The Fed delivered a super-sized rate cut to the start of the cycle last week. More likely they go back to smaller 25bp moves if labour data remains resilient. But another large move is not out of the realm of possibility. We think the BoC is on course for 5 straight 25’s but they could front-load with a 50bp move in October or December if growth data shows a large undershoot vs potential. The BoE and ECB seem set to take things slow, but a larger cut is a non-zero chance.

Participants:

• 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
• Elsa Lignos (Desk Strategy), Head of FX Strategy

* 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. Hello everyone and welcome to this edition of Macro Minutes called supersized. I'm Jason Dah, your host for today's call, which we're recording at 9:00 AM Eastern time on September the 24th. So the Fed delivered a supersized rate cut to start the cycle last week and more likely they go back to smaller 25 basis point moves if labor market data remains resilient, but another large rate move is not out of the realm of possibility. We think the Bank of Canada is on course for five straight 20 fives, but they could front load with a 50 basis point cut in October or December. If growth data shows a large undershoot versus potential the Bank of England and ECB, they seem set to take things slow, but a larger cut is a non-zero chance and to discuss the outlook for central banks and what it means for the rest of the rates market. I'm joined today by Blake Gwinn and Peter Schaffrik and on the currency side we have Elsa joining also up first is Blake to start this segment with thoughts on the US economy and the Fed.

Blake Gwinn:

Yeah, thanks Jason. So going into last week's FMC meeting the market somewhat oddly looking at negative risks, I think on both sides of the coin, I think in the case of a 25 basis point cut, many saw that as the Fed being behind the curve or making a hawkish policy error. But the interesting part was that also on a 50 basis point cut, there were some pushing this narrative that maybe this would signal that the Fed knew something that markets didn't know and that this would kind of signal fear and that we'd see kind of a risk off reaction to that. But I think in the end what we saw is the Powell very adeptly threaded the needle between those two outcomes. He delivered the larger 50 basis point cut and thus demonstrated they wouldn't allow deterioration of labor to get ahead of them. But at the same time he also spoke very positively about the state of the economy.

So I think that really avoided signaling any type of panic on their behalf. If you look at the SEP, that was also relatively hawkish. The median showed a 4.4% unemployment rate by year end, but only one member submitted a dot that showed that suggested there would be another 50 base point cut by year end. So that in and of itself was pretty hawkish. I also think if you look at the longer run dot, which is very broadly viewed as a proxy for the committee's view on neutral rate, that's all a pretty meaningful shift up in the distribution and also the median dot moved higher there. And I think Powell also gave a nod to this in his presser when he said that neutral may be significantly higher than it was pre pandemic. Kind of turning to the forward guidance about the next few meetings, I think it was pretty scant.

He didn't really say much on what they were expecting, but based on the SEP and some of his tone, I think we can pretty much assume the 25 base appoint cuts are going to be the base case for November December. But that line to going 50 is relatively thin and I think if the data justifies a 50 basis point cut, they will not hesitate to do it. Interestingly, I think this largely leaves markets where we were before last week where the cut pricing for upcoming meetings is hovering between 25 50 basis points. Markets are basically left hanging on every major data print to try to figure out what size that next cut is going to be beyond the next three meetings. I think you can make an argument that Powell comments on terminal, the increase in the long run and also just the fact that the Fed seems intent to stay ahead of the curve on any economic deterioration.

I think that probably bolsters our case for an earlier and higher terminal rate to some degree. And to that point, we did not change our fed call after the meeting last week other than to pull a 25 basis point cut that we had penciled in for March of next year to kind of account for that larger cut last week we'd only been calling for 25, so obviously to mark to market on that 50 we had to pull forward that last cut. In other words, we still have a terminal target range of four to four and a quarter reached in the first quarter of next year. So we also still see 25 basis point cuts in November, December and should note that this higher earlier terminal forecast that we have penciled in isn't really due to a very optimistic economic view relative to what the Fed's calling for.

If you look at our economic forecast are not materially different than what you see in the fed's SEP, but I think where we differ is we just think it's going to take fewer cuts to achieve that stabilization and soft landing outcome than the Fed currently does. You could put that another way and just say that we see a short run neutral rate that's probably a little bit higher than the Fed. So what could disrupt this view and get the Fed to cut 50 basis points either November, December? That's a bit of an interesting question, especially after we heard from Waller last week. Waller spoke late last week pointing to the C-P-I-P-P-I data that came out to kind of explain why he shifted from the 25 basis point camp to the 50 basis point camp during the blackout period, particularly kind of flagging that the PCE passed through suggested inflation is running too low.

That was a bit interesting because up to now I think we have largely written off inflation as a potential driver for larger cuts for sure. Higher inflation data could certainly get the fed to pause or give them second thoughts about cuts, but at least on what would drive fifties or what would drive a lower terminal rate or drive them into more dovish direction. I think we had kind of pushed inflation off to the side markets were not putting a lot of weight on inflation prints. Those had really died down as far as market activity around them and all the attention who really shifted to the labor side of the mandate. But if what Waller is saying is true, that could imply that the Fed could get to a 50 basis point cut at a coming meeting, not based on deterioration in labor as he said heading into the blackout, but really they could get there just on slower inflation.

So that may pull some of that risk back onto inflation data and instead of just focusing on labor data, and maybe now we're going to see a bit of a dual reaction and some of that spread moving back in the direction of inflation. Just a couple of quick high level comments on the economy and market direction before I hand it back to you, Jason. I think with this established commitment from the feds to not get behind the curve, it does seem like the very, very negative economic narrative that has taken hold over the last month or two does seem to be running out of steam a bit moves around labor data are still going to be skewed to the downside. I still think people are going to be watching for any signs of deterioration, but over and over again we're hearing in our client conversations that markets think we've priced in a bit too much economic pessimism.

I think near term where that kind of leaves markets, we probably, I think we can continue to see yields leak higher, go back to those August September levels. I think it's pretty unlikely that we go back to pre August levels before we saw that major rally at the beginning of August, but the path of least resistance here doesn't seem to be a leak higher in yields particularly at the long end. The last thing I'll just say is that with the first cut out of the way, I do think focus can start shifting back to elections in the coming weeks, all else equal. That could also put some upward pressure on yields. So keep an eye on that kind of election narrative coming back to the forefront with the fed cutting cycle. Finally starting.

Jason Daw:

Okay, thank you Blake. Three topics I want to discuss. The first is Bank of Canada pricing. The second is cross asset returns in fed cutting cycles and the third is bond market drivers and insights from client discussions. So market pricing for the Bank of Canada is hovering around a 50% chance of a 50 basis point cut at each of the next two meetings in October and December. And we don't disagree with market pricing currently. Ultimately the market has caught up to our view since we flagged the risk of a 50 basis point cut back in late July and we feel the bar is low for the Bank of Canada to front load. We think the evolution of Q3 growth is going to matter a lot for the Bank of Canada's decision. And when you look at where we are so far in Q3, we're tracking around one to 1.5% area and that's very low compared to where the Bank of Canada is closer to 2.8%.

Now they've told us that they want growth to be above trend and ultimately that could be very challenging for Canada to get to on a sustained basis. So with inflation risk now tilting to the downside, there is a chance that the bank might feel compelled to act more forcefully at one of the meetings this year. But for now, our forecast does remain a steady dose of 25 basis point cuts for the next five meetings, but the bar to us changing to a 50 basis point move at some point this year is low. Moving on to the cross asset side, earlier this week I published a slide deck that looks at the evolution of asset markets in the 12 months leading up to the first fed cut and how asset markets have behaved in the 12 months after the first fed cut in past cycles. And there's a few key points I'd like to make.

Typically leading up to the first cut bonds credit equities have all performed very well. This has happened this time also, but the performance of all three of these asset classes is either at the top end of the range or the highest ever leading up to the first fed cut. So this does raise the question of whether these assets have borrowed against future performance, at least in fixed income. We can make the observation that credit spreads are already near the lows and we have terminal fed pricing around 3%. So that's baking in a lot of cuts already and that means that we would probably need to see market pricing move to well below 3% for the Fed for fixed income to perform well in the next 12 months credit you get carry treasuries, you get coupons, those are going to help, but the primary source of return will have to be a duration from here and that might be challenging from a risk reward standpoint.

As Blake mentioned, maybe equities, maybe they're the best beneficiary of the bunch if the hard landing narrative starts to erode as we expect. But even here, the strong performance of the past 12 months needs to be factored into asset allocation decisions. When you look at other asset classes, FX and commodities, that's been really a mixed bag in past cycles. Lastly, bond yields across the curve they have been, and at least for now at this point in the cutting cycle, will continue to be tightly linked to terminal pricing and terminal pricings come up from the low both in the US and Canada and bond yields further out the curve. They have followed suit. It does seem like the Fed was a classic buy the rumor, sell the fact and importantly, clients on the asset management side appear more willing to reduce duration risk here than add to it. So if the market moves back to this soft landing narrative bond yields could tactically squeeze higher from here, which reinforces the points that Blake made earlier. So now over to Peter to provide insights on the situation across the pond.

Peter Schaffrik:

Thank you Jason. I think before looking forward it's imperative to look back and look at the guidance that the central banks have given us and actually what they have done. So so far the ECB has cut twice in a cut, pause, cut style and the Bank of England has just started and then paused. So it looks like they have the same kind of pattern and what they have told us, or specifically what the ECB has told us is that they want to go in a cautious manner. Now what cautious the interpretation seems to be more of what they have delivered already. However, various speakers have indicated that if the data was to deteriorate significantly further on the growth side that could change the deliberations. And I think it's really here where the rubber hits rot because at the end of the day our economies have been starting the year well, but then the recovery has started to fade a little, particularly in the Euro area.

And this is also where there's a little bit of a discrepancy between what the Bank of England is likely going to do and deliberations that are probably going on within the ECB. In both cases we have the hawks on the one hand stressing the tight labor markets and the still high service inflation and the clinging onto that. The doves, however, particularly in the ECB, are stressing that the growth momentum seems to be fading to some degree and therefore relatively high interest rates above whatever the neutral rate is, should be lowered quicker and in order to keep the theme supersized in our part of the world would probably not mean larger cuts. It probably would mean quicker cuts. So therefore the question before us is will they accelerate the cutting that they have started already? Now the ECB has so far been relatively reluctant to embrace a back-to-back cut, but the market is pricing it now after the latest round of pmmi that came out this week with more than 50 basis, more than 50% chance.

So we're pricing in about 13 and a little bit more basis points for an October rate cut. The situation for the Bank of England looks slightly different because the next meeting is one where pretty much everyone expects a cut and the question is whether they would follow up with a cut in December, but that's obviously a little bit further away than in case of the ECB. So where do we stand now? The risks have clearly increased that the ECB particularly would cut in October and then accelerate from their onwards would cut in December and then probably every meeting in early 25. However, we think there's still a considerable contingency of relatively hawkish leaning, particularly Northern European ECB policy makers that are probably trying to prevent that. So for the time being, we think it's going to be very difficult for the market to push beyond the 50% and in fact we think that's probably slightly on the high side.

We have actually advised to fade that however, the data that we will be getting from here until the next meeting is relatively scarce. So there's only one flash CPI print left to really look at and that is unlikely going to send a very different picture. So it really comes down to what the central bank speakers are going to say. And here I would argue that it's particularly imperative to listen to those who previously have been opposed to a quicker succession of rates and just tonight we will get the president of the bonus bank speaking. So let's see what he will have to say. So just to summarize that, I think you can find good arguments for a accelerated supersized move from the ECB or indeed the Bank of England, although that is much more questionable, but it looks like the balance of power for us, it looks like the balance of power is still tilted towards a more moderate pace that requires them to hold their guns in October as the data deteriorates further. However, we think that the arguments will then tilt and will have to really look very closely what the growth pattern, the growth outlook is going to be like at the moment we're growing below trend. If that slows down to basically no growth at all, clearly the arguments for quicker rate cuts is accelerating.

Jason Daw:

Great stuff Peter. And next up is Elsa to enlighten us on the situation in the currency market.

Elsa Lignos:

Thanks Jason. It's an interesting juncture for currency markets. As we all know, the Fed went 50 last week and the question I'm getting most frequently is, is it game over for the dollar? Now as you heard from Blake, our view on terminal has not changed. We're looking from to four and a quarter. Clearly there are scenarios where the labor market deteriorates faster than forecasted and the Fed is forced into a faster series of maybe 50 base point cuts. But in a scenario where the Fed is cutting in 25 B increments from here, the ECB Bank of Canada Bank of England are doing the same and front-end rate differentials across those four countries or areas are frankly not narrowing materially all of that against a backdrop where markets have actually already unwound their long dollar position. It's hard to argue that a fed easing cycle in line with the median plot or RBC forecast or indeed the forward curve is going to lead to a huge seller for the dollar, but the risks around that view are clearly higher than before.

And in the event that the US data do slow down and the Fed narrows the gap to some of its peers more quickly the dollar does stand to lose. Most notably against the yen. I think everybody would agree on that, but also I'd add against the Euro and here I continue to get pushback in a sharper global slowdown whether US led or not. But one, the Fed is cutting rates faster to a lower terminal. I actually see Euro dollar trading back up to one 20, which is I think a topic we will revisit in a future edition of macro minutes. But now I'd like to focus on the trade I like most at the moment, and that is short Swiss yen both overnight and most notably last week, Postbank of Japan, the year sold off on Governor uda. Basically patients and future hikes. The idea here is I think without Bank of Japan tightening do yen can't sustainably rally.

So I do like short Swiss Yen as an equity neutral trade for those relative risks. I liked it two weeks ago. It had a quick move lower than a bounce in the past week. I think that gives a pretty nice entry point to reenter or enter for the first time.

Jason Daw:

Okay, thank you Elsa. And thank you to all our listeners for tuning into this edition of macro minutes. Macro and monetary policy expectations has been a key driver of yields, the shape of the curve and broader risk assets. So please reach out to your sales representatives or us directly for further insights.

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