The Fed's policy shifts: Impact on the economy and markets

October 03, 2024 with Sébastien Rhéaume

NBI Podcasts

After the beginning of the U.S. Federal Reserve’s monetary easing cycle, our guest Sébastien Rhéaume, Managing Director at AlphaFixe Capital Inc., examines the effects on the economy and markets, including the risks of re-accelerating inflation.

The discussion also touches on the differences between the Canadian and U.S. economies, and how the Bank of Canada might respond.

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Martin Lefebvre

Hi everyone, my name is Martin Lefebvre, CIO and strategist at National Bank Investments. Welcome and thank you for tuning into our NBI podcast series on the economy and financial markets. Today our discussion will evolve around fixed income opportunities. And to do so our guest is Sebastien Rhéaume, CIO at AlphaFixe. Sébastien, welcome.

Sébastien Rhéaume

Thank you, Martin.

Martin Lefebvre

Sébastien, the Fed – the Federal Reserve – finally embarked on an easing cycle with what seems to be an outsized first move of 50 beeps. My first question to you is were you surprised by the move and can you explain why the time seemed appropriate to start that?

Sébastien Rhéaume

Yeah, so I'll start by the last part of your question. So, is it appropriate for the Fed to lower rates and start cutting rates? I think, you know, 5.5% is probably a little bit too high versus where the economy is right now. So, we are seeing a rebalancing in the labour market. So, it's probably justified to start reducing rates, cut rates, and get closer to your equilibrium rate. So, I think fully justified. To the first part of your question, were we surprised by 50 basis points? Yes, we were.

We thought, like I said, legitimate to start the process, to start with such a big move, particularly a few months before an election, an important election in the U.S. I thought that was a bit surprising for the Fed to do that. But again, I think the signal that they wanted to send is that they are embarking on a renormalization of their monetary policy. And I think they would like to get to the neutral point as fast as possible.

Martin Lefebvre

Well, the market certainly seemed to enjoy it and cheered the move, especially equity markets. But bond markets, when you look at yields, they haven't moved much following the announce. Why was that?

Sébastien Rhéaume

Yeah, it's always interesting to see the, you know, you have a bit of a surprise from the Fed and you see I think ten-year rates are probably thirty basis points higher than they were when the Fed actually cut. So, what that tells us is that, you know, the market's interpreting this in a way that they want to get there faster. I don't think that they necessarily want to, or the market's not anticipating that they would go lower, obviously not if rates are bit higher. And maybe it changes slightly the balance of risks too. If the Federal Reserve wants to get there faster, then maybe your alternative scenario, which is a re-acceleration and inflation, maybe has a higher probability. So, I think that's what we're seeing right now in the markets.

Martin Lefebvre

Okay, so what would be the risk of that? I mean, we don't know for sure if the Fed is going to go with another move of 50 beeps, but if they were indeed inclined to move faster, what's the probability of having inflation move faster, like through a re-acceleration of the economy?

Sébastien Rhéaume

Yeah, that's really tricky question and very interesting one because clearly the markets don't appear to be that concerned about that right now. So again, so I think that the Federal Reserve wants to get back to neutral as fast as possible. The issue is that they don't really know where neutral is, right? So, their latest forecast, I think, pins at around 2.9%. But when you talk to any central banker right now, they will tell you that the neutral point is probably higher than that. And I think that's the biggest risk that we see in the markets right now is that if the central bank aggressively moves back to what they think is a low neutral rate, lower than what the market, than the actual rate is, then you end up in a situation where you start re-stimulating your economy.

And just to step back a little bit, the neutral rate right now I think is very low because we pass a post-crisis of 2008, rates were at zero, the economy wasn't doing much, so every central banker just slowly reduced their neutral rate because they figured, well, if rates are at zero and the economy isn't really overheating, that probably means that my equilibrium rate is lower. So, they reduced the neutral rate year after year after year. So, pre-pandemic and pre-crisis ‘08, the neutral rate was probably closer to 4.5%. So, it went from 4.5% to 2.5% in the crisis and the pandemic and slowly trending up now. So, if we assume that the neutral rate is closer to 4%, which it was, like I said, prior to ‘08, and the central bank cuts its rates, so it cut 50 basis points. we're at 5 % now. So cut another 50 basis points from now until year-end, so we're at 4.5%. Cut another 50 basis points early on. So, you really approach really fast that level where you might actually go from being restrictive to stimulative. And that, I think, is a risk that the markets are underappreciating right now. And that's something that we want to keep a very close eye on.

Martin Lefebvre

The flip side of that is that although markets are still expecting a soft-landing scenario, we saw late in July that the Sahm rule was triggered – that is the deterioration of a half of percentage point from its level a year ago. So, do you perceive that risks are tilted to the downside?

Sébastien Rhéaume

Yeah, I think the Sahm rule again, it was triggered, but for different reasons, right? So, the Sahm rule, the unemployment rate went up because we had more people entering the workforce, which is a very healthy environment, a very healthy thing to happen for the economy. from our point of view, it didn't really concern us that much. Obviously, it's something that you want to follow. What we are looking for is if unemployment starts to creep up because of massive layoffs, that's going to be a fundamentally different story.

So, from our point of view, this point in the cycle, higher unemployment rate is something you have to keep an eye on, but not something that really concerns us that much. And obviously, if we get into an environment where the unemployment rate does start to go up for wrong reasons, I think that's where you're to start to see the Federal Reserve's being a bit more aggressive.

Martin Lefebvre

So, in such a scenario where you see rates go? How low do you see them going to?

Sébastien Rhéaume

Yeah, so again, in the environment where we have the unemployment rates starting to go up because we have important layoffs, that's where you get into the reflexivity, the negative reflexivity of the economy and that's what the Federal Reserve wants to avoid. So, and again, so if you step back, the Federal Reserve has two mandates, right? So, they have the inflation mandate, which they basically said, okay, we're pretty much done on that. Inflation is trending back to where we want. And the second mandate that they have is full employment. So, they've really said that they are very focused on full employment right now. So, if we were to see unemployment rise for the wrong reasons, so unhealthy unemployment rise through massive layoffs, I think that they would pretty aggressively want to get as close as possible to the neutral rates. And again, their best estimate is 3%-ish right now. So maybe they get there fast. And obviously, if the economy does slow down, then you could anticipate that they would want to give some more oxygen to the economy by getting under that 3%. So, you could probably think 2.5%, 2-ish % would make sense. I do not think that even in a really negative scenario that we will see rates anywhere close to zero this cycle around.

Martin Lefebvre

Yeah, I think it makes total sense without, you know, huge imbalances in the system. Sébastien, we're getting towards the end of the podcast, but I can't help but asking about the Bank of Canada. you, following the outsize move by the Fed, do you see Canada picking up the pace in its easing cycle?

Sébastien Rhéaume

Yeah, so I think Canada is really starting from a different place, right? So, the Canadian economy is actually operating a little bit under its potential versus the U.S. operating above its potential. So, the starting point is different. The Canadian consumer is one of the most indebted consumer on the planet. rising rates has affected the Canadian consumer much faster than the U.S. consumer. So again, we're starting from a very fundamentally different position than the U.S. So, I think it's very legitimate for the Bank of Canada to start cutting rates faster. And obviously the fact that the Federal Reserve starts cutting now probably gives them a bit more wiggle room in terms of getting to…, Bank of Canada also wants to get close to its neutral rate. Again, their best estimate is two and three quarters right now, but again, they probably think it's a bit higher. And there's probably a case to make that the Bank of Canada, given the weakness in the Canadian economy versus U.S. economy, might actually want to go under or below its neutral rate just to make sure that we don't hit that recession.

So, I do think that the Bank of Canada has a bit more leeway right now in terms of getting to neutral as fast as possible. And the only thing that might prevent them from doing that is the potentially negative impact on the real estate sector of lower rates. So, you lower rates, obviously the real estate sector is actually overheating right now. And if you lower rates, well, if you're increasing the overheating in that sector, what impact does that have in terms of inflation? That's one thing that might slow them down a bit, but for the rest, I think that they're probably going to want to cut rates a bit more aggressively now.

Martin Lefebvre

Well, Sébastien, it's been very interesting. Thank you very much for joining the podcast today.

Sébastien Rhéaume

Thank you, Martin.

Martin Lefebvre

And for all of you listening, thank you again and we'll talk again next month.

host

Martin Lefebvre

Chief Investment Officer and Strategist, National Bank Investments

Martin Lefebvre

Martin is the Chief Investment Officer of National Bank Investments responsible for the development investment soclutions and the management of tactical asset allocation mandates. With over 20 years of experience in financial markets, Martin also managed the portfolio management team at Private Banking 1859.

guest

Sébastien Rhéaume

Managing Director, AlphaFixe Capital Inc.

As one of the founding partners of AlphaFixe Capital, Sébastien is responsible of portfolio management and strategy development. Working in the investment industry since 1991, he specializes in Canadian fixed income. Before founding AlphaFixe Capital, he served as Vice President, Corporate Bonds, at Addenda Capital. In addition, he worked at CDP Capital Communications as Director, Telecommunication investments, after working in the areas of mergers and acquisitions and audit. CPA and CFA charterholder, Sébastien has a degree in Public Accountancy from McGill University where he also completed his Bachelor of Commerce.

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