As 2023 comes to a close, we shift focus to what to expect in 2024, with year-ahead outlooks released for Europe, the US, and Canada last week. Will macro data show a clear direction towards reaching the 2% inflation target? How soon will central banks cut? These questions and more will be the focus of this edition.

Participants:

• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• Simon Deeley  (Desk Strategy), Canada Rates Strategist
• Santosh Sateesh  (Trading), Head of Credit Derivatives Trading

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.

Simon Deely:

Blake Gwinn:

All total, we don't see this tipping into a hard landing. It's softening, but really more what I would consider is some normalization rather than a tip over into a recession. What that means for the Fed, I think we do look at cuts starting in June of next year. We see this more as kind of a gradual adjustment process rather than a very quick cutting cycle to get us back into accommodative territory. The way we've been kind of framing it is this is really the Fed trying to prevent a hard landing rather than being forced to respond to one. I think on those cuts, I think the bar to those is actually a lot lower than markets think it may be. I think if you look at the fed's SEP dots from September, even though they were widely viewed as hawkish, given that they took some of the cuts out of 2024, it still shows that the Fed is willing to cut rates when inflation is above target and even before the unemployment rate has really started to tick up to any significant degree.

This is really I think due to the way the Fed views balance of risk for the last year and a half, two years, all they've really had to be focused on is upside risk to inflation. But as inflation continues to come closer to target, even if it's still above that 2% range, it allows the fed more latitude to really address any kind of growing risks on the labor side of their mandate. So that's really where we see the Fed moving into this cutting cycle, not really because of anything that's happening on the inflation side, but if inflation does continue to lower, it just gives them more latitude to respond to growth to labor side of their mandate. As far as what that means for rates, we think both the slowing in the data and moving into this cutting cycle for the Fed will continue to put downward pressure on rates.

And that's because if the Fed is very reluctant to restart that hiking cycle, as the economy remains resilient, we would expect markets to price that in is additional term premium in the backend. One other place where I think this could come into play is that we see the term premium story that was very big over the last two or three months in the us. We think that term premium story that's really centered around supply and demand, we think that has largely already been priced in. We don't see another move higher in term premium specifically around supply and demand in 2024. But if we are wrong on that front, that also would result in curve steepening of the bearish variety rather than the bullish variety. So I think our base case is that we get this bull steepening as the economy slows and the fed starts to cut, but even in many of those risks to our outlook places where we could be wrong, we would still see that manifesting in curve steepening just of a bearish variety.

Simon Deely:

Thanks very much Blake. Insightful as always. Now over to Peter.

Peter Schaffrik:

The UK has been barely growing and the Euro area is probably already in a technical recession. Now the upshot is that going forward there are likely some stabilization factors coming in as wages in the UK are still around about 8% in the Euro area, we're probably going to be somewhere below that but still significantly above where inflation is likely going to be and that should really help the consumption part of the economy stabilize. Now that means that from a relatively weak starting point in terms of economic growth, we're most likely going to stabilize rather than decelerate. And that's a good starting point. Now secondly, when you look at the inflation picture, one of the things that really has happened, and I would've said this probably with a little bit more confidence if we had this call about a week before, we are having it now because we had some very weak inflation readings.

But nevertheless, the pricing in the market when you look at the inflation fixing suggests that we're back at target for the ECB and the Bank of England probably in q1, the latest in Q2 next year. And if that is the case, then the market essentially deducts that the central banks will be in a position to reduce rates, particularly the ECB. Now we think the risk to that, particularly given everything I just said about the labor market and the wage negotiations is probably slightly to the upside. And then the last point why we probably disagree slightly with the very aggressive rate cutting path that we're already seeing, particularly for the ECB, is that we disagree slightly on the reaction function. The market seems to be pricing the central banks, yes, they've changed their rhetoric a little bit and our relative new AI power tool central bank AI side indicates as much, but it's neutral currently and we're not really getting any signals from the ECB that they would be ready to cut, certainly not as quickly as the market is implying and therefore ultimately what we expect is an on hold strategy from both the Bank of England as well as the ECB, which contrasts with the quite aggressive pricing that we're currently seeing.

But I expect them to talk this down a little bit because that would on the face of it, give a very strong signal, but that's probably not the signal that they would want to send. The second topic that I would raise is that there is a non negligible probability that they would announce a change in the PEP program or rather the investment of the PEP program, which they so far have said that they would keep going the reinvestments until the end of 2024. And that seems to be a bit out of lockstep with some. The other central banks are certainly the elements in the market and they have said that they would look at this topic and we could definitely see that they would make an announcement that brings the end of the reinvestment, at least partial end of the reinvestment forward maybe into early next year. And that could be something that we would be talking about next week. So stay tuned for that.

Simon Deely:

Given our week, but close to soft landing forecast profile, we think early cuts are unlikely from the BOC. Our base case is for cuts starting in July and continuing at a 25 basis point per meeting pace, we put a 60% probability on this scenario. The downside economic scenario is consistent with earlier cuts or more than a hundred basis points of easing over 2024. We pegged this scenario at 25% with a 15% residual of further hikes if activity strengthens and or resurgence in core inflation warrants it. The combination of macro and BOC profiles suggests a downward trend in term yields throughout the year with materially inverted front-end curves such as two fives, two tens giving way to steepening. As we approach the first BOC cuts, our current bias is for steepening out the curve. So 10 thirties and GOC under performance against treasuries also of the curve. Now we'll shift from the rate space to credit with Santosh Sateesh over to you.

Santosh Sateesh:

Thanks Simon, and thanks very much for giving me some time to talk about credit. So for by way of introduction, I trade credit derivatives here at RBC, which is a new product for the bank and we've had a very interesting last month and a half or so in line with some of the moves and expectations around interest rates. Most notably, after we've had peak rates in October, we've seen a very aggressive rally in credit spreads both in the investment grade as well as in the high yield space over the last month and a half. Investment grade CDX investment grade rallied 19 basis points from his Y point to the trough and high yield has rallied a hundred basis points. And in the middle of that we actually had a default with Rite Aid and in spite of that, default high yield is still a notched to very aggressive rally.

From our perspective, we think the market at this point is expecting a very smooth sailing, but to us that's a very difficult expectation to validate or at least to hold at these price points. Case in point is with how high yield CDX high yield, which is a hundred names of the most liquidly traded high yield single names CDS at 400 basis points. Of that 400 basis points, 25% of that spread is encapsulated within the widest 10 names, and that is basically demonstrating how much of the juice has been squeezed in CDX and the credit in general at this point, if you're getting long risk credit spreads, you're basically betting on the lowest quality companies to rally at this stage and the rest of the market is at this point pricing an extreme price professional. So we feel very strongly about the risk reward and credit spreads tilted much more towards widening and towards risk off. We do feel that there's much more yield to be had or at least much more risk adjusted returns to be had in space versus in credit. We would recommend clients looking at what bearish or at least downside hedging structures, both in credit spot as well as in credit options. On that note, I'll stop right there and I'll turn it back to you.

Simon Deely:

Great, thank you Santosh. And just a reminder that the regional rates outlooks discussed on the call are available on the RBC Insight website. Thanks for listening and talk again soon.

Speaker 6:

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