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Produced by RBC Global Asset Management's Chief Economist Eric Lascelles, the #MacroMemo covers what's on our economic radar for the week. Enter your email address and set your subscription preferences to have RBC GAM updates and announcements delivered directly to your inbox.
The Fed's decision last week contained no great surprises, with markets nudging yields down slightly afterward. However, we came away with the opposite impression - the Fed statement, forecasts and press conference suggested to us that the market may be moderately underestimating Fed tightening intentions over the coming year. There are several reasons why: Although unsurprising, the Fed did materially tighten U.S. monetary policy: it hiked the overnight rate by 25bps and committed to doubling the pace at which it unwinds QE starting in the New Year. The Fed has now delivered three rate hikes in 2017. That was precisely what the central bank had predicted at the start of the year. This is bigger news than it seems: the Fed failed to deviate in a more-dovish-than-planned direction for the first time in many years. That could be the beginning of a trend, and yet the market again prices in fewer rate hikes than the Fed for 2018. The Fed revised its growth forecast significantly higher in 2018, from 2.1% to 2.5%, and revised down its unemployment forecast. Within this, Fed Chair Yellen expects a modestly positive growth effect from U.S. tax cuts. The Fed added another rate hike to its 2020 projection. This provides two insights. First, it gives a sense that the Fed is in the business of ratcheting its tightening path higher rather than lower. Second, that puts the expected fed funds rate at 3.1% in 2020 - higher than the Fed's "neutral" rate of 2.75%. In other words, the Fed now expects that it will need to overshoot on monetary policy, presumably because it now anticipates that the economy will itself overshoot normal (i.e. "overheat"). Yellen said the flattening of the yield curve over the past year does not mean the recession risk has suddenly spiked higher. We agree: the flattening has come about via a bear flattener (good) and long-end yields look much more robust once you factor out the declining term premium. Labour market conditions are now described in the statement as "strong" as opposed to "improving." In other words, the Fed thinks the labour market has hits its full potential. That requires monetary action. Yellen says inflation weakness is only transitory. Yellen sees fewer downside risks than usual. The composition of Fed voters should become more hawkish in 2018: the two doves who dissented at the latest meeting lose their vote, and will be replaced by moderates and hawks. All of this is to say that the market may not be pricing in quite enough Fed tightening for 2018, with the implication that bond yields could rise modestly as well.
The Bank of Canada decision was a few weeks ago, revealing a Bank of Canada on hold and cautious about a future tightening path. Governor Poloz then delivered a speech last week that covered a significant amount of ground, both positive and negative. One confusing element related to his characterization of the Canadian economy as "looking positive" and "quite close to home." However, he was also reported to have described the Canadian economy as lagging the U.S. by a few years due to the oil shock of 2015. This is confusing in that the U.S. economy is now widely acknowledged to itself be in the realm of its full potential (or "home"). We are unable to fully reconcile Poloz's two statement. Our view is that the Canadian economy is indeed now near its full potential. What about the oil shock? It clearly harmed Canada, but let us not forget that Canada was arguably ahead of the U.S. going into the shock and has enjoyed a year of searing growth since. Yes, Canada's unemployment rate is higher than the U.S., but it is normally around 2ppt higher for structural reasons and the labour force participation rate tells a much more favourable story about Canada. Furthermore, Canada's capacity utilization rate is outright higher than the U.S. For all of that nitpicking and our own economic assessment, we actually expect a little less tightening in Canada than the market as we see headwinds ahead for the Canadian economy in the form of weaker housing and worse competitiveness.
U.S. tax reform is moving briskly forward, and now looks to have a 90% to 95% chance of successful implementation. Really the only remaining X-factors are Senator McCain's health and the remote chance that a few moderate Republicans could return to the fence for long enough that the recent Alabama special election becomes relevant to the vote count. The tax package includes a big corporate tax cut from 35% to 21%, accelerated depreciation, a territorial tax system, the repatriation of several hundred billion dollars of overseas earnings, and a personal tax cut that now spans all brackets. Helping to pay for this are less generous provisions to deduct interest payments and state & local taxes, plus some measures designed to discourage multinationals from shifting their earnings elsewhere. The package could also spell the beginning of the end for Obamacare by eliminating the penalty for not purchasing a health insurance package, potentially resulting in an upward cost spiral as only sick people remain in the programs. Economic implications: The tax plan will increase the U.S. debt by around $1.5 trillion over the next decade. This is manageable, but unnecessary given the strong starting point for the economy. The economic stimulus derived from the plan is more frontloaded than we had previously assumed, with the implication that - even with a low fiscal multiplier due to the way in which the cuts are distributed - U.S. GDP growth in 2018 could be 0.4ppt faster than otherwise (we have already factored most of this in to our forecast), with 2019 growth 0.5ppt higher. From there, however, subsequent years suffer a slow bleed as components of the program start to expire. Corporate earnings will fare much better, up by an average of 5% to 12% depending on the estimate. Some analysts say that only two-thirds of this is priced into the stock market, though we suspect a larger fraction is now there. Simple, domestically-oriented firms will benefit most, U.S. multinationals will land somewhere in the middle, and foreign multinationals with significant U.S. sales could even slip backwards. Criticisms: the public is skeptical of the plan - it is not clear that Republicans will pick up votes at the midterm elections from this legislation. The timing is poor: the Fed will have to raise rates by more than otherwise to prevent the economy from overheating. The package was built in haste and so could age badly. The lack of bipartisan support means that the Democrats will be gunning to kill it at the first opportunity should they manage to reclaim power.
Less than three months after Catalonia's illegal referendum unleashed havoc upon the region, it is back to the polls. This time, the event is an election rather than a referendum and the national government promises to fully recognize the result (indeed, it called the election). The need for the election stems, of course, from Madrid's decision to trigger Article 155 of the Spanish Constitution and thereby dismiss the independence-seeking Catalonian government in response to illegal acts and reduce the region's autonomy. The election's legitimacy doesn't mean the result will be much cleaner than the referendum, however. Polls show a very close result, with a (pro-Spain) nationalist party in the lead, but trailed closely by two sovereigntist parties. Experts predict an almost perfect split in the final tally of seats between nationalist (62) and sovereigntist parties (63). If the outcome is truly this close, the precise tally arguably won't matter: no coalition will be able to reliable govern with a majority of just one seat given the enormous political divide across theoretically aligned parties on issues other than independence. As a result, Catalonia could lack a coherent government coming out of this. As we have argued for some time, we put the odds of Catalonia securing independence quite low given the Spanish government's past response to similar efforts and given the lack of recognition by other country's to Catalonia's recent effort. In the meantime, the Catalonian economy suffers moderately, with some spillover to Spain as a whole.
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