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.
Blake Gwinn:
Hello, I'm Blake Gwinn, head of US Rate Strategy, and this is the April 16th edition of RBC's Macro Minutes, which I'm calling Breaking Rank.
Expectations for Fed cuts this year are wavering as US economic data continues to come in hot, but that economic performance hasn't necessarily been replicated in other regions. Against that backdrop, one of the most frequent questions my strategy colleagues have been fielding in recent weeks is whether other major central banks feel pressure to keep in step of the Fed, or start marching to the beat of their own drummers. I'm joined today by Canadian rates strategist, Simon Deeley, chief European macro strategist, Peter Schaffrik, finally, chief Australian economist, Su-Lin Ong.
It's just the structure of the global economy that the Fed tends to make policy decisions through a very US-centric lens, largely independent of the global rate environment, leaving many other central banks with a decision to either follow suit or diverge, and indeed, the recent narrative shift has largely been driven by US data, and a shift in thinking around the Fed, with many wondering how other central banks are going to react. As such, I thought it would make sense to start off a conversation with the Fed today, and then pass it over to my colleagues to discuss how these shifts may be rippling out across the globe.
So after the March CPI, we changed our 2024 Fed call from three cuts, starting in June, to just one 25 basis point cut in December. On its face, the CPI print wasn't necessarily a disaster. Consensus expectations were for core to show a 0.3% increase month-over-month, but in the end, it just barely rounded up to a 0.4%. So why did we change our call? One is there was a somewhat troubling trend in the so-called supercore measure. The Fed's been putting a lot of emphasis on that measure. January and March are the two highest super core prints we've had since September of 2022, and even February is still somewhat problematically high.
Second issue for us was that the March print, while only modestly above consensus, does change the framing of the January and February prints. If March had come in at a low 0.3, or even a 0.2, as I think many of the pre-release whispers were suggesting, I think it would've been pretty easy for the Fed to view that super hot January print as an anomaly, with February and March showing a gradual return to that late 2023 disinflationary trend. But instead, they're left with this super hot January print, we've now got two problematically high prints for February and March, and I think even if we see a meaningful dip in inflation in the April data, it's really going to be that April print that looks more like the outlier than January now. So I think it makes it very hard for the Fed to justify a cut, heading into that June meeting.
I also think that dynamic's likely going to hold into July as well. Fed speakers have said that you need consecutive good prints on inflation, so that they can have the confidence that inflation is moving sustainably lower, and that it's going to safe to cut. This Q1 data in its totality, I think, has really reset that counter for consecutive good prints, and our modal case, at this point at least, is that the Fed isn't going to have a substantial enough string of those good prints by July either.
A quick note too on the pass-through of CPI to PCE, I think there's been a lot of pushback, just talking to market participants, against the strengthened CPI. Some people have been noting that some of the sources of the strength in the March print aren't necessarily going to pass through to the PCI print. But I think a lot of times, we put a bit too much weight on that gap. The Fed certainly does choose to express their inflation target in terms of PCE, but they're not going to ignore strength in CPI that isn't necessarily showing up in PCE. CPI still impacts the optics around their decision, it's much more closely followed by the public, and also, I think, Congress as well, which is important, and it does have a direct influence, I think more so than PCE, on inflation expectations. So really something that the Fed just can't ignore, even though I think there's this idea that people want to write off the CPI strength, saying that it won't pass through to PCE.
So I covered why we took out that June cut, and also don't see one in July, but I think it's also worth explaining why we pushed that first cut out to December. I think that's largely a function of the US election. We've long argued that the election cycle won't deter the Fed from taking necessary policy action, but I think this was much more true when what we were talking about was simply carrying through on a cutting cycle that was already underway, meaning if they started in June, I think it would've been very easy to justify another cut, or a follow-on cut, in September, as part of a quarterly pace or something that they had already initiated. I think that's a lot harder to justify when you're talking about starting a cutting cycle in September or November, right in the heart of that election cycle.
I think it's also true that when we are discussing a adjustment-minded or completely preventative style of cutting cycle, that's really a nice-to-have not a need-to-have. So I think opening that door and starting a cutting cycle in September or November just brings a lot more heat down on the Fed than it's probably worth, and I see them delaying out into December. Beyond the first cut in December, we really only have two more cuts forecast for 2025, which I think now put us almost completely in line with a '95, '98, 2019 style adjustment cycle, where the Fed cuts 75 and then we have an extended pause period.
So where does all this put us on market pricing? Even though our modal call is for one cut now in 2024, I think the current pricing around one-and-a-half to one-and-three-quarters cuts for 2024 is still fair, that's largely because I think the bar to hikes is still very high, which means the distribution of potential outcomes is really clipped at zero. Meanwhile, you've still got seven months where something could go wrong this year, so with a modal call at only one cut, that leaves a long of potential downside risk, and I think that's something that has to be accounted for in markets, and I think puts a bit of a ceiling on at least pricing it around one-and-a-half cuts. I think it's really a somewhat similar story for 2025, which already we're only pricing around 60 basis points of cut right now. So I think markets, more or less, in that range of what I would consider fair value for cuts this year, even with our modal expectation at just one cut this year.
I think this is also why the continuation of post-CPI sell off that we've seen over the last few days hasn't really been about the shift in Fed expectations, it's really more about positioning capitulation and a mini buyer strike, as I think a lot of these potential dip buyers are regrouping, deciding how they want to proceed with most of the curve comfortably through to new higher yield ranges. Given our forecast, we're a bit biased towards longs and flatteners, but that's really more of a medium to longer term call. I just think right now may not be the right time for those positions yet, as markets still are a bit uneasy with this break of 450 and fives and tens, and we just continue to bleed higher in both yields, but also steeper in the curve.
One last note, I think the upcoming refunding meeting from Treasury may help settle things a bit, open the door to start adding those duration or flatteners. I say that because with this break higher in yields, I think there's a lot of concern about a repeat of last August and September, which, if you remember, was at least partially driven by angst around supply and deficits. But I think this is going to be a very strong tax season. Recall that April 15th was the tax deadline in the US. I think there's a possibility that Treasury's deficit and supply forecasts actually get revised down when we hear from them in a couple of weeks. So if you couple that with what's likely to be guidance towards no change in auction sizes, I think that could at least appease some of these bubbling supply concerns that I've been hearing in conversations with the market participants.
So with that, let me turn it over to Simon to discuss Canada.
Simon Deeley:
Great, thanks very much, Blake. The narrative has definitely been a fair bit different in Canada, as the January and February CPI report saw the BOC's two main core inflation measures each [inaudible 00:07:55] plus 0.1% month-on-month. That took their three month annualized rates to just above 2%, and has been reflected in increased BOC confidence that the economy is on the right track back to 2% inflation. Indeed, that was their message last week, while emphasizing that they needed to see more of the same in order to cut the overnight rate.
This morning's CPI report showed a continuation of these trends, with CPI trim and median again around up one-tenth month-on-month, averaging out to about 3% on a year-on-year basis, and below 1.5% each on three-month annualized bases. This emphasizes that divergence with US inflation, with Canada's period of choppy inflation data late last year giving way to three low prints, just as the US is seeing a re-acceleration. How much can the BOC diverge from the Fed? We think potential is high early on, as the BOC responds to domestic macro data, and we don't see an issue with the BOC cutting several times this year. Our base case start remains the next meeting on June 5th.
However, it can impact cuts further out if the Fed is not moving, or moving much more slowly than the BOC. The effect of the currency tends to be overstated most of the time, but a sizable depreciation, so something approaching 10%, for example, would still have an impact, and there would be an eventual sensitivity to it, depending on what is happening with other macro factors. Just to highlight, there is a lot of data before the next meeting on June 5th. We get one more full CPI report, full Q1 GDP, and regular monthly data flow for essentially two months.
The BOC's commentary has been really to downplay some potential upside risks in Canada. First thing we'd note is that their emphasis on core inflation measures has meant a relative downplaying of higher gasoline prices' impact on headline inflation, so this has been possible and supported by progress in inflation expectations in some of their surveys. Short-term metrics moving back towards the 2% target, although there's still some concerns there and more normalization is needed.
On the growth side, indications for a strong Q1, so a fair firm January GDP bounce back from public sector strikes, and a solid February now cast, are tracking to plus 3.5% annualized, just assuming March at flat. However, the BOC's forecast is a little bit below that at 2.8%, so these combined with a below potential Q2 GDP projection of plus 1.5%, to leave growth in the first half of the year around potential. So that means that their narrative around excess supply in the economy, which is weighing on inflationary pressures remains, and indeed, that was clear in their monetary policy report last week that that was their takeaway as well. So downplaying headline inflation risks, downplaying upside near-term growth risks, while noting that they're confident in the inflation narrative.
The core inflation narrative means that we do think the BOC is keen to get started on a cutting cycle, and if we continue to see the data like we saw this morning for CPI, then we do expect them to start on June 5th. And our base case is several cuts in a row, so four cuts indeed, with the risk there to both lower and less, given what is going on with the Fed and the US.
Blake Gwinn:
Thanks, Simon. So Peter, what are you thinking on the European side?
Peter Schaffrik:
Well, clearly, as you outlined, the main narrative, since last CPI report, or indeed even before that, is that divergence story, and one might be forgiven to really think that, when you look at Europe in comparison to the US, it seems almost like a slam dunk. We essentially had a recession, or at least a technical recession, in the UK, we narrowly escaped it in the Euro area, and clearly our growth data has been very poor.
Also, when you look at the market moves, we have now clearly broken to the upside in US Treasuries, but have not in [inaudible 00:12:03], as an example. And also, when you look at the comparison in terms of the rhetoric, the Fed has now dialed down its rhetoric. Whereas previously, it was obviously indicating that rate cuts might be coming if further confidence is built, in last week's ECB meeting, the ECB has essentially put in an explicit easing bias, and have firmed up June as expectations in the market for the first cut to come. So indeed, one might be forgiven to really embrace the divergence story.
However, I would like to echo what Simon just said as far as Canada is concerned, I think this really only goes so far. When you think about it in the early phase, I think divergence in terms of policy direction is perfectly possible. The ECB, as I was just saying, they have essentially nailed their color to the mast, and June, bearing any significant surprises, will indeed be a rate cut. The Bank of England has also suggested that the next move is clearly down, and we think the first cut will probably come in August, and that would be a couple of months before we see the Fed moving. We even think that a second rate cut could be coming before the Fed moves.
But then, in my mind, we really enter difficult territory, for a number of reasons. First of all, we actually think that the growth picture I was just describing is probably underplaying what's going to happen as the year progresses, because our leading indicators have actually been accelerating. The UK already has the first two months of GDP data in hand, and that has been on balance stronger than expected, and Q1 might actually turn out a decent 0.3, 0.4. The Euro area is probably lagging behind a bit. But what we're seeing is, in contrast to the US, we're only now really coming through with positive real wage gains, which, in our mind, as the year progresses, will really bolster consumption in Europe, and thereby drive GDP that way. Yes, we also see headline inflation coming down, but just like in other jurisdictions, what we do see is the domestic part of the inflation picture, predominantly service inflation, remains relatively sticky, in both the Euro area and the UK.
So therefore, I would argue that if we have one or two rate cuts under the belt, and we come out on the other side of the summer, and if the economy indeed remains relatively firm, that will not go unnoticed in Europe either. As I was just saying, the first tentative signs of a re-acceleration of the economy are already there, and if that indeed pans out, I think the central banks will find themselves in a difficult spot in acting like a very strong cutting cycle without the Fed. If, on the other hand, we do indeed see inflation behaving and the Fed will be able to cut, then I think the story will be, well, we've just been ahead of the curve a little bit in Europe because it was required. But by and large, the cycle is still relatively synchronized.
And let me maybe say one last word on this. We think that the European economies, at the end of the day, will remain in synchronization with the US cycle, maybe a less significant amplitude, but by and large, the direction will be the same. The trade links, the financial links, the personal links, the know-how links, the same firms that are operating across the Atlantic will have the same kind of technology at play, so at the end of the day, we think it's very unlikely that we have a complete divergence. But one of the things remains very apparent, and this is probably the point that I will come back to in the future episodes. What we have seen in the US is relatively strong productivity growth, and we haven't seen that over here in Europe. What that means though is that we probably remain more inflation-prone, and that means the central banks will have to be very careful in enacting a cutting cycle, even if they want to stimulate the economy.
Blake Gwinn:
Thanks, Peter. Finally, let's head over to Su-Lin.
Su-Lin Ong:
Thanks, Blake. Market-rate pricing of Fed cuts has clearly spilled over to other markets, including Australia. There's just one 25 point cut expected now by late '24, and only about 45 basis points by the middle of next year. As our global colleagues in Canada and Europe highlight, domestic considerations there support some fairly decent easing cycles, particularly in Canada. For Australia, and from an RBA and rates perspective, we've been asking ourselves, are we more like Canada or the US? We err towards Canada, with policy traction clear in Australia, but there remains reasons why any easing cycle here will be far more shallow than most other places, and we're alert as well to signs of US-like resilience that could see a patient RBA stay on hold for longer. We highlight three reasons why, and these are somewhat unique to Australia.
Firstly, while growth is well sub-trend, with a particularly weak consumer, some pick up from mid-years likely, reflecting across-the-board income tax cuts effective 1 July, which will boost disposable income. We're also likely to see some supportive fiscal measures for households from the upcoming federal budget in mid-May. House prices are rising in Australia, testing new highs, and this is usually associated with high turnover and increased durable spending, so any upside to the consumer could see the RBA stay on hold for longer.
Secondly, there's some real uncertainty at the moment over the labour market in Australia, following some outsized strength in recent labour force prints, with the unemployment rate dropping to 3.7% in February from 4.1. We're always pretty wary of such unusual and big moves, and it may just reflect changes to workforce behavior and seasonal adjustment issues, with a clear softening trend prior to January and February. But we're going to probably need to see more than just the next labour force print this Thursday to be sure. This uncertainty and the risk of a stronger starting point for the labour market, even if the leading indicators are weak, will keep markets wary and the RBA patient. Full employment in Australia we think is around 4.25%, and we've basically been mostly sub-4% for the last two years. We also think there's a risk that March labour force this week, the risk is asymmetric ,with a stronger print likely to prompt a bigger reaction and rethink, while a soft print may just be payback with more data needed.
Thirdly, unit labour costs here are really quite elevated at just under 7% annually, and while likely to ease somewhat amidst a cyclical improvement in productivity and likely moderation in the labour market, they will remain high and keep moderation in services inflation challenging. The stickiness in US inflation, even with a better productivity performance, is a bit of a warning, especially if our labour market is more resilient than we think.
Overarching these three factors is perhaps the most obvious, which has underpinned our view for a long time that any RBA easing cycle will be far more modest than most of its counterparts, and that's the relatively low level of the policy rate at 435, it's only really mildly restrictive. So we're sticking with our base case of two cuts in Q4 and another two in the first half of next year, but given the factors we've discussed in the domestic considerations, the risk remains skewed towards a later start and smaller cycle, possibly around 75 basis points, and that's a bit different to some of the other markets we've discussed today. Markets were already moving towards our base case in recent weeks, and are now more than priced for it. They could overshoot a bit further, but we think opportunities are emerging to receive the front end, especially with less than two full cuts now expected for the cycle.
Blake Gwinn:
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Speaker 6:
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