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 and welcome to the June 11th edition of Macro Minutes titled, Cuts For Thee But Not For Me. I'm Blake Gwinn, Head of US Rate Strategy at RBC Capital Markets, and I'll be your host for today.
The BOC and ECB both kicked off long-awaited cutting cycles last week with questions about the death and duration of these cycles likely to drive markets from here, but in other regions, the case for pulling forward cuts remains weak. With other central banks on hold, the trading environment might remain relatively range-bound into the summer. So we've got a great panel today to address the status of cutting cycles across regions. Let's start with the central banks that have already cut. First, we'll go to Canada Rate strategist Simon Deeley to discuss the BOC. Then we'll go to the Head of UK European Rates and Economics, Peter Schaffrik, to discuss the ECB. Then to the banks that are still on hold, I'll cover the Fed and we will close with Chief Australia Economist Su-Lin Ong to discuss the RBA. So with that Simon, please take it away.
Simon Deeley:
Great, thanks very much, Blake. As you mentioned, the bank delivered a 25 basis point cut last Wednesday, the first cut since the start of the pandemic and taking overnight rate to 4.75%. They own the cut, noting improvement across the suite of inflation metrics including clear downward movement and three-month annualized core metrics, CPI trim and median both below 2% on this measure. We had a June cut in our profile since December with pricing fluctuating in the intermeeting period, but ultimately four straight soft reports for core inflation in 2024. In direct contrast to the US, made a cut 80% price heading into the meeting. On future cuts, they said it was reasonable to expect further easing if the economy evolved as expected. A more explicit easing bias than many anticipated, though they emphasize decisions will be taken on a meeting by meeting basis.
So what does the BOC do from here? This is likely to be the start of a sequence of cuts and we expect cuts at the next three meetings, reducing the overnight rate to 4% by year-end. This is not something we expect to be preset by the bank. Instead, we see continued below trend GDP growth, a rising unemployment rate and inflation trending around 2%, keeping the BOC deciding to cut at those meetings. The risk is that data is more mixed than we anticipate and the BOC opts to pause at one of the three meetings. The main question we've been getting asked recently is whether and how much, the BOC can cut with the Fed firmly on hold. The bank has moved in a similar fashion as the Fed at times when both economies have been hit by global, so the pandemic global financial crisis tech bubble. But the BOC has repeatedly shown a willingness to deviate when needed.
The most obvious recent examples are the 2010 hikes during the commodity price boom and 2015 cuts following the oil price collapse. We anticipate the bank to continue in this vein with Governor Macklem, noting they are not close to the limit of their divergence with the Fed. Indeed, the impact of the exchange rate on activity and inflation can be overstated and we don't think dollar/CAD around 1.40, which it's not even at yet, is an issue at all. Above that level and approaching 1.45 is probably where it would become more of an issue for the bank.
Blake Gwinn:
Thank you, Simon, and over to you Peter, to talk about ECB.
Peter Schaffrik:
Thank you, Blake. So actually, I want to do two things. I want to speak about the ECB and I want to weave in the events that took place over the weekend and how they might or might not be relevant for the ECB. So first of all, I think it's fair to say that when the ECB cut rates as the market was widely expected, it was a very hawkish cut. So what the ECB has done after cutting rates, they've changed the statement initially taking out the easing bias, putting in phrases that suggest that rates will remain on hold probably going forward. And then in the press conference when Lagarde was given opportunities to sprinkle the message with a bit of a dovish tone, she always refused and took the other way. So overall, I think the market clearly walked away from, the ECB probably wouldn't have cut if they hadn't painted themselves into such a corner, or at least if they had decided anyway, the path to more rate cuts is much more rocky than was previously probably anticipated.
And that's actually how we think about it as well. So we have been forecasting for quite some time that the ECB will cut rates three times this year, starting in June as they did, and then in September and in December. But we also think now, going forward the risk around that is clearly much more elevated than it was before, with clearly the risk that they do less rather than more. And why is that the case? Well, A, because the data has surprised to the upside and it's quite plausible and that the inflation progress and has been made, it's gone sideways from here onwards. Furthermore, and I think that's actually quite important, over the more medium term, their forecasts rely quite heavily on the assumption that as the economy recovers, productivity growth will recover as well. And with that, wage growth developments should be arrested and therefore, second round effects should not take place.
We think that the key assumption of the ECB that is very likely going to be challenged as the year progresses and there is already some talk from some ECB members that suggest that they will have to look very careful at their forecasted, forecasting process going forward. Having said all that, we haven't changed our forecast. We still think it's more likely than not that in September, the ECB will cut rates again, mainly also because there is a very strong constituency within the ECB, we think, and that will want to reduce rates further no matter they're going. And it's very likely that these parts of the ECB governing council will be pushing very hard as the odds are, as the year progresses, that their window of opportunity closes. So therefore, for the time being, we have left our forecasts in place, we think it is more likely than not that they will reduce rates again come September.
But clearly, if inflation and growth but particularly inflation continues to surprise on the upside, the risk is that they wait longer with a second move. And in fact, when she was given the opportunity in the Q&A to rule out that the ECB would do a so-called one and done, she has not really ruled that out. So that must be at least a small probability as well. Now, how does that all hang together with the events over the weekend? For those of you who have not followed it, we had the European elections that produced a shift to the right, but more importantly, it has also led to French President Macron announcing a snap election for the French Parliament and that in turn, has put the CAD amongst the pigeons in a market that was set up for carry trades and has widened European spreads within the ECB space, but also, has now moved into wider spreads in the credit space as well.
And we think that if this accelerates further, which is not entirely unreasonable to assume, if this accelerates further, of course, this puts more pressure on the ECB to cut rates rather than less because it represents a form of financial tightening that the ECB will probably would want to rest at some stage. Now, we don't necessarily suggest at this stage that the levels we've reached are already levels that need to provide sleepless nights to investors, but certainly, the speed of the market reaction that we've seen is one that shouldn't be repeated for too long because that clearly presents a risk for not only the ECB but also for investors, by extension, the market as a whole and potentially then, the economy.
Blake Gwinn:
Great. Thanks a lot, Peter. So onto the Fed, given that this podcast is going to be posted the night before the FOMC meeting, many of you may actually be listening to this after the meeting's already occurred. So, I'm going to try to keep my discussion of the actual meeting pretty brief and instead, try to focus more on our longer term outlook and what that means for markets. So very briefly on this week's FOMC meeting, on net, I think very little has changed on the economic front since the May FOMC meeting, and I'm expecting the Fed to essentially repeat that prior messaging. That means indicating the rates remain on hold until they have confidence that inflation will be moving sustainably to 2% and reiterating that the bar to hikes remains extremely high.
Notably, there was a bit of a dovish narrative starting to bubble up over the last few weeks heading into the meeting, but that was essentially quashed by the surprisingly strong May NFP print and the ISM services last week. So if you look at these various proxies we have of the economic narrative, I like to look at things like Atlanta Fed GDPNow, Citi Economic Surprise Index, just to get a feel for where that economic narrative is moving. We've basically done a roundtrip since the May meeting.
On the inflation front, the data we've received since May certainly come in low enough to I think alleviate some of the concerns we had about re-acceleration as we were coming out of that very strong Q-1 data, but the data's still pretty problematic for the Fed. Both core CPI and PCE are coming in at monthly levels that if they're maintained throughout the year would see year over year inflation actually rising pretty meaningfully by year-end. So definitely not those "good prints" that the Fed's looking for.
So overall, I think the Fed's in a holding pattern here. We're still very comfortable with our call for first cut in December, but thinking about what would get them to move earlier? I do think there's a bit of asymmetry between inflation and the labor side of the mandate here. I think to truly pull forward or deepen the path of cuts, it really would take a meaningful deterioration in growth and labor. Meanwhile, on the inflation side, if the stickiness that we've seen starts to relax, inflation starts moving more consistently back to target. That alone, meaning absence of labor and growth slowdown, that alone is probably not enough for the Fed to really start pulling cuts much closer than what's already priced into markets. Moreover, I think it really does take a collection of multiple low prints for the Fed to be convinced that that's actually happening and inflation is actually back on track towards 2%.
So with the year essentially halfway over, I think the ship has largely sailed on getting to more than one or two 2024 cuts just on the inflation data alone. I would also just mention, I still think that inflation returning more consistently towards target, that's not a strong enough reason for the Fed to start a cutting cycle right in the middle of the US election cycle. Despite the degree to which Fed officials have really been insisting the opposite over the last month or two, I still think that that's a bit of a higher bar to cross to cutting in September and November if you're not seeing that deterioration in growth and labor on top of the decline in inflation. And so, I think that leaves 2024 cut pricing largely bound between one and two cuts for the near future. And with it, I think rate markets are in a bit of a holding pattern until either inflation starts falling more convincingly or the growth and labor picture moves beyond what I would consider further normalization and really starts showing signs of, risks of a hard landing.
So if our economic outlook is right, inflation continues to moderate fairly slowly, labor and growth doesn't really show signs of rolling over and the Fed doesn't start cutting until December, I think this current range-bound environment that we're in could persist well into the summer. At some point, US political themes are going to start driving more positioning and volatility as we get closer to that election, but that still might be several months away. And I think that leaves us in a bit of a difficult environment for really trading themes or these high conviction, directional positions and duration of curve, at least for the next few months.
But I do think it lends itself to tactical trading. So really playing inside of these technical ranges, playing against key technical levels. It lends itself to cross market views as these expectations for other central banks' cutting cycles continue to evolve versus the Fed on hold. And I also think it's an environment where investors are looking to collect carry, whether that's by selling or buying spreads, holding positions that are positive carry like flatteners, et cetera. Those kind of themes, I think, are really what's going to drive most of the trading activity over the next month or two, not these kind of high conviction directional bets on duration or the direction of rates or curve. And so with that, let me throw it last to Su-Lin, who is going to cover the RBA.
Su-Lin Ong:
Thanks, Blake. The RBA will soon move into blackout ahead of next week's June meeting. As far as leaders and laggers go, the RBA is firmly in the latter camp. We've long argued that it will lag the global easing cycle with far more modest cuts versus at dollar block [inaudible 00:12:46]. And there's been little in recent weeks to shift our view that rate cuts are unlikely in 2024 and we stick with just 50 basis points of cuts in the first half of next year. With cash at 4.35 and only mildly restrictive, a full easing cycle is unlikely with adjustment cuts more appropriate at some point. We'd say on balance, that the key domestic data and events of the last few weeks will keep the RBA cautious and see it continue to maintain maximum optionality at its June meeting next week. It's likely to repeat that phrase that it won't rule anything in or out.
April CPI was higher than expected. National House prices continue to rise to new highs. Household consumption in Q1 was revised higher over the last year or so, and that was almost entirely due to more Australians holidaying offshore and we're in the middle of budget season with the Commonwealth budget and state budgets released thus far, erring quite stimulatory with a focus on numerous cost of living measures and across the board income tax cuts from one July. Coupled with ongoing signs of stickiness in global services and domestically generated inflation, we don't think rate cuts are on the RBA horizon, which is in contrast to most of the G7. If anything, we suspect the RBA has little tolerance to much more upside to inflation, although it clearly remains very reluctant hike any further, with recent RBA communication continuing to elevate the full employment objective and desire to protect as much of the labor market and employment gains of the last few years as possible.
So the bank looks pretty sidelined, it's going to worry and wait for some time to come amid multiple uncertainties, including the risks that the impending fiscal stimulus see some recovery in household consumption in the second half of the year. The labor market remains tight and we expect this week's May labor force to show an unemployment rate that's still around 4% and core inflation stays elevated. Next week's June meeting doesn't include a quarterly statement and forecasts giving the RBA a bit more time before its August meeting for those full updates. Markets are understandably wary with very little easing price by the end of this year and a full 25 point cut not really priced until about Q3 of next year. Despite this, we've argued for patience in receiving the front end and think that that strategy is still prudent.
Blake Gwinn:
Thank you, Su-Lin, and to the rest of our panel. And thank you for joining this edition of Macro Minutes. Institutional clients of RBC can find additional content on these topics and more on RBC Insight or by reaching out to your RBC sales contact. Hope you join us next time. Thanks.
Speaker 2:
This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.