The Breakdown - The Bank of Canada Cuts Rates; Will the Fed Follow?

Episode Date: June 7, 2024

The Bank of Canada has moved to cut interest rates, with the markets pricing in additional cuts throughout the end of this year. Will the US Federal Reserve follow suit or are the two central banks dealing with a fundamentally different set of circumstances? Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on Macro, Bitcoin, and the Big Picture Power Shifts remaking our world. What's going on, guys? It is Thursday, June 6th, and today we are going macro with some Bank of Canada rate cuts. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. friends, well, as I said, today we are going over to the macro side of things, where the Bank of Canada has broken the seal, becoming the first G7 central bank to cut rates. Rates were reduced by 25 basis

points to 4.75% at Wednesday's meeting, with officials citing significant progress on inflation. BoC Governor Tiff Macklam said, with further and more sustained evidence underlying inflation is easing, monetary policy no longer needs to be as restrictive. He guided further cuts to come as well, stating, if inflation continues to ease and our confidence that inflation is headed sustainably to the 2% target continues to increase, it is reasonable to expect further cuts to our policy interest rate. But we are taking our interest rate decisions one meeting at a time. Consensus among economists is that the BOC will continue to cut at each of the four remaining meetings for this year, bringing rates to 3.75%. Stephen Brown, an economist at Capital Economics,

said, if we're right that growth will remain below potential and core inflation will fall, then there will be little justification to maintain a restrictive policy stance. So this is the narrative being put forward by central bank officials, that Canada is headed for a soft landing, meaning that rates need to moderate alongside declining inflation. The latest inflation data had headline inflation in Canada at 2.7%. The fourth month in a row below 3%. Growth is another story, with first quarter GDP coming in at 1.7% annualized, which is well below the BOC's forecast of 2.8%. In addition, per capita GDP has declined during six of the last seven quarters. The unemployment rate now sits at a 27-month high of 6.1% while job vacancies have fallen to their

lowest point in more than three years. Macklems said, we'll certainly be looking at our growth trajectory going forward, but claim that so far it looks like a soft landing. He said, the plane hasn't been landed yet, we're not cheering yet, the runways in sight, but we still need to land this. The obvious overhang in the Canadian economy is a heavily indebted housing market. Housing prices have recovered significantly this year after stumbling in 2023. Canadian and home loans are typically taken out with a fixed rate of four or five years before switching to a variable interest rate. Officials estimate that there's around 500 billion in U.S. worth of housing debt still being serviced at ultra-low 2020 rates, which will need to be

refinanced over the next two to three years. Interest rate cuts will help, but existing mortgage servicing costs are still likely to increase significantly over that period. Shelter inflation in Canada is already running at 6.4% annualized rate, with rents moving up even faster at 8.5%. The big question will be whether the narrative that Canada is heading for a soft landing holds water, or if a nasty recession is already inevitable. Royce Mendez, managing director at Dejardine Securities, thinks that the rate cut is the right approach in either situation, stating, rather than waiting for a recession to take hold, officials are acting preemptively to guide the economy towards a soft landing. With challenges on the horizon and monetary policy

only working with a lag, today's 25 basis point rate reduction is consistent with a risk management approach. Bloomberg economist Stuart Paul said, easing inflation and excess production capacity prompted the BOC to cut rates. We also think expectations of weakening consumption growth as mortgage rates reset played into the decision. Still, lower rates run the risk of stalling disinflation, or even re-accelerating inflation. If inflation does accelerate in Canada, the currency channel could play a key role. The Canadian dollar has already devalued by 4% against the U.S. dollar since its local high at the beginning of the year. A further currency decline would drive inflation by increasing

the price of imported goods and could also trigger capital inflows to bid up the value of assets. markets aren't showing signs of an out-of-control deflation, but there is a fear that rate differentials could drive the loony lower. Ahead of this cut, BOC rates were at parity with Fed rates. We're not at the stage currently where rate differentials are large enough for concern, but if the Fed holds rates steady into the election, the Gulf could widen significantly. Maclum noted these concerns during yesterday's meeting, but justified the rate cut by saying that Canadian inflation had eased more, while the U.S. economy had remained stronger. He said there is a limit for policy divergence, but added,

I don't think we're close to that limit. There's no sort of bright line. And you can see from history there have been periods of considerable divergence. Regardless of Fed action, rate cuts are quickly becoming a global consensus. The Swiss National Bank and Sweden's Ricks Bank have already begun cutting rates, and the European Central Bank delivered its first rate cut at their meeting earlier today as well, reducing its marginal lending rate to 4.5%. There is a growing concern that global central banks outside of the U.S. are moving too early, reacting to signs of economic weakness rather than staying the course on the inflation fight. Gabriel Foa, a portfolio manager at Algebra's Investment, said,

As things stand, we believe an ECB cut this week may soon be viewed as a policy mistake. Indeed, this is the first time in the ECB's 25-year history that it has moved ahead of the Fed. Although Fed officials have been reluctant to signal cuts, markets are once again moving up their expectations. Pricing surrounding the September meeting shows a 60% chance of a rate cut, according to the CME's Fed Watch tool. Two rate cuts by the end of the year is now the base case with only a 6% chance that rates are held steady. The next FOMC meeting will be held next week, so we'll have more information on that

direction the Fed is heading by Wednesday. As usual, Twitter commentators had no praise for central bank decision-making. Many focused on the risk of a currency devaluation. Analyst TXMC trades wrote, The next wave of dollar strength likely begins when all of the U.S.'s closest friends begin cutting rates because their economies need it, and the Fed is unable to join them. Icecap tweeted, the Bank of Canada just gave a signal to the world to short the Canadian dollar. A more considered but no less concerned take came from Canadian mortgage broker Ron Butler, who tweeted, the BOC governor made the expected move and cut the bank's key lending rate by 25 bips. The Y is easy. The Canadian economy, particularly in central Canada, is slowing. The point of raising

BOC rate from 0.25% to 5% the fastest increases in Canadian history was to force inflation back to target by seriously damaging the economy to the point people are buying far less, and prices deteriorate because of falling demand. Mission accomplice. New home construction has collapsed in Ontario. Retail sales are down across the country. Loan delinquency is way up. Simply stated, Canada is well on its way to going to economic hell in a handbasket. I hear from now, we will wonder why the first rate cut wasn't March or April. Butler suggested that rates would reach 3% at the bottom of the seizing cycle, but pent-up demand for housing could keep prices afloat. This highlights one of the key differences in this macro

cycle compared to the last few decades. Very few people expect rates to get anywhere near zero. The Bank of Canada governor even presented this as a warning to households and businesses. Now, in the interest of balancing out the macro doom, it's worth remembering that many expect rate cuts to boost global liquidity, providing a tail win for risk assets. Van Spencer of Framework Ventures tweeted, Canada became the first G7 bank to begin cutting rates today. So it begins, I'm not sure people are appreciating just how high rates are and how low they will move in the coming one to two years, likely the largest rate cut cycle of our

lifetimes. One of the biggest macro questions to play out over the next year is whether central banks are starting to cut in response to easing inflation and a garden variety slowdown, or whether systemic risks are bubbling to the surface. Taking a look at the state of play in the U.S., the FDIC has warned that pressure on the banking system is still a problem. Their first quarter report showed that U.S. banks still have $517 billion in unrealized losses sitting in their portfolios. These losses began showing up in 2022 as the Fed began its hiking cycle. Bond prices fall as rates rise, pushing longer-term reserve holdings underwater. The majority of these assets are warehoused in what's

known as Hold to Maturity portfolio, meaning the bank doesn't intend to sell them for a loss. However, as we saw with the collapse of Silicon Valley Bank last year, sometimes that choice is forced by a bank run. These unrealized losses increased by 8% in the first quarter. The FDIC claim that increased paper losses were largely centered on residential mortgage-backed securities rather than treasury bonds. More troubling is an additional 11 banks classified as problem banks, defined as banks with identified operational or managerial weaknesses. That brings the total to 63. The total assets held by problem banks has risen from $15.8 billion to $82.1 billion, implying that a few mid-sized banks have now made the

watch list. At this stage, none of these issues imply systemic risk, but bank runs and failures have a way of cascading out of control once they get started. Problem banks are now 1.4% of all banks in the U.S., which the FDIC said was within normal range for non-crisis periods. Earlier in the year, Fed Chair Jerome Powell had acknowledged that we would likely see more bank failures during this cycle, so this report shouldn't be news to policymakers. More interesting is the conversation around FDIC insurance and how it should be applied to a changing banking system. In early May, Fintech infrastructure provider CynAPs declared bankruptcy, setting off a chain reaction within the industry.

Synapse had around 100 partners serving around 10 million end customers. At least one Fintech powered non-bank has closed withdrawals for customers, and several others have cut down services like linked debit cards. At this stage, it seems like the FDIC is washing its hands of this issue. None of the banks with fintech partnerships have failed, and the agency doesn't appear willing to cross the Rubicon in providing gratuitous coverage to non-banks. the regulated problem banks that could fail during this cycle, there's still the issue of large uninsured deposits. The FDIC extended coverage to large depositors during the Silicon Valley bank failure as a way of halting the domino effect of bank runs. It appears the question of

whether the ceiling for deposit insurance should be permanently raised is still under consideration at the FDIC. Another growing problem area of the U.S. financial economy is private credit. This once niche sector has grown exponentially over recent years to an estimated $1.2 trillion in assets under management, roughly doubling since 2019. Private credit funds typically lend to mid-size firms with annual revenues between $10 million and $1 billion, but have increasingly begun servicing larger firms. These funds can provide credit where bank loans or commercial bonds are impractical or unavailable, often dealing with bespoke loan terms for more complex underwriting. On the other side of the deals are high net worth individuals and institutions looking

for a little extra yield compared to public market securities. A recent report from the Chicago Fed found that private credit now represents 20% of U.S. life insurers' bond portfolios. Private credit funds are usually completely illiquid with no ability to sell loans prior to maturity. They're also more opaque than public instruments, meaning that write-downs often come all at once. The issue has been the rapid growth of private credit as banks curtail lending. The suspicion is that this explosion and scope has led to lax underwriting of loans at hidden risks within private credit funds. Last week, J.P. Morgan's CEO Jamie Diamond said he expects problems to emerge in private credit and warned that, quote, there could be hell to pay. Multiple major funds have already halted

redemption, so we'll have to wait and see how deep the problems are within the sector. Advisor Mark Ladeen wrote, private credit is going to be super interesting to see unwind. There are so many times when companies extending credit think they've found an untapped area of growth when all they've actually discovered was looser underwriting terms. Similar issues are also bubbling to the surface in private equity. Earlier this week, one of the largest private equity firms Apollo Global Management pulled back the curtain at a conference in Berlin. The firm's co-president Scott Kleinman said, I'm here to tell you everything is not going to be okay. He noted that private equity firms haven't taken the significant markdowns related to the Fed's hiking cycle and last

year's downturn in the lower end of public markets. Kleiman says this means that, quote, investors of all sorts are going to have to swallow the lump moving through the system. Rite downs are largely still coming for assets purchased prior to 2022. Kleiman said that the need to refinance at higher rates would mean fewer realizations and lower returns. The business model of private equity is largely about buying out existing companies, restructuring, and then exiting via a sale or an IPO. A glut of deals in recent years, followed by a slowdown in IPOs has derailed this process,

leaving private equity firms holding the bag. Currently, private equity fund distributions are as low as they were during the global financial crisis, but at a much larger scale. It's important to note that it is not all doom and gloom out there. Wall Street appears looking forward to partying all summer long in the public markets. We're only a week in, but we've already seen another round of meme stock mania kickoff, and Nvidia hit an eye-popping $3 trillion in market cap to become the second most valuable company on Earth behind Microsoft.

Goldman Sachs managing director Scott Rubner thinks the liquidity will keep flowing, writing this week, new quarter, new half year, this is when a wall of money comes into the equity market quickly. He added, I'm seeing a reemergence of retail traders during the summer. They tend to come around in July. Seasonally, the S&P 500 has never topped in June dating back to 1980. It's also very rare to see a top in July or August. According to Ruhner's report, the first half of July has historically been the best two-week trading period for stocks. The last nine straight July's have been positive for equities with an average return of 3.7% for the S&P 500. By his calculations, around nine basis points of fresh capital are deployed into the public markets every July,

which this year would mean 26 billion worth of inflows. He wrote, The bar for being short equities right now is very high given these upcoming flows and random market dynamics. So friends, that's the macro story from here, some good, some bad, a lot of big questions remain. Ultimately, what we've seen from this Fed is that it truly does not care what the rest of the world is doing. And so it will be interesting to see next week if Powell tamps down the new enthusiasm coming out of these rate cuts, or whether he indulges the idea that this actually does mean a shift in the U.S. as well. For now, though, that is going to do it for today's episode. Appreciate you listening, as always. And until next time, be safe and take care of you.

other. Peace.