Will Trump’s bite match his bark on tariffs? If it does, the economic damage could be severe but central bank responses are not clear cut in the short term. While Trump policy is the primary risk factor, there are many other question marks – Is the Fed finished the easing cycle? What happens with Canada politics? Will the ongoing rout in global bond markets continue? Is the USD destined to remain strong? – that are important for asset markets in 2025.

Participants:

• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Jason Daw (Desk Strategy), Head of North America Rates Strategy
• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• Elsa Lignos (Desk Strategy), Head of FX Strategy

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

Jason:

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.

Blake Gwinn:

Yeah. Just as a reminder, Jason, we've been on the Hawker side for quite a while. We've had a four-to-four 25 terminal call for quite some time, expecting a final cut in January. But that call was already on very thin ice following the hawkish December Fed meeting. I thought there was still a possibility that Powell, him leaning more dovishly in the committee, may have been able to build a case on the data that we saw between the December meeting and the January meeting to cut again.

But quite simply, the data just hasn't given any cover to cut again, particularly the December NFP last week came in very strong, and I think coming from the Fed, we've just heard Fed speakers repeatedly emphasizing these words like cautious, gradual, careful, and really suggesting that they're looking to slow the pace of cuts. That was culminated in the release of the FOMC minutes last week, which made it pretty clear that a substantial majority on the Fed think they're well-positioned to, quote, "Take their time" in assessing the outlook. So it just seems like they're setting up for a cut, and there might've been a possibility, setting up for a pause, there might've been a possibility that the data gave them some excuse to get one more cut in, but at this point, it doesn't really look like that's going to be the case.

Elsa:

Blake, we've seen persistent and substantial bear steepening since the start of December, and the conversations around this move seem to have been circling around two major themes. One, that it reflects growing concerns about deficits and treasury supply, and two, that the Fed is making some kind of dovish policy error, and that inflation expectations are starting to push up long-dated yields. What's your take?

Blake Gwinn:

So I have certainly heard those themes. I think there's been a lot of discussion, a lot of questions, coming in along those two fronts throughout this back-end-led sell-off. I think both of those are probably, to some degree, retrofitting a narrative onto the price action. If you look at some of the other places you would expect both of those themes to show up in price action, meaning looking at assets swaps, which should move on deficit expectations, looking at longer-dated inflation expectations that should be rising if the Fed was seen as losing control or being stubbornly dovish, those things aren't really moving the way that I would expect if those themes were what was driving the sell-off.

So instead, I think what we're left with, I think for one, we did have a lot of supply to start the year, so markets were having to absorb not only treasury issuance, we had a round of long-end auctions, but also a lot of IG issuance coming to the market, so that probably kept some upward pressure on yields. I think there was some pressure coming from overseas, so some of this wasn't even necessarily a US story. We have Pete on today, obviously he's going to talk a bit more about what's going on overseas, but that was probably driving, and we've seen at times both boons and guilds underperforming treasury, so it doesn't even necessarily seem like it's a US-specific story.

I also think there's a bit of a buyer strike. I think starting off the year, a lot of these would-be dip buyers, your big real money type of investors, are probably a bit slow to get started in the year, and probably aren't interested in catching the falling knife, particularly in the first few weeks of the year. And also, that's probably where you have these nebulous concerns around what Trump's policies are going to look like, deficits, inflation, maybe that's circling around inside of that buyer strike, and just providing one more additional reason for would-be buyers to sit on the sidelines for the time being.

Lastly, I would just say that this focus on term premium, I think the reason we're steepening is just because we have priced out about as much cuts as the market's willing to price out. The market's not really willing to start thinking about hikes at this point, and so the front-end has been capped. And so, when we get positive data, when we get hawkish Fed developments, and there's a selling pressure coming into the market, that's hitting the back-end a lot more than the front-end, because we have the front-end pegged at these levels because the market's just not really ready to go into thinking about the potential for hikes yet. So that's what I think's been driving the steepening aspect of that.

Peter:

Blake, can I return to the deficit that you just mentioned, and is there a risk to US economic exceptionalism from potential fiscal tightening? Some budget hawks in the Republican Party are already making some noises. What's the likelihood of meaningful US fiscal tightening in the coming term, and what would be the implications for Fed policy? Or if I can put it differently, how much of the US economic strength is fiscally-driven?

Blake Gwinn:

So I do think fiscal has been an important driver of some of the strength that we've seen over the last few years, but I do think it's a part, not the only part. There are other reasons coming out of the pandemic that I think rate hikes haven't had as much downward impact on the US economy, fiscal being one of those, but as I said, not the only factor.

Now, the question is, is that going to shift going forward? At least not in the near-term. I am somewhat glad that this is not a visual medium, because I'm sure I make some involuntary facial expressions when asked about DOGE and the likelihood of cutting budgets. I just don't see a realistic scenario where we're meaningfully cutting down on the spending side. When you take off interest payments, social security, Medicare, military spending, things that are very unlikely to be touched by DOGE, you're really left with probably less than 20% of the actual budget that's even up for debate. And even when you get inside of there, you're going to find that a lot of the big areas of spending do have very passionate constituents behind them. You think about something like Department of Education that sends out Pell Grants to help kids go to college, are we going to cut that spending? So any thing you start trying to carve, there are people that start showing up and saying, "No, no, no, no, you can't do that."

So I think their actual ability to cut down on spending is probably very limited, and at the same time, deficits over the next year at least, for the remainder of this fiscal year and probably into next, are going to remain very, very large, and I think fiscal is going to remain an accommodative stance.

Peter:

Okay, that makes sense. But as a follow-up then, so if it's not the fiscal side, what other potential dovish risks do your forecast are out there? Or put differently, under what scenario do you see the Fed cutting again?

Blake Gwinn:

To me, the dovish scenarios all come down to tariffs and trade war. That is the big risk, that is the big X factor.

Blake Gwinn:

So, let me kind of turn that a little bit around on you, Peter. I'm going to kind of flip the nature of the question, just because everybody's... I mean it makes sense you're asking me about dovish risks because we do have this theme of U.S. exceptionalism going on. So, I'm going to flip it on the European side. Everybody's very bearish on Europe. Can you give me a bullish economic case, or maybe I guess hedge that and just say a less bearish one than the doom and gloom that I think has been circulating out in the market recently?

Peter:

Yeah. Well, I think your hedge is setting it up nicely. So, let me get the first thing out of the way. Structurally, we are in a difficult position over here. And I could go on and on about the structural impediments to growth in both the Euro area and the UK. But leave them aside for a second. I do think the marginally more optimistic case can be made from the cyclical side. In fact, we just put a note out highlighting five areas where we think growth could potentially surprise slightly on the upside.

And without going into any one of those, the big one that I would highlight is just personal consumption. Personal consumption has been so weak over the last couple of quarters. And one of the things that we've seen is despite an increase in wages and real wages, we've also seen an increase in savings. And if that just normalizes halfway back to historic levels, I think we should see a positive contribution from personal consumption here. But there's other reasons of course, that we cyclically could surprise, as you said, a very, very downbeat consensus. And I think that's actually the point that we're highlighting the most, that the consensus is so negative that the hurdle is very low to surprise from the cyclical side.

Blake Gwinn:

So I guess if we kind of assume that we actually do get some of the downside risks on growth side over there, but we have this upside pressure on inflation that you're kind of hinting at here, but what does the ECB do? I mean, I guess part of this is coming from the experience on the U.S. side where we have a dual mandate. But given the single mandate, are they going to respond to downside growth, or are they going to choose to attack more the upside inflation risks?

Peter:

Well, I think the answer here must be a little bit of both. And what they've done so far is they've obviously cut interest rates from levels that were restrictive. They're still in an environment where they say it's restrictive, and they have indicated that they want to bring it back to neutral. Now we can have a debate about where neutral is, but one of the things where I think it would become really interesting as the year progresses, is once we get into that neutral zone, Lagarde has mentioned 175 to 250, so two more rate cuts and we're at the top end there, is how far down can they go? Because one of the things that we see playing out over the course of the year, is that because of these structural impediments that basically lower our trend growth, even relatively small surprises to that reduced trend growth will be inflationary.

And now our labor markets remain very tight. And if inflation just remains sticky, then I can see the ECB stopping at levels before we reach the area that the market is currently pricing for. And I think for market terms, in my mind that is the risk for the bond market, that we simply do not get enough rate cuts compared to what the market has been pricing for quite some time. Now, we've priced out some of that already, but I think the risk as the year progresses, is that we price out even more.

Jason:

So one of the big talking points in the U.S. has been term premia around deficits and supply. Yields are rising, specifically the ten-year point pushing to new highs above the levels that we've seen during the Liz Truss budget drama. Peter, are the bond vigilantes sniffing around the UK again? And how serious is the situation?

Peter:

Yeah, so the first thing... Thank you, Jason. The first thing I would say is that the situation in my mind is not comparable with the Liz Truss drama, as you put it, at all. Because back then, we had a self-fulfilling loop of higher bond yields and position squaring. And higher bond yields and position squaring, that's simply not the case at the moment.

Now what is the case though, is that, as you say, we've seen a fairly significant rise in bond yields. And what we also see is that there is talk again about the sustainability of the fiscal situation in the UK and a closing of the self-imposed gap between what the government has said is acceptable and not a so-called fiscal headroom. Now, there is now talk that the government, probably in March, would revise its spending plans. That's probably going to happen in the later years. But the perception in the market is that the government has to respond now to the increase in bond yields that makes carrying the debt more expensive.

And what we reckon, when I look at the market more broadly, is that this rise in term yields is ultimately a fiscal tightening that will, in my mind, have to bring the Bank of England into play. And out of the concert of all the big central banks, the Bank of England has been, in our mind, under priced for quite some time. And we're pricing not even 25 basis points for the next meeting where we think it's very, very likely that they will cut. So, I think that the front end should be supporting the gilt market going forward.

Jason:

Okay. So if we had to boil that all down to one sentence, do you think we keep pushing higher in yields? Or do you think bearer sentiments become so extreme at this point that we're nearing an end?

Peter:

I mean, I personally think that the risk is still that we push to the upside, maybe moreso in euros than in sterling. But as Blake was also saying earlier, it's a concerted global move that we've seen. And in my mind in Europe, we're still not nearing the end just yet.

Jason:

We think the currency, that won't stop them from cutting unless it really decouples from fundamentals. Or if there's some material risk premia or sentiment premia that starts getting attached to it. And ultimately, the inflationary consequences of the currency depreciation that we've seen so far have...

Jason:

Now, I would say that the general fly in the ointment is tariffs, and there's a lot of uncertainty and they could cause the Bank of Canada to pause, do less in the short term during a period of uncertainty. But ultimately on the end of it, it might require them to cut more than otherwise, assuming that the negative growth consequences are greater than the inflationary ones. So further divergence, it's still on the table over the medium term, in our opinion, under various scenarios and the market's mispricing it, we think.

Peter:

Jason Wise, I've got the floor here asking questions. We're also heading into an election campaign in two months time in Canada. And from a market perspective, what are the potential implications or scenarios that we need to watch out for? How could it impact the market?

Jason:

Yeah, there's definitely a lot of noise and uncertainty right now, and I think first, we kind of need to figure out who's going to be the liberal leader. It seems like it's coming down to a two-horse race between Carney and Freeland. And then we need to see if either can get one of the minority parties, the NDP for instance, back on side in order to delay an election until October. Right now, May and June does seem like the most likely time period for an election, but with US tariffs, there is a possibility that that could get pushed out further.

And the third thing we need to think about in the bigger election picture is that the liberals are well behind in the polls. And it's a major uphill battle, I think, to change public sentiment in a short period of time. It's not a 0% chance, but it's definitely an uphill battle that they face. And if we stuck with the status quo in the polling, a conservative government could be net positive for the economy. Less tax, less spending, maybe a little bit more business friendly. And potentially a more productive negotiating partner with the Trump Administration, simply from the fact that they're on the same side of the political spectrum and they share some common ground on some different bigger picture issues.

But it's messy and noisy now, especially with the looming tariff threat, but staying focused on the big picture, there could probably be a more conducive environment for the economy, maybe general fiscal tightening, balanced budget earlier. To be honest, the implication for bond yields for what happens with different election scenarios is probably pretty modest, as far as how it would impact the supply picture.

Blake Gwinn:

So Jason, you mentioned tariffs just a second ago. I'm a bit curious because I've been pretty sanguine on the US side about tariffs. I think Trump's bark, generally going to be worse than this bite, but I get a lot of pushback from colleagues and clients, particularly in other regions, just given that I think some of our major trading partners don't really have the luxury of just assuming that this is going to be kind of a best-case outcome. So I guess my question is, from your side on a scale of let's say zero to 10, how much angst is there in Canada about Trump tariffs and how much of that angst do you think is already priced into the markets at this point?

Jason:

So, my level of concern is increasing for sure. Even if Trump takes a slow and graduated approach, the path for both economies to successfully navigate the negative economic fallout, that path is very narrow. But I would say in the rates market, most people haven't expected or pre-positioned for across-the-board tariffs. Rather, it seems like the vast majority of people are taking a wait-and-see approach.

The rate story is complicated from a timing perspective. It's fair to say that over the long term, if there are large and sustained tariffs, that the Bank of Canada probably has to cut more and rates are lower than otherwise. But the short-term interplay between inflation dynamics and negative growth consequences, that could create a situation where the central bank wants to take a wait-and-see approach, wants to pause for a period of time before reacting to that. So, you could have a period where rates are more stable or possibly even move higher, but I would say the upside in yields, at least in Canada, is very limited at the front end because rate hikes are an unlikely response to tariffs going forward. So, the general bias should be, rates stable to lower, and it really comes down to a timing issue.

Blake Gwinn:

Yeah, thanks for that, Jason. So, I guess a different flavor of a similar question to Elsa. It appears on the dollar side, USD is going from strength to strength. What do you think is driving that? I mean, is this US being strong? Is it the rest of the world being weak? And how much of that do you think is related to this threat of Trump tariffs?

Elsa:

So this is the question on everyone's mind at the moment, particularly as we get closer to inauguration. And I think if you look at the market reaction to both the Washington Post article last week, the one suggesting tariffs would be limited to targeted sectors, and then again last night, so that proposal for low tariffs which rise incrementally, both show that there is clearly some kind of tariff premium in FX markets. As both times we've seen a bounce in pretty much every currency against the US dollar. But everyone we speak to wants something more precise than that, and this is not an exact science, but here is what we can do.

We've got a fitted framework we use to understand dollar CAD in particular, and decompose its returns across its main drivers. So that's rate differentials, equities as a proxy for general risk appetite, crude prices, general dollar direction. The residual on that model captures factors outside those usual drivers, and in this case, it can offer some measure of a tariff premium. So as things stand, we estimate there's about half a percent in the price for dollar CAD at the moment. Dollar CAD is half a percent higher than it would otherwise be. That tariff premium has been as high as 1%, it's fluctuated quite a bit, it's not huge.

I tend to agree with you, Blake, that Trump is more focused on using tariffs as threats, rather than actually wanting or being willing to stomach the potential economic pain. But that's not to say we won't get some tariffs, likely more than his-

Elsa:

... economic pain. But that's not to say we won't get some tariffs likely more than his previous administration, but well short of what was promised on the campaign trail. I feel like current market pricing is somewhat reasonable for where we eventually settle. But to Jason's point, we're likely to swing back and forth. We've spoken to clients out there who expect universal tariffs on day one. And clearly even if you don't get tariffs being implemented, it can have an impact on economic activity, both through consumer sentiment and business investment. So not much in the sense of tariff premium baked into FX at the moment. Clearly potential for more noise around that, particularly post inauguration. But as time goes on and if universal tariffs are not implemented, the impact of incremental threats is likely to diminish.

Blake Gwinn:

So given all those factors, where do you think USD positioning is right now? Where are we in that process and how much of that has been basically put on by investors?

Elsa:

Now, that's not to say it can't get larger still and it absolutely can. Just referring back to the comments I made previously on tariffs, if we were to see much more aggressive tariffs being implemented by the Trump administration, clearly we could see the dollar appreciate further from here and long dollar positioning grow further from here. But it does highlight the fact that the market is pretty well priced for a lot of the strong U.S. data, U.S. Exceptionalism, hawkish Fed, much less dovish Fed, however you want to think about it. And so it's not an unsustainable equilibrium because the carry on holding a long dollar position is mostly positive against most other currencies, but it does mean that if anything happens to upset that equilibrium, whether it's science of weaker U.S. data or it's a bond and equity rally that happens in parallel, that could cause quite a sharp reversal in the dollar. I think that's what keeps investors nervous and maybe not wanting to add to longs at current levels.

Let me finish with one final thought, which is particularly relevant to those hedging FX exposure. And I've had this conversation with some of our large corporate clients. At the moment, I'd say the probability of a 5% move higher in the dollar is still higher than a 5% move lower primarily because as I said earlier, there's not a huge amount in the price in terms of a tariff premium. And if the incoming Trump administration comes out the gates a lot more aggressive than markets are priced for at the moment, you could see quite sharp market reaction even if ultimately those tariffs are not implemented in anywhere near that scale and size.

But just bearing in mind, valuation, positioning, the starting point, from my point of view, the probability of a much bigger move. So say 20% move higher in the dollar is far, far smaller than the probability of a 20% move lower in the dollar. Now you'd need things to change quite materially in order for moves of that size to happen. You'd need a real turnaround in the U.S. data. You'd need a substantial repricing of the outlook for the Fed. But I think it's just some helpful context when thinking about the balance of risks around the dollar at the moment. Positioning doesn't need to correct, it doesn't need to turn around right away, but it does mean that if the underlying conditions change, there's potential for a far bigger move to the downside in the dollar than perhaps there is for the upside.

Peter:

Elsa, we have seen Euro weakness versus the dollar, but even more so we've seen sterling weakness including versus the Euro. So what's your take on sterling?

Elsa:

What's going on in Sterling at the moment is really interesting because some people have pointed to it as evidence that the situation in the UK is far worse than people are talking about right now. The fact that Sterling has been underperforming as much as it has over the past week. But I think positioning actually plays a big role in this and how sterling has performed. If I rewind a week ago, positioning in sterling was actually long on the crosses. So the market was short Euro sterling and it was pretty light even against the dollar. I've said markets really long dollar across the board, very crowded in short Euro dollar, very crowded in long dollar CAD, long dollar Swiss, long dollar yen. But positioning in cable was actually on our metric only net short around 20 to 25%.

That has obviously changed in the past week. That short positioning cable has more than doubled. And we have seen the market flip from being net short Euro sterling to being small net long, but it's the fact that the market was so under positioned in sterling or wrongly positioned on the crosses, which I think has really reinforced the underperformance of sterling over the past week.

Blake Gwinn:

So given that we are a Canadian bank and IMA U.S. strategist, I just have one last question that I would hate to not ask you, Jason. When Canada becomes the 51st state, which NFL team are you going to support?

Jason:

Well, Blake, one, we have our own brand of football up here, the CFL, we don't need an extra down, just the bigger end zone. But I guess if I had to actually pick a U.S. team, I'd have to say I've been a long time Bills fan and supporter. I know you're a diehard Chiefs fan, but I do think this is Buffalo's year

Blake Gwinn:

As a Kansas City guy, I just can't support that answer. But thanks for giving it.

Jason:

Thank you everyone for joining this episode. If you have further questions, you can reach out to us directly or via your sales coverage or visit RBC Insight to read our content.

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