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.

Hi everyone, and welcome to this edition of Macro Minutes called Ready, Set, Slow. We're recording it at 11:00 AM Eastern Time on September 11, and it's going to be focused on the outlook for the Fed and Bank of Canada. I'm Jason Daw, head of North America Rate Strategy, and I'm joined by Blake Gwinn, who's our head of US rate strategy.

Now, today's call is going to cover the key macro themes that are driving monetary policy decisions and discuss when if policy cycles will restart, how fast they could proceed, and how low terminal rates might go. Now this is obviously an important topic because as the outlook for Global Central Bank policies continues to evolve, and particularly for the Fed, it could have far-reaching implications for global asset markets. So to kick off this edition, we'll start with kind of like, let's say a brief discussion of how we got here, which has really been a few soft payroll reports in the US, which has decidedly skewed the risks for the Fed's dual mandate to them focusing on providing some monetary support to help the growth side of the equation. So Blake, what's your take on the current state of labor market? Is it as bad as what some of the headline numbers suggest?

Blake Gwinn:

Yeah, thanks Jason. Okay. If we consider a scale of zero to 10 where zero is heading into the Great Depression, 10 is the large surge in hiring we had out of the pandemic and 5 is perfectly neutral. I guess on the labor markets I'm probably about a 4, 4.5. I think it's completely fair to say that we are in this kind of soft, low hiring, low firing mode and we've been stuck there for a while. And I think it's also fair to say that we're marginally softer than we were say six months or a year ago. So not neutral, definitely a little bit soft, but I don't think we're really seeing clear signs that we're tipping over into something much more problematic or seeing any signs that were ramping up into some dramatic slowdown. You mentioned NFPs. A lot of the negativity that we've had over the last month and a lot of the focus on the labor market really started when we got those very large revisions in the July NFP print.

And I do think that has changed the lens a little bit through which markets are looking at labor market data. Once that narrative has kind of shifted and everybody's on the hunt for negative labor stories, we're grabbing any kind of data that you can find that kind furthers that story and really kind of highlighting that while dismissing other measures that may not be signaling the same kind of weakness. I think we're recording this on the day where we got big bump in initial claims and I think that kind of dynamic is perfectly on display here. My rule with looking at claims is basically ignore anything that happens on a one-week basis. You got to look at the moving averages, you got to look at the trends. It looks like there's some idiosyncrasies driving that around Texas, but still markets just grabbed onto that and it overwhelmed the price reaction that we were seeing to the CPI print.

So just kind of goes to show you how things have really been reframed and what markets are looking for and what they're grabbing onto on the labor market side has really changed since we got those NFP prints. The problem with the NFP prints, I think we have almost no context for what NFP prints really mean in this environment. Usually we kind of assume that the supply of labor is relatively fixed or slow moving, and so we can look at those changes in NFP in terms of job creation and kind of say, well, the labor market is clearly softening, it's gaining slack, it's tightening. We can't really make those kinds of determinations now because we cannot make that assumption that the supply side is relatively constant. We have huge retirements related to just the demographics of the US with baby boomers in that kind of prime retirement age.

We have a major shift in immigration policy, which is having some pretty large effects on the supply of labor and we don't know how to net that out against what's happening on the demand side. So when you tell us there's 22,000 jobs created a month, I don't know if that's good, bad, the same, et cetera. So I think you have to turn to more to basically broader, better measures of the labor market that don't take those things into account. And I think you can look across at a lot of things like the unemployment rate, prime age, percent of the population that's employed, even continuing claims hasn't really moved. I mentioned that bump in initial claims, but continuing claims stayed relatively flat. You're not seeing signs that wage pressure is coming way off. All of these signs that you would expect to see if labor markets were significantly loosening or a lot of slack was building. You're just not seeing that. And I think on a level basis, a lot of those metrics I just mentioned, if you look back over 30, 40 year timeframes were at very, very strong levels historically speaking. And lastly, I would just say on the momentum side, we're not really seeing momentum accelerate like we did last year. Last year, the fear was that okay, levels are fine, but we're picking up steam in the negative direction. Right now, I think best you can say is we're kind of ticking a little bit softer. It doesn't seem like we're really picking up speed towards the downside. So overall, yes, we're softer, but I feel relatively confident that we're not immediately turning over into a deeper slowdown.

Jason Daw:

Okay. So against that backdrop, September cut right now is obviously the path of least resistance, but the macro situation's very fluid. So Blake, what's your overall take on the chances of 25 versus 50, the sequencing of policy moves this year? Is the Fed going to go at every meeting? Are they going to skip, and how does that kind of relate to where you're looking at terminal and where that kind of lands in the context of a neutral policy rate for the Fed at the end of the cycle?

Blake Gwinn:

Sure. So let me just first say we recently, after this last NFP release, we changed our call from a pause in September. We were really hanging onto that, probably a bit late to the game markets, we were fully pricing 25 basis points at that time, but we were really looking at things in terms of the trade-off with inflation risks. As I said in the last question you asked, we were kind of talking about how I do think labor markets are softer in a normal time when we weren't... If you had a core PCE at 2% or 1.8 or 1.9, or even if you had core inflation at 2.5 and it was very steadily heading back down towards that 2% target, I think it'd be a no-brainer to start cutting. You would look at that softness and say, well, we want to make extra certain that that doesn't turn into something worse.

Let's go ahead and start doing some insurance cuts. But right now we're facing upside inflation pressure where a lot of unknowns around how this tariff pass through is going to hit the inflation side of the Fed's mandate. I think if you look at the breakdown between the Doves and the Hawks on the FMC, a lot of the Doves are seemingly very confident that this inflation is A, entirely tariff related, and B, that it is going to be a one-time shock. It's a one-time price level adjustment and then we get back to 2% as soon as it works its way out of the data. Whereas the Hawks are saying, well, look, if I look at both the labor side and the inflation side, we're currently missing on our inflation target by a pretty fair amount. We've got a free handle on core CPI and moving in the wrong direction.

Meanwhile, labor, as I mentioned before, at levels that historically would be considered very healthy. So fight on the committee comes along the lines of how much weight it seems like they're putting on the two sides of the mandate. If we had been heading into this meeting with NFP prints that were on consensus, maybe kind of bounce back a little bit from that July data, then you add on to that a bit of a hot CPI. That's what I was kind of thinking in regards to that pause. But when we got that software NFP print, even though I have a lot of questions about what that really means, I think it just took a lot of energy out of the Hawks. I don't think there's really any will to go into the meeting and really try to convince some of those that are sitting on the fence on the committee.

I don't think there's really a lot of energy to try to convince them to support a pause. I think the administration wants it. The markets have priced it. You got about a third of the committee that really wants to start cutting. It's really just I think not worth it for them to put up a big fight. They're fine going along with the cut. So that seems like the path of least resistance. I still think there could be a pause in October. I think if we kind of use last year as a playbook, we did see a bit of a bounce back in the QFOR data.

I wouldn't be totally shocked to see something happen again. When we get the September data coming out in October, that shows a bit of a bounce back in some of the labor data and we actually get to that meeting at the end of October and the Fed decides to pause while still signaling that they are going to cut again before the end of the year. Beyond that, we expect them to start cutting again in December. Maybe you just call that a skip of October to cut in December and then basically work their way down to a 3% terminal level.

Jason Daw:

The other thing that's been going on in the market has been concerns about the third year bond yield in the US. Obviously yields have come down over the past couple of weeks, but before that yields were pushing up to around the 5% level and there was a lot of concerns related to supply, fed independence fears, possibly the monetary policy angle, over cutting when inflation is still sticky kind of to the upside. So how do you think this confluence of factors, monetary policy and these other issues that are happening in the background, what do you think that means for the bond market and particularly the long end, the third year?

Blake Gwinn:

Well Jason, I think you have to conclude that the bond market is telling us that we've solved all our deficit problems over the last two weeks, given how much we've rallied off of those fears around deficits earlier this year. No, but seriously, I think my view on that, I do feel like this rally that we've had, the strength at the long end that's pulled yields back down below the bottom of those ranges we've been trading since April. I think it's running out of steam a bit now. I say that on a day when we're still rallying, we've got tens and thirties lower by three or four basis points the day we're recording this. We're hanging right around that 4% level, which I think is going to be a place where we see a bit of resistance in tens. It just feels like we are running out of steam.

And I think that comes along a couple fronts. I mentioned that 3% terminal rate. It's kind of interesting to me that as many discussions and disagreements I've had and conversations I've had around whether the Fed should cut in September, whether they should cut 50, how fast they should go, et cetera, everybody seems to still be looking for kind of a 3% terminal rate. No matter what path and how quickly you think the Fed needs to get there, most people are still saying, look, the Fed doesn't really need to cut into accommodative territory. This is more about getting back to neutral, making sure labor market risks don't accelerate. If that's the case, we've got terminal priced slightly below that 3% level already, so there's not a whole lot more room for repricing of the fed and repricing of that terminal level to pull bond yields down.

So that's largely gone as far as it can unless we start to tip more or seem like we're tipping more into recessionary types of risks. The other thing I would say on the FOMC, I do think there's a risk that next week I kind of lean towards it being a bit of a hawkish cut. I think they're going to cut 25 basis points, but I think the tone we get out of Powell could surprise some people a little bit in the hawkish direction.

I don't think he's going to be waving his hands in the air, super concerned about labor. I think he's going to be relatively measured. There is probably even subconsciously feel some responsibility to wrap in the views of some of the Hawks into his comments. So he's going to perhaps sound a bit more hawkish than he did at Jackson Hole. And then if you look at the dots, I don't think we're going to get as big of a shift in those dots as maybe some people are expecting and maybe even see that median for 2025 continue to imply only two more cuts, which would basically be suggesting that they're going to skip in October.

So that could read a bit hawkish as well. That could put some upward pressure on yields. And lastly, just this rebound in the data that we were talking about, looking at last year as the playbook, thinking there's some weird things going on, particularly around education payrolls in the data. If we see some rebound as the school year got underway and heading into Q4 and also as some of those liberation day, the spike in uncertainty for corporations as that continues to fade, if we see some rebound in the data in Q4, that should also put some upward pressure on yields.

The last thing I would say, you do have this kind of spike risk around those things you mentioned. Deficit concerns, fed independence, these are tail risks that could... Not something I'm calling for, not something I think you can very easily set up for, but things that are just kind of hanging out there that at any time we could get a development on either of those fronts, whether it's a bad auction or whether it's some news on the cook firing or something that sends backend yields meaningfully higher. So I think that you're kind of carrying that risk from day to day as well. All right, Jason, let's turn around and start talking about your side of bed. Labor data, very similar to the US. You guys have had some softer data, Labor GDP, all looking a bit softer in Canada. How do you see the macro landscape developing north of the border?

Jason Daw:

Yeah, thanks Blake. A couple observations on the recent data and then some thoughts on the outlook. Yes, the recent data, when you look at the headline numbers, whether it's GDP or unemployment, that's been bad, no doubt about it bad, but when you look at the underlying details, it's not so worrisome. So first the GDP data. Yes, the economy contracted 1.6% in Q2, but consumption and domestic demand, those grew around 4% annual wise. So there was a pretty strong snap back in Q2 from what we saw in Q1. And the growth rates in Q2 were very similar to what we saw in 2024. So even though sentiment was generally depressed, consumers still spent through that, albeit with a bit of a drawdown in savings. But it kind of shows that the animal spirits in the economy were still more on the positive side, potentially.

The two negative payroll prints, yes, not great. Two months ago it was all about a big decline in youth employment. This has been a problem for many years. It's been a big contributor to the increase in the unemployment rate from the cyclical lows to where we are now. This is an echo effect from strong immigration that we've had over the past couple of years and it's not something that monetary policy can really address.

The last payroll print was all in the self-employed category. And when you look at it historically over multiple years, five year spans, decades, self-employment does not contribute anything to employment growth. It's a net-zero contributor. It's volatile, so it's hard to put a lot of weight on that in the very last print. So yes, the underlying details of the data that we've seen definitely better than the headline suggests. And there's been some rebound in the higher frequency sentiment indicators on the business and consumer side. So we could see even more of a snap back in the second half of the year if trade is not being a major drag. So for our part, yes, modest recovery in the second half, but it's not inconceivable that the skew to that is stronger rather than weaker.

Blake Gwinn:

So given all that, thinking about what that means for the bank, markets right now pricing at around 80% for a cut in September, where are you on that? Are they going to pull the trigger or do you think they're going to pause here?

Jason Daw:

Yeah, as you mentioned, the market's highly priced. 80% plus chance of a cut. Consensus has firmly swung in that category. For our part, we think it's a lot closer call than how the market or consensus is handicapping it at the moment. Now just to rewind a little bit, to kind of give you background on what our core views have been and when they changed and what we're kind of thinking now. For the longest time, well over a year, year and a half, we thought terminal was going to get down to two and a quarter. After the Bank of Canada went on hold a couple times, we thought that the bar for them to restart was pretty high and our modal forecast changed to no more cuts in the cycle. Now from a probability standpoint, we only gave it a 60% chance that the BOC was done. So not a high conviction call but was our base case.

We gave it a 30% chance that we might have to revert back to our previous terminal rate forecast, which would be two more cuts. That was a 30% chance and the [inaudible 00:15:51] 10% chance was a hard landing. Something breaks that they have to cut rates four times plus. That was a low probability type of an event. So we're going into the meeting still with our base case, slightly in favor of them being on hold at this point, but we think it's really a game time decision based on what we get in the CPI report on Tuesday, the day before the Bank of Canada. So if we had a situation where core inflation printed, let's say 0.1, then it gives them a path to potentially cut and maybe pushes them over the edge to do so. If there was a higher print, let's say 0.3, then they probably had a minimum punted decision to October and choose to skip the September meeting. Something around 0.2, that's kind of no man's land.

It does become a very difficult call at that point, but I think there's some other bigger picture reasons to think about on why they don't really need to cut right now or possibly not at all. The first one is there's been a lot of data distortions. We know this because of tariffs. We see it in the economic data. There is an expectation that that will improve. So should that be something that monetary policy reacts to or do they need to get further evidence before they'll provide more stimulus? The second one is we're going to get the fiscal budget in probably October. They may choose to wait until that time to better understand how the fiscal side will impact the economy. And third, potential GDP is compressing to a very low level by the end of this year. Population growth is slowing rapidly. Labor productivity has been weak for 10 years.

So potential GDP is somewhere in the zero to 1% range and maybe closer to the bottom of that than the top. So you don't need a lot of organic or residual growth in the economy. Never mind if there's fiscal stimulus, to tilt a balance to where the economy is growing above trend. And we have a lot of these distortions happening from a trade standpoint. Monetary policy is just not the tool to solve it. Fiscal policy is much better. Targeted measures to certain sectors, infrastructure, investment, these are all things that are better suited to handle the current economic environment than broad-based monetary stimulus. And I guess lastly, in the back of their mind, it has to be the COVID situation where there was too much monetary and too much fiscal stimulus. Not that it would be at the same degree now, but there's definitely parallels and it's a lot more worrisome when the starting point for inflation is a higher and a stickier level than we saw back then.

Blake Gwinn:

So assuming they do cut in September or at least start cutting relatively soon, how far do you think they need to go? Are we talking just a move back to some kind of neutral level or you think they're going into accommodative territory or maybe not even going to neutral?

Jason Daw:

Yeah, so the Bank of Canada's neutral range estimate is two and a quarter to three and a quarter. So right now we're smack in the middle of that. Assessing where neutral is always difficult before the fact. You kind of only know after and how the economy has been behaving as far as being able to calibrate that type of situation. So again, our base cases, they probably don't need to cut going forward. If they do cut, it's probably down to the lower bound of their neutral range, which is two and a quarter. And at least from our lens, there's not a lot of reasons unless there is big US slowdown, something breaks for them to go into accommodative territory. So the market's already priced for two cuts in this cycle. So it does seem like at least the front end of the curve is fully baked at the moment.

Blake Gwinn:

Okay. I guess last, just wrapping it all together, putting a bow on it here, what does all this kind of mean for the bond market? What's your view on yield levels, et cetera, here?

Jason Daw:

Yeah, we think we're in basically a stable to higher yield environment across the curve. So the monetary policy angle, that's kind of already been factored in. The BOC would have to cut more than two times for there to be a strong move as far as bond yields heading lower. So generally yes, stable to higher yields. I think the one interesting dynamic that's been going on this year, which we've liked and we continue to like is the Canadian bond market underperforming the US market.

And that is because of two factors. One, the monetary policy side, the Fed probably outcuts the Bank of Canada from here. So that will help as far as treasuries outperforming GOCs. And second, the relative supply story combined with the monetary policy story makes it a much more difficult situation in Canada for a term premium standpoint. So both the supply monetary policy side, we think favors GOC under performance versus treasuries. Thanks to everyone joining the call today. The macro situation is obviously very fluid. The outlook for central bank policies will be shifting depending on the incoming information. So if you have any further questions, please reach out to your RBC sales representative or to Blake and I directly and we'll be more than happy to help you.

Speaker 3:

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