We have seen very large market moves triggered by the US labour market report over the last few days that have also led to quite a few market participants changing their view on Fed rate cuts. We take a deeper dive into the data, highlight important questions that need answering and reiterate our rates call for the Fed and all other major central banks. We do not feel the need to make changes at this stage!

Participants:

• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Simon Deeley (Desk Strategy), Canada Rates Strategist
• Cathal Kennedy (Desk Strategy), Senior UK Economist
• Su-Lin Ong (Research), Chief Australia Economist

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

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.

Peter Schaffrik:

After the nonfarm payrolls in the US on Friday, we've seen a significant amount of market moves in pretty much all kind of markets. We've seen equity markets dropping and rebounding a little bit. We've seen in particular Asia and the yen move quite significantly and rebound.

We've seen bond yields dropping, in the case of the 10-year US for instance, all the way down to the levels that we came from at the beginning of the year and rebound a little bit. We've seen talks in the market about accelerated Fed cuts, in some cases, even pricing temporarily for intermeeting cuts, and rebound to some degree. So the question for us and before us is, is this all noise or is this something genuinely that has changed?

To make sense of that all, I'm once again joined by a very good and strong cast of RBC experts. We'll start with Blake Gwinn in the US, move over to Canada with Simon Deeley. We'll get insights on the rate cut that we've actually seen from the Bank of England and some of the changes that they made from Cathal Kennedy, and also get a view from down under in Sydney on the RBA that hasn't moved rates. So without further ado, over to you, Blake.

Blake Gwinn:

So we've obviously gotten a lot of questions around this volatility. People are wondering, is this recession concerns? Is it due to a rethink of the Fed path? Is it low summer liquidity? Is it BOJ and the unwind of these kind of popular yen carry trades? Are there other carry trades that are getting unwound? Which does kind of make sense after two or three months where this kind of mantra has been carry is king. My answer to those questions is yes. It's a little bit of all of the above, I think. It's very hard to pick out one single smoking gun for what's driving all of this move.

But that being said, it does seem like the worst has passed to some extent. Positioning looks a lot cleaner across a wide variety of products. There seems to have been some opportunistic buying and risk assets that started to trickle back into markets. And as we noted, we have seen retracement in rates from those kind of Monday low points and yields, and those are showing some signs of stabilization.

So I want to cover two main things in the rest of my portion here. First, just a little bit of commentary about the NFP print itself in the US, and then second, talk a little bit about the Fed path. But before I get to that, I just want to be very clear about a couple of things because I think there's been a little confusion around kind of what we are arguing and what we've been kind of talking about in our pieces.

First, I do think labor markets and the economy more broadly are slowing. The question is just whether that slowing is towards normalization and soft landing or whether it's towards a recession and hard landing.

So let's kind of move on to NFP. You know, what happened? This was definitely a big disappointment. We printed 114,000 on the headline number versus 175K expected on Bloomberg. And most important, I think we got a surprising jump to a 4.3% unemployment rate when the expectations were for that to remain unchanged at 4.1%. Very notably, that jump with the unemployment rate did trigger the Sahm rule, which is just a way of kind of telling whether you're in a recession that is held in past cycles that there has been a lot of attention on in markets over the last month or so.

In our view, the data does leave though a lot of unanswered questions. That increase in the unemployment rate was almost entirely driven by a very abnormal spike in temporary layoffs. We saw 250,000 temporary layoffs. Without those, if you strip away those temporary layoffs, the unemployment rate actually would've stayed at 4.1%.

If you look at the more worrying side of the equation, which is permanent layoffs, that's people permanently losing their job, which is obviously much more worrying for the economic outlook, if you look at those, they remain near all-time lows and barely budged in this unemployment report, so that is one reason to look at this with a little bit of side eye. Also, if you look at the prime age employment to population ratio, which I think's a very good measure of the underlying strength of the labor market, that also remains extremely strong.

We're also cautiously optimistic, I think, but we just need a little more context around what these temporary layoffs represent, whether it's some kind of idiosyncratic factor. People have mentioned the possibility that the hurricane we had, and the Southwest was driving some of this, but BLS did say that that was not a factor driving the data.

But still, those questions kind of remain because we have seen some impact on jobless claims that seem to be regional and related to the hurricane, so there's some questions that remain around that. But even if it's not the hurricane, whether there is some kind of idiosyncratic factor, that we might expect those temporary layoffs to disappear in future prints.

The more worrying case would obviously be if those temporary layoffs do eventually become permanent layoffs, but historically speaking, that has not been the case. When we see large spikes in temporary layoffs, if you look at kind of the three months after that, they do not have a tendency to become more permanent. They usually are exactly what they say, which is temporary.

So all of this puts a lot of weight on next month's NFP report. We just really need some more context around this and try to figure out what the actual trajectory is and whether this is kind of an idiosyncratic one-off type of print.

So onto what this all means for the Fed. As I said up above, I don't think they're panicking. The Fed has avoided overreacting to single data points, and some of these big swings in kind of Fed pricing, where markets start pricing in either extreme hikes, extreme cuts, they've largely stayed the course through these if you look at the last few years. And I think both in the hawkish and the dove's direction, it's generally served them pretty well to try to kind of ignore these and pick a straight line through these wide swings that the market does in Fed pricing.

I will say, we've heard from two Fed speakers since then, both of whom tend to be on the dovish side of things, and both of them have taken a very calm approach after the NFP data. We had Goolsbee kind of saying what I just said, that the Fed's trying to find a smooth path through these swings, and they don't tend to overreact to a single data point.

But I think even more notable to me was that we had daily another noted dove coming out saying that she looks at 50 labor market indicators, talks to all these contacts in her district, and she's not seeing a single flashing red light on any of those indicators, which to me, was a pretty remarkable statement. So they certainly seem relatively calm.

I do acknowledge that the probability of a 50-basis-point cut in September has moved higher after this NFP report. I probably would've told you it was a sub-5% risk a week or two ago. That's probably closer to 25% at this point. So that risk has grown, but I think it's largely conditional on what we see in this August NFP print and what happens to those temporary layoffs that I was discussing.

One thing I would point out, that I think in the Fed's mind and also the way I'm kind of viewing it, is that cutting 50 basis point could actually do more harm than good. I think markets would have a tendency to look at that and say the Fed knows something that we don't. They see deterioration in the data, they're getting worried, they think they're behind the curve, and it could actually accelerate some of the pessimism in markets, accelerate some of the pullback in investment and economic activity in kind of a harmful way.

I would also say that 25 versus 50 basis points in September, or I would even say 50 basis points or 100 basis points to cut this year, it's not really going to be the make-or-break for a soft landing versus a hard landing. Really, the kind of rates that really matter to actors in the economy, whether it's consumers, businesses, investors, what really matters is what's priced into term rates.

The last thing I would say on kind of that September supersized cut, with the election hanging out in November, I think it's very unlikely that 25 or 50 in September is really going to matter much for the economy, because a lot of investment decisions, business decisions and consumers are just going to want for some clarity on what the economy's going to look like post-election. We could be facing very different regulatory outcomes, tax outcomes, et cetera.

And so whether we get 25 or 50 may not be the deciding factor in whether you invest in a new factory, or buy a house, or these types of things. A lot of that may still wait, and those decisions may still be put off until after the election. So I am not currently seeing this kind of 50-basis-point case, and as I said, we are keeping our call at 25.

The last thing I just wanted to say is that if we are to change our call, like I said, a lot's going to hinge on this August report. I will just say if we see in the August data that we don't really get much change from this month, meaning those temporary layoffs stay elevated, we kind of hang out at this elevated 4.3 unemployment rate, my first response would probably be to start adding a November cut into our forecast.

If we see a little bit more deterioration, if some of those temporary layoffs start becoming permanent, if we see the unemployment rate actually ticking up for bad reasons, meaning permanent layoffs starting to tick up, then we might start thinking about a 50-basis-point call in September. And if things deteriorate more than that, then we start talking about a series of 50s or a lower terminal rate. So that's kind of how I'm looking at that August data and how that might potentially change our call. With that, I'll pass it back to you, Peter.

Peter Schaffrik:

That's very clear. I can certainly say that from a market point of view, as far as I can see it, every piece of information from here until that August report that we would be getting that gives us any clues about the state of the US labor market, be that the weekly jobless claims figures or be that indeed some other data and that will be available on the regional side, will be digested by markets and will be turned upside down to glean what is really going on. And I think we will or we can have quite a bit of volatility around these data points from here until August.

But with that, having said that, let's move over north of the border. What's going on in Canada, Simon?

Simon Deeley:

Canada was subject to the sizable market volatility last week driven by weaker US data, especially the aforementioned payrolls report as well as the BOJ hike. The five-year yield fell from 324 on July 26th to 289 at the early 1:00 PM close on August 2nd. This early close and Monday's holiday in Canada meant that Canadian rates markets were not fully operational for a chunk of the high volatility period. The five-year yield is currently 303, just above where it was prior to the US payrolls release.

The Bank of Canada is a central bank that focuses squarely on its 2% inflation target and is less influenced by global peers including the Fed than many assume. The shift in pricing towards more BOC easing is actually quite consistent with the dovish communication delivered at the July 24th meeting.

Alongside the second straight 25-basis-point cut, this noted there are increased concerns on downside risks to growth and the need for them to stimulate future growth in order to eliminate the persistent excess supply in the economy. Indeed, Governor Macklem sidestepped a question on whether a 50-basis-point cut was considered rather than acknowledge or outright deny.

Market pricing did not move with the BOC communication, and we highlighted the increased dovishness and risk of a 50-basis-point cut in a note early last week prior to the more extreme bouts of volatility and yield decline. So while not coming as a result of the BOC communication, we think the market pricing, so it's about 125 basis points of easing in the next six meetings, is pretty fair.

Our own view has been on the more aggressive side for BOC easing with four consecutive cuts, starting in June, our base case since late last year. Our forecast is for a two-meeting pause after that before resuming cuts, but the increasing risk is that the BOC opts to keep cutting rather than pause.

What about a potential 50-basis-point cut at some point? We think it's unlikely that inflation and growth data can be weak enough by the next meeting on September 4th, so we just have one inflation report and the Q2 GDP release to make 50 basis points a likely outcome at that meeting.

The more likely timing, though still not our base case, would be at the October 24th meeting, with three inflation reports, three jobs reports, and even early indications on Q3 GDP all available by that time. And that's the story in Canada. I'll send it back to Peter.

Peter Schaffrik:

Very insightful as always. Another event that we had last week, and which preceded the volatility a little bit, although it caused some volatility locally, was the rate cut from the Bank of England, and it was accompanied I think by quite an interesting change of tact from the bank.

So after the ECB, after the Bank of Canada, after some others here in Europe, the Bank of England finally decided to cut rates. So Cathal, can you fill us in the details here? What is going on and what we expect going forward?

Cathal Kennedy:

As you suggest, a very important meeting for the Bank of England and indicating an important shift in its decision-making process. Now, I think you mentioned the decision for the bank just worked quickly reflecting on that, I think. They delivered the first cut as expected.

Now, it was a very tight vote, five-four in favor of that first cut, and the tightness of that vote was reflected in I think kind of cautious messaging from the MPC overall. One of the opening parts of the press conference, the governor said that the MPC needed to be careful not to cut rates too much or too quickly.

But again, as has been the case since February, the MPC again sort of giving indication that the broad direction of travel in terms of interest rates is down in the UK. The governor's saying that bank rates should come down as the degree of persistence in inflation eases.

Now, we didn't change our bank call either in the wake of the meeting or last week's event. To a certain extent, you have to take the MPC's rhetoric at face value here, and from what it said at the meeting, it didn't seem minded to rush to deliver another rate cut imminently at the next meeting in September certainly. So we retained our call for a follow-up cut to come in November and with two further cuts next year.

And again, in terms of the fundamentals here in the UK, the picture the bank is still looking at is one of rebounding economic activity after the softness of the second last year, a labor market that has loosened, but it's still tight, and still kind of elevated domestic inflationary pressures.

Now, as I said at the topic of the call, one outcome of the meeting which we thought was very important was the introduction by the MPC of a new decision-making framework. Over the past year or so, we've become really accustomed to the MPC's data-dependent approach. Now, they've had this particular focus on three indicators: services inflation, the tightness of the labor market, and private sector wage growth.

So how can we kind of sum this up, if you will? Look, previously, as I said, the MPC were data-dependent, focused on a couple of indicators which would then dictate the reaction. Now, we've moved onto something encompassing a more holistic assessment of evidence and making judgments based on that evidence, so we've gone from data and reaction to evidence and judgment.

What does this mean in terms of policymaking? Well, it makes it a bit harder to judge the direction, if you will, of the stance of monetary policy, but it does give the MPC greater leeway, in particular greater leeway where, as was the case of this meeting in August, the data wasn't necessarily that supportive of a rate cut.

Now, the bank has said that the new approach was one of the means by which it's putting into place the recommendations of the recent Bernanke Review, but we would know that it is not alone in this shift. This new approach downplaying data was also evident at the ECB meeting in July, and actually, President Lagarde said something which is kind of similar to what Governor Bailey said at the MPC meeting. She said in July that the ECB was data-, not data point-dependent.

So here we have in Europe two central banks, the Bank of England, much more explicit, but the ECB also seemingly following a similar strategy of downplaying individual data points, if you will, and instead taking this more holistic evidence judgment-based approach to policymaking. And with that, Peter, I'll hand it back to you.

Peter Schaffrik:

That's very insightful, and I certainly think that this change that you're highlighting in the framework or indeed sort of the way how the ECB is looking at things does open up more potential for rate cuts compared to how they were looking at things beforehand, and certainly opens the path to the sequence of rate cuts that we have in our profile of four, in grand total, 25 basis points of cuts in every other meeting both for the bank as well as for the ECB. Finally, let's move down under to Su-Lin, who is going to tell us what the story is in Australia and how the RBA is going to react to this?

Su-Lin:

It's also been a pretty volatile week in Australian markets with domestic rates following the global roller coaster. Yields are currently around 20 to 30 basis points low across the curve compared with the start of last week, although there's been some pretty big moves in between. The curve's pushing about 10 basis points steeper, and there's been some really big swings in front-end pricing of RBA expectations from a decent chance of a hike to more than a full cut this year. It's been really all over the place.

We kicked off the move in yields lower in the middle of last week with key quarterly Q2 inflation data printing better than expected and allaying our concerns that the RBA may be forced to hike rates again. Core inflation printed just below 4% in year-on-year terms, and it was good enough in our view for the RBA to remain on the sidelines.

The rally in Australian fixed income then turned more global late last week post the US data, and in 10s, Australia's largely underperformed the move in US treasuries given that sharp pricing of Fed funds, but it's moved broadly in line with most other markets. In outright terms, 10-year Australian yields remain in a 4 to 4.5% range that's prevailed for most of this year, albeit towards the bottom of this range.

And with the discussion I guess now dominated by just how weak global labor markets could be, especially the US, talks of recession, all of that will be pretty important in determining the pace and quantum of easing, and the odds are yields will likely shift to a lower trading range.

Some markets here have settled down somewhat in recent days, largely reflecting the clean-out in crowded positions that the team have discussed already with similar skewed positions in Australia. Plus, there were also a lot of paid positions in our front end ahead of CPI. I guess some of the calming down in markets has allowed a bit of a shift back towards the underlying fundamentals, and in Australia, these fundamentals would suggest that the RBA will still continue to lag its global counterparts in terms of easing.

In delivering another steady rate decision at its August board meeting this week, the RBA made it very clear that inflation is too high, it's taking longer than it thought to return to target. It repeated several times that excess demand remains in the economy and labor market, and the governor pushed back on the idea of cuts this year, despite trying not to give any forward guidance.

So as we look ahead with inflation, while inflation data will remain important, the next quarterly print, which is the most comprehensive, is not due until the end of October. Like most other central banks who have begun easing, we think that the focus for the RBA is starting to shift somewhat to two other areas.

The first is part of the global thematic that's underpinned the start of cuts in other countries, and that's the softer labor market. Canada is the standout I think there. And so the unemployment rate gets a lot of attention in Australia, but we're really watching a broader set of labor market indicators, especially the leading ones such as vacancies and the various business survey components of employment, which are all moderating. That's going to be really important in our view for the RBA.

The second has probably a more uniquely Australian flavor, and that's around households. There's a large boost to household disposable income underway at the moment, reflecting the across-the-board income tax cuts which began on 1 July, skewed towards low-to-middle-income earners, and with various cost of living relief measures, also helping to free up income.

How additive this is to demand and inflation is uncertain. Will consumers spend more of this disposable income, or will they choose to save and pay down debt? We think there's scope to do both as household incomes lift, and we'll be watching a number of household metrics really closely in the coming months, including retail sales, household spending indicators, confidence, and deposits. Back to you, Peter.

Peter Schaffrik:

And that concludes our call. I hope you found it very insightful. I certainly did, and I also hope you're going to join us again for the next episode of Macro Minutes.

Speaker 7:

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