Let’s talk about rate cuts

Since the end of November, both stock and bond investors have been receiving an early Christmas gift with markets seeing ongoing evidence of easing inflation, increased slack in the labour force and modest deterioration in overall economic conditions. Currently, it seems consensus expectations are pricing in a goldilocks scenario, with the US Federal Reserve (the Fed) orchestrating its planned soft landing for the economy, while also bringing inflation back to its 2% target. In response, we’ve seen an aggressive move lower in bond yields, now down almost 1.00% from their highs in October —and with that, a strong improvement in risk markets.

Where are rates going?

Futures markets are now pricing multiple rate cuts over the next 12 months (in Canada more than four are priced in) with the first coming as early as next spring. We would agree that enough time has passed for higher rates to have impacted consumers and the economy. There’s a high probability that we’re done seeing policy rates move higher.? However, we can’t ignore the fact that markets remain extremely volatile. If we see economic data come in higher than expected, markets could quickly reverse course. We’re expecting both the Fed and the Bank of Canada (BoC) to start cutting rates in 2024, but pricing in for next spring may be premature.

Weekly economic data

This week, the BoC elected to leave its overnight rate unchanged at 5.0%, representing the third consecutive meeting with the policy rate on hold. This was largely expected by the market, seeing as Q3 GDP came in far worse than expected. The BoC confirmed the economy was cooling and inflation was moving in the right direction. It maintained its cautionary stance, warning that further rates could be warranted if inflation re-accelerates.

Q3 productivity fell by 0.8%. This represents the sixth consecutive quarterly decline.? A word of caution, negative productivity doesn’t bode well for corporate profitability in Canada, which ultimately increases the risk of further layoffs going forward.?

US employment data was the focus this week with JOLTS job openings coming in well below expectations at 8.7 million. This brings the jobs/jobless ratio down to 1.34x from 1.47x —signaling increased slack in the labour force. This is one of the key metrics that the Fed is watching, especially as they look to bring the labour market back into balance. This also represents a material improvement from the peak of 2.0x seen in March 2022 and compares to the pre-pandemic level of 1.2x.

We also saw non-farm payrolls for November, which came in stronger than anticipated with an increase of 199k, although the past two months were revised lower by 35k. It’s worth noting that jobs were concentrated in less than obvious sectors, including private education and health and government. Retail lost 38k jobs, which is especially uncharacteristic as we move into the holiday season.

Other labour market data came in stronger than anticipated, with unemployment ticking lower by 0.2% to 3.7%. Weekly hours worked and average hourly earnings both moved higher. Lastly and unlike Canada, US productivity exceeded expectations, rising by 5.2% and supporting lower unit labour costs (ULC). ULC fell by 1.2%, which is supportive of lower inflation over the medium-term as it implies companies are less pressured to pass on higher costs to consumers.? ?

Bond market reaction: Still moving lower

Bond yields continued to move lower this week as markets further priced in an end to both the Fed and the BoC’s tightening cycles. This was further supported by the BoC’s decision to maintain its overnight rate at 5.0% which was accompanied by what was interpreted as a dovish statement. Both investment grade and high-yield corporate bonds also saw credit spreads tighten further this week as appetite for risk assets remains strong. While new issuance activity has started to cool ahead of the holiday season, several new deals came to the primary market, all of which were well oversubscribed and performed well.

Stock market reaction: Returns driven by the Magnificent 7

With a few weeks remaining in 2023, the ‘Magnificent 7’ have driven a significant portion of equity returns this year. Despite its size, companies like Amazon are growing rapidly. Black Friday generated a 7.5% increase in ecommerce sales for the industry despite a tougher spending environment. With ~40% market share in the US, Amazon is well positioned to capture underlying market growth.

Recent market entrants including Shein and Temu have taken shoppers by surprise at shocking prices and discounts. However, Amazon continues to impress with their services and logistics, in addition to competitive prices.

On the topic of larger companies in the US, Tesla unveiled their CyberTruck last week with mostly positive reviews, although the physical appearance of the vehicle will take some getting used to. The EV market is getting more competitive with new options for consumers. Tesla has done a good job challenging norms to stay ahead on product development.

What to watch in markets next week

Next week in the US we’ll see CPI, hourly average earnings, PPI, business inventories, import/export prices, retail sales and the last Federal Open Market Committee (FOMC) rate decision for the year.? In Canada, data will be very light with only manufacturing sales.

Authors : Adam Ditkofsky, Pablo Martinez, Sandor Polgar, Steven Lampert, Craig Jerusalim et Rahul Bhambhani

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