There are nuances in every economic cycle but this one continues to feel different. Central banks are firmly in easing mode - the Fed will join the rate-cutting party in September. The timing and magnitude of rate cuts is the main topic for financial markets and is highly dependent on the assessment of the economic cycle. Listen to our macro and rates experts discuss the US, Canada, and European economies and central bank outlooks.

Participants:

• Michael Reid (Desk Strategy), US Economist
• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Jason Daw (Desk Strategy), Head of North America Rates Strategy
• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics

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.

Jason Daw:

Hello everyone and welcome to this edition of Macro Minutes called Is this time Different? I'm Jason Dah, your host for today's call, which we're recording at 9:00 AM Eastern Time on August the 28th. So while there's nuances in every economic cycle, this one continues to be highly unusual. For instance, the US unemployment rate is giving a more bare signal compared to other economic data. How has Europe been able to keep its head above water when it could barely do so with zero rates and is Canada destined for a multi-year period of below trend growth with little prospect of a rebound? Now central banks are firmly in mode with the US Fed expected to join the rate cutting party in September and the Bank of Canada adding their third cut in the cycle and with further modest cuts expected from the ECB and Bank of England, the timing and magnitude of rate cuts, it's the main topic for financial markets and it's highly dependent on assessments of the economic cycle. Today we're joined by Michael Reed, our US economist, to shed light on the uniqueness of the US cycle, Blake Wynn, to tell us what he thinks of the Fed for September and beyond, Peter Schaffer to enlighten us on what's happening in UK and Europe and myself to discuss the Bank of Canada outlook. So to kick off today's discussion, it's going to be Michael Reed on the US economy. So take it away, Mike.

Michael Reid:

That is very different from a worker who is reclassified from employed to unemployed. A good example of reclassification of a worker from not in the labor force to unemployed a graduate, we think there was a large number of recent graduates who delayed graduation during covid and are now just finishing school and entering the labor market looking for jobs. And again, this is an important distinction because in previous cycles when the SOM rule was triggered, the rise in the unemployment rate was due primarily more to permanent job losses, which represent a loss of income. And therefore when you think about the cycle that sets off a recession, you lose that purchasing power and consumption continues to fall and that results in further layoffs. However, in this cycle we're not seeing a rise in the layoff rate and consumption growth has remained positive. Now thinking about seasonality, that's another factor that has contributed to the perceived weakness in the labor market.

So from about 1970 to 2010, the ratio of retirees to new entrants looking for jobs was about one-to-One meaning you had a person leaving and a person entering that number. That ratio has risen dramatically since the baby boomer generation has started retiring. That's now close to three to one. So that's going to help put downward pressure on the unemployment rate. And just for context, I think this is another important thing to note is replacement demand does not show up as a net new job growth, meaning you could have this continue to put downward pressure on the unemployment rate without showing up in the payroll report as monthly job gains. Lastly, another reason why we think retirements are so important to this cycle is we know that baby boomers are sitting on record levels of wealth. We expect that they will continue to draw down those retirement assets and that is going to continue to support the strong consumption growth we are seeing here in the near future.

Jason Daw:

Very useful insights, Michael. I think a lot of people are confused on what's happening with the labor market, so this has been very helpful Now over to Blake to tell us what this all means for Fed policy for September and beyond.

Blake Gwinn:

That's always the case with these September SEP dots. They do give you quite a bit of information, at least more information than they usually do, given that they only cover those last two meetings of the year. So I think right now as things stand, the base case for the majority of the FMC is still in line with ours that the NFP print next Friday shows the unemployment rate coming back down and the payrolls generally remain strong on the sidelines of the Jackson Hole meeting. We heard Harker say that two to three is still his base case for 2024. We've heard bargain and daily acknowledge that while downside risks do exist, they're both pretty sanguine on the state of the labor market, both when they look across the constellation of labor market data, but also when they talk to their contacts in the marketplace about the potential for headcount reductions, et cetera.

I think the Fed generally sees the risk still as balance not overly skewed towards the downside on labor, even though Powell recently said they don't welcome any further weakening of employment. I think implicitly they also don't welcome any pullback in the disinflationary trend. Looking at the constellation data across labor growth inflation, I think the Fed generally sees low level not very pressing risks to both sides of the mandate. Some moderate downside risks to the labor side, but also some very low level risks to the upside on inflation. Against that backdrop, I think it's appropriate to start cutting rates, but I also think there's no need to move more aggressively lower, especially with so much uncertainty around where short run neutral rate is this kind of history busting nature of the post pandemic recovery where we've seen a lot of old relationships, old patterns around cycles essentially break down and I would say even with data quality as we heard Mike kind of mentioning before with regards to some of these seasonal adjustments and how those have been disrupted because of the pandemic.

So this view, our house view that the unemployment rate's going to drop that payroll growth is going to remain relatively steady. The fed's going to go 25 basis points and that the dots are possibly going to show some debate about a skip in November. Perhaps that comes in December. I think that's quite out of consensus and if that actually does end up happening, I think it would drive a pretty meaningful frontend led selloff and bear flattening as markets are both pricing in a higher near term Fed funds rate, but also some aspect of a hawkish policy error, keeping those longer term yields depressed or even driving some kind of pivot in the curve where the front end rates move higher and the backend rates actually move lower as long-term growth and inflation expectations come down. Now if we get another bad NFP print next Friday, I think the bar to 50 basis points, which we think is still pretty considerably high, I think that could still be crossed, crossed and by bad what I'm talking about here is an increase in the unemployment rate to 4.4%, something like 75,000 or less on payroll growth or even the unemployment rates staying at 4.3%, but some kind of evidence that those temporary layoffs are becoming more permanent In this case, I think markets move to price in 50 basis points pretty quickly and the fed will almost certainly take that opportunity and cut by 50 basis points.

Markets probably take this a bit further and start almost fully pricing in 50 basis points for November and I would think a higher probability of 50 basis points in December as well, at least more than they are currently pricing in. But this market response and controlling the narrative is part of the reason I think the Fed is putting such a high bar. It's to cutting 50 basis points in September in the first place. They don't want markets to run away with this cutting narrative such that it gets out of control or that you start seeing, start seeing that raise alarm bells in the economy that the Fed kind of knows that there's more deterioration coming or something like that. Lastly, I think perhaps the most difficult outcome for NFP isn't the bad or the good side. I think both of those are relatively clear. I think the more difficult outcome is what happens if it's just okay, and what I mean by that is the unemployment rate staying elevated a very low 4.3, a high 4.2, seeing those temporary layoffs that we can't really explain.

I think that's actually the reason that most of the markets seem to assume that FOMC is going to simply take whatever markets are pricing into the meeting. To be honest, it's hard to disagree with this. I think we've seen evidence that the Fed A does not like to surprise markets. B probably does not want to do another press leak as they did in June, 2022. And so it does make sense and probably is the most likely case that if markets priced to 50 even on a more seguin and a P print, that they do take that opportunity in cup 50 basis points. But I do think there is some probability that if we do see that kind of middle of the road type of NFP print and markets only price somewhat closer to 50 basis points that they actually do for once come out and deliver a surprise relative to market expectations.

Jason Daw:

Okay, great stuff, Blake. Now for Canada this time has been different but not that unusual. So Canada has rightly experienced softer growth compared to the US over the past one to two years, and if it wasn't for immigration, Canada would've probably had a deep recession. Now the growth gap has been wide between Canada and the us, but it's not been overly unusual versus history and what has mattered and what will continue to matter going forward is that excess supply in the domestic economy that started a year ago only continues to grow. While CPI used to be the only game in town for policy decisions, the importance of growth has increased dramatically for the Bank of Canada and I would say notably at their July policy meeting, the BOC pivoted to a more output gap focused approach that they've used pre pandemic and they explicitly told us that growth needs to pick up so future inflation does not fall too much.

So that means how many successive cuts that the bank delivers or whether they entertain doing a 50 basis point move is almost primarily going to be determined by growth surprises in our opinion and with headwinds from mortgage resets continuing to happen, the delta on immigration going to shift going forward and the cooling in the US economy, even if it's just modest, there is little prospect of domestic excess supply being reduced anytime soon in our view. So we do maintain our long held forecast that the bank will cut again in September. It's not a bull call now, it was more controversial right after the July meeting when the market was only pricing a 65% chance of a September cut and ultimately consensus and market pricing has gravitated towards our view of a September cut with the CPI now in the rear view mirror. The report that we got a couple weeks ago, the Q2 GDP report on August the 30th, that's really the only piece of data between now and the September BOC that has scoped to shift market pricing to either side of 25 basis points, but we don't feel that there's a plausible growth scenario that could result in them skipping a cut in September.

Peter Schaffrik:

Thank you Jason. You asked whether things are different this time round and certainly it feels like both in Europe and the UK things are somewhat different and I would like to use the recent PMI data that came out last week to elaborate a bit, but before I go there, let me just reiterate. What hasn't changed is our view on either the ECB or the Bank of England since the start of the year. We've been calling for a rate cutting cycle, but a very measured one, both in terms of how speedy the rate cuts will be delivered as well as where we're ultimately going to end up. For the ECB, we have expected to start in June. We have been calling for a cut, pause, cut cycle with the next cut in September, which now looks very likely followed by another one in December and a terminal rate of 3%.

That call hasn't changed for the Bank of England. We've also called for a start of the rate cutting cycle when it actually did in August and have the same kind of pattern of a cut, pause, cut cycle in our forecast profile. We think the next cut is going to be in November and that hasn't changed for quite some time either. So what is going on over here in Europe and why does it feel a little bit different? We have to go back really for quite a few years because for the first time since basically the financial crisis or indeed the European debt crisis, we are in an environment where we operate at full employment and that has been the case ever since we rehired people after the pandemic and that hasn't changed. So our economies now are growing not necessarily by adding people to the labor force, although that does happen in some cases, but by real wages regrowing again after they have been negative during the European energy crisis.

And that is really driving our consumption over here. And when you look at the pmi, what you can see that on an aggregate basis, either for a total economy in the UK or indeed for the entire U area, that pattern is almost certainly going to be unbroken. When you look at the pan-European number, it is not too different in the PMI terms where it was in Q2 when we eek out 0.3 on a quarter on quarter basis, and for the UK it's almost at the same level or slightly above the levels for Q2 when we even had a very healthy 0.6 quarter growth rate. So it seems very likely that our economies will keep growing. However, underneath the surface, I think there are quite a few things that are different, and I would start with a headline one that whereas in the past 10 years or so, it has been northern Europe, mainly Germany, that has been a growth engine for Europe and the Southern European economies have been doing quite poorly.

This is very different now. In fact, it's the polar opposite and you could see that also in the last PMI numbers where the leading indicators for Germany and both the headline level as well as on the detail level in manufacturing and services have both turned down. Whereas on the pan-European basis and almost certainly on the Southern European basis where the numbers have not yet released, but it should be, so we'll have increased again. So where is this coming from? What we think is happening over here is that we have a very, very negative backdrop for manufacturing. That has been the case since the pandemic ended, but it really is hitting hard on places like Germany in particular that are very reliant on manufacturing. In fact, we think there's different reasons for that at the moment, particularly we think that it's the strong competition from Chinese companies that make it very difficult for traditional exporters and manufacturers out of Europe to compete that is doing the damage.

However, what you can see is that the service sector is really more than balancing that weakness, but as Germany is much more exposed to manufacturing than other economies, you also see a shift in dynamics within Europe away from the German growth engine of past years, two more Southern European service that boom in tourism and other places that lead to this more balanced picture. Now bringing it back to market, where does it leave us? Now what we have seen is that the growth in wages I mentioned earlier that has been driving our growth in GDP is fading to some degree and that gives the ECB some leeway to cut. We get the next batch of CPI releases on Friday, and it's probably going to give them a little bit more of a green light to cut again in September. However, there is no weakness in the labor markets and therefore the question is whether that picture of them having enough leeway to cut remains over a multi month period.

Furthermore, both the Bank of England as well as the ECB, have also created some slack for themselves. They have changed a little bit the way how they describe their own reaction function and have said that they're not data point dependent, but data dependent. Something that the Fed has also said but has probably more novelty factor over here in Europe where we previously were laser focused on particularly relatively high service inflation. The ECB in particular has now stressed that they're bit worried about the weakness in some economies creeping in. Most notably Germany has elaborated and that probably gives them some cover to cut rates even if headline inflation is maybe not directly at target or if core inflation service inflation is not coming down as much as they have forecasted before. In short, we think they have created wiggle room for themselves to follow the path that our forecasts are indicating. The question will come at where they're going to stop. Again, we think the terminal rate is probably higher than what the market is pricing, but that's probably a debate for another one of these calls.

Jason Daw:

Thanks a lot, Peter, and thank you to all our listeners for tuning into this edition of Macro Minutes. Monetary policy expectations has been a key driver for bond yields, the shape of the curve, and also broader risk assets at different points in time. So please reach out to your sales representative or us directly for further insights.

Speaker 5:

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.