidence. Now, make no mistake, the Feds view has definitely changed since the March FOMC. Before that Powell speech we had heard from a number of dovish centris type of members who were backing away from that kind of idiosyncratic bump in the road type of narrative around the inflation data.

So even though if Powell repeats that messaging elaborates on that prior messaging, it may read a bit hawkish, especially if you're just looking at summary headlines or some various poll quotes from Powell. I don't think market participants should really be surprised by any of this language. If Powell's does kind of follow along what we're talking about here, just reinforcing and kind of backing up that lack of confidence. I'm saying they're very unsure about where they're going from here given the inflation backdrop. I think this is basically consistent with current market pricing, which is right now showing about one and a half cuts this year, two and a half cuts in 2025, and I also think it's consistent with the Fed call change that Peter, you referenced in the opening there As a reminder, we still see the first cut in December, June and July we think are on hold due to the problematic inflation data and then September November due to the election cycle with just two more in 2025.

I do think twos have probably found the top end of the range for now at around 5%. I don't think that's a particular controversial view at this point. Even though that 2024 and 2025 fed pricing is slightly below our kind of modal fed call, as I mentioned, that downward skew does make sense that both of those are pricing a bit below those levels. So I think it's going to be tough for front end pricing, particularly to your point to move much higher without some major further upside on inflation prices. Given that I think the belly is probably more sensitive to any further economic positivity unless the fed seems resolutely dovish in the face of that positive data, in which case I think the 10 year 30 year sector is probably likely to take a bigger hit on those higher growth and inflation expectations. So basically better data with the Fed being more responsive is probably more like a threes 10 kind of flattener versus better data with a Fed being stubbornly dovish probably more in kind of the threes 10 steeper type of quadrant.

I prefer the former both because the positive carrier but also I think this near total consensus for steeper curves in higher term premium that seems to exist right now. Notably, I should say we're still not big believers in supply and demand driven term premium or higher long run inflation or R star pushing the backend meaningfully higher if we get steep and I think it really is more likely to be that kind of positive data stubborn fed type of dynamic I mentioned before to that supply point. We also get the refunding announcement, let's not forget on Wednesday on top of before the FOMC announcement, that should reinforce that coupon auctions are on hold for the time being and I think could alleviate some of the angst around deficit supply that's cropped up in the last month or so and in turn be modestly supportive of long-term yields.

Peter Schaffrik:

Thank you Blake. I think let's just move north of the border where probably the argument for divergence despite the geographical proximity is relatively strong. Over to you Jason.

Jason Daw:

And I would say that importantly the periods when policy cycles in Canada and the US have been closely aligned as far as timing and magnitude. There was a common shock. So going into covid, the post covid global inflation shock, GFC, the pre GFC commodity supercycle, the tech bubble, the Asian financial crisis, and outside of these kind of common shock episodes, the Bank of Canada has been willing to forge its own path. So the timing and magnitude of Bank of Canada cuts is not dependent at all on the fed cutting in my opinion. So if the fed's on hold, the BOC can do its own thing. Now our base case since last summer has been a June cut followed by four successive moves. Now this doesn't seem like an unrealistic assumption given the macro differences and the Bank of Canada's past behavior, but the risks are skewed to less rather than more because these cuts are adjustment ones in nature and they're not in response to a hard landing scenario.

So then it leads to the question of what stops the Bank of Canada from cutting too much before the Fed. The first one is obviously the domestic data could change inflation, could pick up growth, could pick up that would cause them to pause earlier than we expect the housing market could accelerate. It's probably going to pick up a little bit, but the bank does not want to see it pick up too much. The other one is if the Fed or the market pivots to rate hikes, then it's unlikely the Bank of Canada would be cutting if the Fed is expected to raise rates. And the last one is a materially weaker currency and the FX channel seems to be what most clients are worried about in my discussions, but we think it would probably take dollar Canada being closer to 1 45 to materially influence their policy stance. So with that said in our client meetings the last few weeks, the Canada US divergence view is a strong consensus and that's being expressed in long government of Canada trades versus short US treasury trades. It does make me uncomfortable though when consensus is so one sided. So maybe we've seen the lows in Canada, US spreads for the time being and we probably need to get through a couple Bank of Canada rate cuts with the expectation that there's more to come for Canada US spreads to move meaningfully lower from current levels.

Peter Schaffrik:

Thank you Jason. I think I was very clear. Let's move to our side of the Atlantic here and let's see what's in store in Europe and particularly for the Bank of England that meets next week. Over to you Cathal.

Cathal Kennedy:

Thanks Peter. Well I think the first thing I'll say is that even before the change in outlook for the Fed, there was already enough we thought in the UK data to suggest that the MPCs ability to deliver an aggressive cutting cycle was fairly limited and economic activity here in the UK has been recovering since late last year in line with return to positive real wage growth. Indeed it now it's almost looks set that QQ one GDP growth would be above the bank's last projection. The labor market has loosened but it's still relatively tight as Governor Andrew Bailey regularly points out the UK is inflating with full employment at the moment. Now all that said, the bank's rhetoric continues to lean towards delivering a first rate cut in coming months. Governor Bailey at the IMF spring meetings for example was a pain to differentiate between the inflation dynamics facing the US and European policymakers.

In the former he described inflation as being more demand-led, whereas in the latter it was more supply led with those mainly external supply shocks now beginning to fade. Now the inference here was pretty clear that the Bank of England could begin their cutting cycle before the Federal Reserve if necessary. Now the bank meets again next week on Thursday and we're not expecting any policy change at that meeting. Instead the question for us is how the MPC uses it to set up subsequent meetings. At the moment, the guidance still has a bit of a hawkish tilt if you will, talking about the persistence of inflation and how long policy needs to be kept restrictive for to return inflation to the 2% target. We think that we'll have to switch to some formulation that expresses more confidence that those risks of persistence in domestic inflation in particular are receding.

Well, it's kind of a similar story, although here we think we have a better idea of when the ECB first cut with a first rate cut in June, all but telegraphed at this stage. Indeed it will take a very high bar for the ECB we think not to deliver that first rate cut in June. Similar to the uk we are seeing a stronger than expected start of the year Q1 growth this morning coming in ahead of expectations at 0.3% quarter and quarter. And in our estimates both core and headline inflation are tracking a little bit above the ECBs projections from its last forecast round. So again, similar to the Bank of England, the ECB cutting into a recovering economy would still pronounce domestic inflation pressures which will as in the case the bank limitate scope for how much that can actually deliver once it begins cutting. So for the ECB we see once it gets started, it delivering just 75 basis points of cuts this year.

Peter Schaffrik:

Thank you. And now we're moving down under and give the floor to Su- Lin who had recently changed her RBA call as well.

Su-Lin Ong:

In doing so, the question we keep asking ourselves is this, are we more like Canada or the US and the answer continues to shift towards the us So core inflation here is not accelerating but progress towards the inflation target is stalling it really far too high a pace and the starting point for the labor market is stronger than we expected. It remains really pretty tight with the unemployment rate sub 4% for most of the last two years. So in the context of the divergence to the US there seems to be far less of that in Australia versus most of the G 10 economies we've discussed today. The next big event for us is the RBAs May meeting next Tuesday on the 7th of May and it will release its quarterly statement at the same time as the board decision. We do expect the cash rate to remain unchanged at 4 35, but the statement will earn hawkish with the risk that the very, very mild tightening biases strengthened and if not explicitly definitely via likely revisions to its forecasts.

We'll see upward revision to their inflation forecasts and downwards to their unemployment rate forecast and I think the RBAs likely to be less confident in meeting its inflation target within a reasonable timeframe. And if that's not glaringly obvious in the statement, it probably will be in the press conference. We're also fairly curious to see whether there's any board discussion of rate hikes next week. Markets and clients are really pretty nervous ahead of next week. Two year yields have backed up about 25 basis points post CPI 10 years about 10 basis points and Australia has been the key underperformer in global fixed income and incredibly market pricing has swung from almost fully pricing in a 25 point cut in late 24 about a week ago to now being almost 50% priced for a 25 basis point hike by September. We do think the barter hike is high and the RBA have proven to be reluctant hikers, but we wouldn't fight market pricing here. It could well move further. There's a lot of uncertainty over the labor market outlook following a volatile period of data and that may take some months to resolve. We do get monthly inflation numbers, but the series is relatively new and not as comprehensive as the quarterly data and we also have a commonwealth budget in two weeks, which we expect to include some stimulatory measures. We flagged emerging value in the front end in our last edition of macro minutes, but clearly the goalposts have shifted and patience is required to buy or receive this front end.

Peter Schaffrik:

Thank you Su-Lin. Insightful as always. And last but certainly not least, we'll change topics a little bit and speak about the currency market, particularly about the end where I hand over to Elsa.

Elsa Lignos:

Thank you Peter. So I'm going to talk a little bit today about dollar yen and it ties into what we've heard previously from Blake. First just to talk about what actually happened early on Monday we saw sharp move up to one 60 in yen. That's a three decade low for the yen. It quickly reversed to the low one 50 nines and then a very sharp move driven by suspected intervention took us down to 1 55. That's a 3% move, which on the face of it looks sizable but actually just took us back to where dollar Yen was trading on Friday morning. First question is how much do we think actually went through Now the Bank of Japan released its daily projection this morning talking about commercial bank deposits expected to drop around seven and a half trillion yen, which would be equivalent to just under 50 billion US dollars.

That compared with an expected drop of about 2 trillion yen, which money market brokers were predicting last week. You can couple that with our own estimates of the turnover that went through yesterday in Dollar Yen and our EFX trading team estimate that on an average day we'd expect to see around 15 yards of dollars trading in the dollar yen market yesterday. That appeared to be just over a hundred yards. So some really sizable flow going through in dollar Yen. The big problem for the Bank of Japan and the Ministry of Finance is that we're already drifting higher, 1 57 50 speak and when speaking to clients, we get the sense that a lot of them were waiting for the pullback driven by intervention in order to reload on long dollar Y positions. The reality is that with the interest rate differential as it stands at the moment between the US and Japan, it's going to be extremely difficult, if not impossible for Japanese officials to turn around dollar yen and send it in a different direction without some external help.

We've never had a gap this wide in terms of the cost of hedging against the running yield on the overall portfolio going back 20 odd years in the data. And a lot of people will point to the current level of the yen and say it's really cheap and it is from a PPP perspective or most valuation metrics that people tend to focus on. But portfolio flows are far more important than trade flows in driving currencies and currencies which are cheap or expensive can remain that way for very extended periods of time. So from our perspective, it really does feel like dollar again is going to continue to grind higher from here, one 60 will be the first immediate target for investors, but beyond that 1 65, even one 70 are not out of reach as long as US inflation remains sticky and elevated. Trading is tricky and people are conscious that it's not easy to jump into dollar yen at current levels and I suspect that investors will continue to try, try and either wait for intervention led pullbacks to quickly buy into or try and opt to play in the options market, which again is particularly broken with very thin liquidity.

Very little going through in the interbank and broker market. From our perspective, we have heard of investors using the yen as a funding currency. That still seems to be a very popular trading strategy. We do think there are better ways of funding the high carry positions, particularly when thinking about emerging markets and we'd favor some of the more pro-cyclical risk proxy currencies, even likes of the Australian dollar. You heard from Su-Lin around the change in the outlook for the RBA potentially no cuts at all this year, but the reality is that we're far better off funding long EM carry positions with short higher yielding than the Japanese, but low yielding relative to EM risk proxies like Ossie or cad. Then looking at the Japanese end or the Swiss Franc in terms of trading the Japanese yen, we expect that people will still be looking to buy those dollar yen dips, as we said, and still feel like the direction, the spot is higher from here until and when the US data turn.

Peter Schaffrik:

Thank you Elsa for that. That's really insightful as always. And that concludes this week's edition of Macro Minutes and I hope you're going to join us again next time.

Speaker 8:

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