Stimulus (Almost) Everywhere | Transcript

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.

Jason Daw:

Hello everyone and welcome to this edition of Macro Minutes called Stimulus almost everywhere. I'm Jason Daw, your host for today's call, which we are recording at 10:00 AM Eastern time on October 17th. The ECB delivered another cut today and there's more to come. The Bank of Canada is primed to start cutting in 50 basis point increments and do quite a lot over the cycle. The Fed should cut further but only a little bit and China has recently delivered a lot of stimulus. The Reserve Bank in New Zealand has recently cut 50, could follow up with more going forward, but the outliers, the RBA who's sitting patiently and doesn't appear ready to cut anytime soon. So while most central banks are moving in the same direction, there is notable differences in the speed of magnitude of policy easing across countries. To discuss the outlook for major central banks, I'm joined today by Blake Gwinn on the US, Peter Peter Schaffrik on Europe, Su-Lin on Australia, New Zealand, and Alvin Tan on China.

I'm going to start the discussion today on Canada and touch on three items. First, our updated Bank of Canada forecast. Second, what that means for the Canadian bond market. And third, the implications for Canada. US interest rates spreads on October 9th. We made our first material bank account on forecast change in over a year. The three things that we changed were one, we lowered our terminal rate forecast to 2% from 3%. We introduced a 50 basis point cut as our base case for the next meeting on October 23rd, and we also have back-to-back 50 basis point cuts in the profile this year. Notably since our forecast changed for our 50 basis point cuts on October 23rd, the market and consensus has followed suit in our opinion, the urgency for the Bank of Canada to front load rate cuts and move at least into a neutral and arguably an accommodative policy setting is rising quite significantly.

This is because the economy remains stuck in low gear at below trend growth rates that's causing the output gap to rise and introducing material downside risks to inflation in 2025. So for some context we think that 1% or lower headline inflation over the next year, that's much more likely than inflation being 2% or higher. Now what does this mean for bond yields? So if our expectation of larger rate cuts relative to market pricing comes to fruition, it suggests that bond yield should have lower across the curve, but in a non-linear fashion, the front end that's going to the most, but the impact to monetary policy as far as how that affects the long end, that will be less pronounced. So for example, we have the two year bond yield falling down to 2% next year and the 10 year bond yield moving to the two 50 area.

So there is scope for additional curve steepening, but I would highlight that steepen do remain a challenging trade, a challenging position to have on considering the negative carrier role in that position. Lastly, on the Bank of Canada versus Fed policy gap, this is something we get a lot of questions from investors on. We are more optimistic on the US situation as Blake is going to discuss later. And we have the Bank of Canada cutting rates to 200 basis points below where the Fed ends this cycle. And I think it's important to remember that the Bank of Canada Fed policy gap that was plus 200 basis points in 2003 and it was minus 200 basis points in 1996. So there is precedent for the policy rate gap to get to the extremes of 200 basis points. I would also like to point out that the only episodes over the past 30 years where policy cycles were very aligned between Canada and the US where they were moving in the same direction or magnitude was quite similar, was during periods where there were common shocks and this was the 2001 tech bubble, the oh five to oh seven commodity boom GFC in 2008 and going into and out of the covid period.

Now absence and unforeseen development, the Bank of Canada, they should be able to forge their own path with our base case being a material policy gap of 200 basis points, which in our opinion is not out of the realm of possibility. So in this spirit, in our opinion, the most logical place on the curve that Canada continues to see outperformance versus US treasuries is the front end. Okay, so up next is Peter to unpack the ECB announcement today and what it means going forward along with insights on the uk.

Peter Schaffrik:

Thank you Jason. So the ECB press conference just ended about an hour ago before the recording and the interest rates were cut 25 basis points as was widely expected. We were expecting it, the market was priced for it so that in itself didn't really move the needle. The statement was changed a little. We were expecting a larger change but that wasn't happening. But what they did do is they were highlighting quite clearly the downside of inflation and in fact we just had a release earlier this morning where the previous flash estimate was revised downwards to 1.7% and indeed a warning from the ECB about poor growth numbers and how they might be weighing on inflation going forward as well. So that already left a slight dovish taste of the statement and when the actual press conference rolled around, lagar kept coming back to the same theme.

What really has happened though in the market is that the market is now starting to imply with a small probability, but starting to imply that there might be the off chance of a larger 50 basis point cut in one of the meetings coming forth and now we think that's rather unlikely. And I think where it comes from is that when she was asked about whether that was discussed, she did not say no, this wasn't discussed. She did say 25 basis points was the option on the table and that was unanimously accepted. So she didn't rule it out entirely and with the ongoing stress about weak growth data forthcoming and the market is starting to imply a tiny probability of a larger cut. So obviously there's a bit of a theme of the call here in contrast to what Jason was elaborating earlier. However, we think over here in Europe that is still rather unlikely.

And one of the other things that the regard has been saying is that they think that the labor market remains relatively resilient, relatively firm, that they don't expect a recession and therefore we think at this stage it'll be very difficult to see them jumping to a larger 50 basis point step move. So our forecast remains unchanged and we think they will continue to cut 25 basis point increments in the forthcoming meetings until they reach two and a quarter percent in April, which is probably then a neutral level where they can start pausing very quickly. Moving on to the uk, I want to highlight first and foremost that we've also recently changed our Bank of England call and we also think that they will be going in 25 basis point increments at every meeting now and the data that we received particularly this week from the UK has also been to the downside whilst the labor market data remained firm, the inflation data came in on the weaker side and clearly given the market a boost and we're now pricing round about 40 basis points in grand total over the next two meetings, which we still think is probably slightly on the low side.

So we remain relatively constructive that the market can perform a little bit further. Gilts are currently trading relatively cheap two buns in particular. The spread has started to come in. We think there is a little bit more scope to do so. Now one last topic that I think is absolutely worth raising as far as the UK is concerned, we've got the budget coming up, that's the first budget of the current government and there is a lot of concern in the market over here in the UK whether or not that will see a fairly substantial widening of the so-called fiscal headroom through a change in the metric how debt is being measured. And without boring everyone with too much detail, the risk of a fairly large move out would be that obviously the budget deficit would be widening. We think some of the larger numbers that are out in the market up to 50 billion widening in the budget deficit are probably overblown. We think the changes will be a more moderate probably to the tune of about 15 to 17 billion. And once that budget is out of the way, we reckon that this will also help the UK market perform in relative terms.

Jason Daw:

Okay, great stuff Peter. Now over to Blake to tell us why he's been the most optimistic on the street and continues to call for the least amount of cuts versus consensus.

Blake Gwinn:

Yeah, thanks Jason. So as you said, I'm going to be a bit of the odd man out on this podcast. I'm very much of the belief that the American exceptionalism theme is alive and well as regular listeners of this podcast will know I've been pretty consistently more optimistic on the US economy versus consensus and the market to be honest, it's been a bit of a tough road to travel through most of the late summer, given all the momentum for the hard landing narrative that came on the heels of that surprise bump in the unemployment rate in July. So throughout the period we've basically maintained that the slowing and labor markets is really more emblematic of normalization than the early stages of our hard landing that you basically can't expect changes in labor market data to follow the same path of prior cycles for a variety of reasons.

I think the SOM rule and how we've seen that kind of develop over the last couple of months is probably the most obvious example of this, but we've also seen numerous relationships and kind of typical patterns around recessions in the data that have already broken down over the past year. We also maintain that when you look at levels of most labor market series things have generally looked pretty good. That includes that the rise in the unemployment rate in particular was pretty benign given that it was largely being driven by shifts in labor market supply. Also the rise in the unemployment rate in July particularly what we saw in temporary layoffs was at least partially driven by some quirky seasonal issues and likely to reverse. And lastly that when you kind of look outside of a handful of labor market data that is admittedly slowing but still at relatively healthy levels and also looking past some of the survey data that's diverged from real activity in a pretty meaningful way over the last year, the economy looks to be on pretty solid footing.

The prime age employment as a percent of the labor force is still near multi-decade highs. You've got layoffs near historic lows, consumption remains strong. Consumer and corporate balance sheets are in very good shape. Corporate profitability remains high, equities are near all time highs and against all of that you have a fed that just made a very splashy start to their cutting cycle with a 50 basis point cut and fiscal policy that's likely to remain accommodative into 2025 regardless of the outcome of the election. So against that backdrop, and I think combined with our view that some potential growth in inflation tailwinds may be kicking up a little bit late 2024, early 2025, our fed call has had a terminal rate of only four to four and a quarter after 25 basis point cuts in November, December and January with a long pause starting in March.

In other words, we're looking more towards the adjustment cycles of 89, 95, 98, 20 19 as the roadmaps for what's going to come over the next year rather than these more recessionary type of cycles. So as I noted before, this has put us a bit at odds with consensus, the fed dots and I think the general trend across other major markets. But the last month of data, which I would say primarily the retracement of the unemployment rate but also last week's higher than expected CPI print and today's really blockbuster retail sales print, I think has really set the narrative pendulum swinging back in our direction quickly from going from hard landing back towards soft landing. A lot of the client conversations we're having this last week have really turned towards this idea that the 50 basis point cut in September might've been a mistake. We've gotten a lot of questions on whether the fed might skip in November and if anything I'm a bit worried that we may now be in danger of again swinging too far into the no landing territory if the data keeps coming in like it has over the last month.

All that being said, I maintain our call that the fed's going to cut 25 basis points at the November meeting in a few weeks. I think a skip is still probably more likely than 50 basis points, but both are very low probability in my mind. A 50 basis point cut really took a critical blow from the labor market data that I mentioned. It was probably finished off by last week's CPI print and I'm not sure there's really anything that could come before that November meeting that would really revive any arguments for a 50 basis point cut. Even if we get a week October NFP print, I think that may have a bit of an asterisk on it given that we're all expecting these potential hurricane impacts to show up and there might be some tendency to brush off any weakness in that print. As far as the skip goes, I think at this point the fed may feel the need to go 25 basis points just to undo some of the financial condition tightening that's come with the unwind of hard landing probabilities.

That's happened since the September FOMC. Just as one data point to that, mortgage rates have already risen 40 basis points since that September FOMC meeting, so in my mind if the fed skips, it may actually represent further tightening in terms of financial conditions. So I don't think they want to do that. So I think 25 basis points still our base case. So if you kind of take all this together, I think the November meeting might end up being a fairly boring one. I think we're going to be pretty fully priced and pretty solid expectations for 25 basis point cut going into the meeting. I think that's going to be delivered and as a reminder we don't really have any dots coming out that have the potential to massively shift the narrative or move things outside of what they decide to do with the rate setting.

I would also say with little major data until this October NFP release coming up in a few weeks time and I would say more balanced market positioning after the moves we've had over the past couple of weeks, I think yields are probably going to remain in a fairly tight range until the US election on November 5th. To that point, I think it's pretty remarkable that I've gotten this far without really mentioning the US election, but I think we might save a more in depth discussion on the US election for a later episode. But at a very high level, I can't just say I think the risks around the election are likely skewed towards bear steepening. That would be the kind of surprise outcome on a red sweep, meaning Trump wins and the GOP takes both the house and the Senate. That is much more likely at this point than a blue sweep.

And I think any kind of scenario where you have a split Congress is probably going to be a relatively muted market reaction. But as I've written in the past, I think I fundamentally disagree with this idea that a Trump win GOP Congress should necessarily be a bear steeper and I would look to fade any kind of steepening post-election that just looks back at what we saw in 2016 where the steepest point really came right around the election. And then throughout the next four years of Trump's presidency, we saw curves flatten, but also on expectations that fed pricing is eventually going to be forced to converge with our higher terminal view, which should push the front end higher and I think probably markets view that as a bit of a weight on longer term growth and inflation.

Jason Daw:

Okay, thanks a lot Blake. Very insightful. And now over to Su-Lin to tell us about the situation in Australia, which seems more like what's happening in the US and New Zealand, which seems like it's behaving more like Canada.

Su-Lin Ong:

Thanks, Jason. The RBA remains the outlier in terms of the global central bank easing cycle that the team has outlined with our Bank of Canada call for 2% terminal, really the standout. In contrast, the RBA looks to be sitting patiently on the sidelines and we think it's giving very few signals that it's likely to cut rates anytime soon. We'd also highlight that it's Kiwi cousin New Zealand recently stepped up the pace of easing, delivering a 50 basis point cut and we expect another 50 at the next meeting in November. Marketers got even more priced in at closer to 60 basis points and we are looking for further cuts at every meeting thereafter until May taking terminal in New Zealand down to about two 3.5%. So the very different story between the two antipodean economies and central banks. When we think about Australia and the RBA in the global context, we continue to come back to the central theme of labor markets.

We think they remain key in driving the timing pace and likely quantum of these easing cycles. The Australian labor market has been very resilient. We had data today for the month of September that was nothing short of stellar in our labor force survey. We have had continued strong employment generation driven by full-time jobs. We saw a rise to a new record for participation with the unemployment rate managing to drop to 4.1%. So despite still strong migration and labor force growth, Australia continues to absorb all of this labor supply and more with the employment population ratio. Moving back to its record high, it's really hard to poke any holes in the latest employment data with ours worked also continuing to lift, risen now for about four or five consecutive months. The more cyclical youth unemployment rate falling and under utilization also declining. A key factor that goes some way in explaining Australia's labor market outperformance is the strength in public sector jobs plus those that are funded by the government.

Growth has been quite disproportionate over the last decade concentrated in healthcare and social assistance and that's largely reflected the introduction of a big scheme here called the National Disability Insurance Scheme. It's continued to grow, it's now worth almost 2% of GDP and it has been quite important in terms of contributing to activity and employment in Australia. Little to suggest that it changes anytime soon. So the Australian labor market still is tight. The leading indicators point to moderation ahead, but the starting point is really pretty strong. And we also note that some of the key leading indicators of employment that we watch, particularly the various vacancy measures, look to be bottoming out and also remain above their pre covid levels. So even if Q3 core inflation surprises to the downside and some of the partials have been soft, these labor market dynamics are likely to keep the RBA wary we think on the easing front for the RBA to be confident that inflation will move back to target on a sustained basis, the net labor market really needs to loosen.

That seems to be very much the key message when we look around the globe. We do expect the unemployment rate to lift into a four and a quarter to 4.5% range over the next 12 months, and that may be more consistent with just two rate cuts, but we're mindful of this global easing cycle with monetary policy working through other transmission mechanisms including the exchange rate, which could well see the RBA deliver three cuts in 2025. And so we are fairly comfortable sticking with our base case of a modest 75 basis points of easing from February. It's hard to quibble too much with market pricing and terminal around three and a half. Australia is however we think starting to look interesting against a number of other markets including Canada, and we are getting closer to levels that suggest buying receiving Aussie versus Canada or the US or Europe at around that 10 year mark is looking interesting.

Jason Daw:

Thank you Su-Lin for highlighting the differences between what's happening in Australia and New Zealand and now over to Alvin who's going to tell us about what's happening in China from a stimulus standpoint.

Alvin Tan:

Thank you, Jason. The world was excited by the stimulus splits unleashed by the People's Bank of China in late September and seemingly endorsed by China's highest policymaking body, the deposit bureau two days later. However, up till now, the fiscal side of the stimulus measures remains very light in terms of the details provided. We are unlikely to get the clear picture of the fiscal package until China's parliamentary meeting at the end of the month whose dates have not yet been announced. But there are three points worth mentioning about China's stimulus measures based on what has been announced and what is likely to come out in the next few weeks. First, it's important to note that the PBOC has been cutting its various policy rates and also the banking sectors required reserve ratio for several years. Yet the economy has continued to struggle. So the impact of monetary easing appears to be losing potency in China.

Hence fiscal policy is becoming ever more critical in boosting the economy. Second, finance Minister LAN's briefing last weekend signaled that the upcoming fiscal package will focus on recapitalizing the banking sector and augmenting local government finances with limited emphasis on supporting consumption recapitalizing banks, and refinancing the local government debt is not what we tend to think of as fiscal stimulus measures in a conventional sense. Which leads to the final point. The impact of the fiscal package on China's growth outlook. Incoming quarters is likely to be modest even if the headline figures are sizable. If indeed the fiscal package is focused on capitalizing banks and refinancing local government debt. On a broader point, the likely fiscal package is going to be probably more about nudging the economy back to 5% growth target or slightly above, instead of a bold step to banish the fundamental problems afflicting China's economy.

Jason Daw:

Thank you Alvin. And thank you to all our listeners for tuning into this edition of Macro minutes monetary policy expectations. That's been a key driver of bond yields and the shape of the curve and also broader risk assets. So please reach out to your sales representative or us directly for further insights.

Speaker 7:

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.