The US unemployment rate rose by 0.2 percentage points to 4.3% in July, which triggered the Sahm Rule. This rule links the start of a recession to when the three-month moving average of the jobless rate rises at least half a percentage point above its low from the past 12 months.
As a result, market fears of a recession intensified, leading to a sell-off in equities and a drop in bond yields. The policy-sensitive 2-year yield was down the most in more than a year, falling 29.2 basis points (bps) to 3.871%. The 10- and 30-year yields also saw their largest weekly declines since March 2020, falling by 40.4 and 34.5 basis points, respectively.
Just two weeks ago, the economic headline was that real GDP growth had surprised to the upside at 2.8% for the second quarter. Since then, we’ve seen higher-than-expected weekly unemployment claims and weaker readings on durable goods orders, home sales and manufacturing. Last Friday’s jobs data capped off this string of weaker readings.
Softer economic data and further easing of inflation have already prompted the Fed to signal an intention to cut rates in September. Despite the Fed Chairman continuing to signal that cuts would be slow and deliberate, the futures market has nearly priced in a 50-basis point cut, with the Fed-funds futures showing a decent chance of a 50-basis point cut occurring by the end of the year.
We have several important questions to consider: What is the most likely near-term scenario—recession or slower growth? How is the Federal Reserve likely to respond, and what will this mean for short-term and long-term interest rates? Finally, what implications does this have for the Canadian market?
A deeper look at the US jobs market
The July jobs report was weaker than expected, but it’s important not to overstate the weakness. Employment is still growing. The payroll survey showed an addition of 114,000 jobs, and the household survey showed an increase of 67,000 workers.
Although the Bureau of Labour Statistics stated that Hurricane Beryl had no discernable impact on the data, this should be interpreted as no impact on data collection; this does not mean the hurricane had no impact on employment. Last month, 436,000 people reported having a job but being unable to work during the survey week due to bad weather, which is about 10 times the usual level for July.
Other employment data still indicate a relatively strong jobs market:
- Weekly initial (unemployment insurance) claims, although they have risen 249,000 in the latest week, are still below recession levels.
- The Conference Board Consumer Confidence survey is showing twice as many respondents indicating that jobs are plentiful compared to those who say they are hard to get.
- The number of job openings at the end of June stood at 8.2 million, which is well above its pre-pandemic level.
Employment growth tends to lag real GDP growth. With real GDP up 3.1% year-over-year at the end of the second quarter, we should expect payroll employment to rise on average through the remainder of 2024 and into 2025, albeit at a slower pace.
Productivity growth remained strong in the last employment report, with output per hour in the non-farm business sector increasing by 2.7% year-over-year. This, combined with ongoing employment growth, supports the potential for continued non-inflationary growth.
Solid productivity growth and an easing in average hourly earnings to 3.6% should give the Fed confidence that inflation is retreating. With lower energy prices, due in part to slower global growth, the consumption deflator could reach the Fed’s 2% target sooner than expected.
With more confidence on the inflation front and a weaker economy, the Fed may be inclined to be more aggressive with rate cuts. Unless Fed officials push back on market expectations in their commentary or we see markedly stronger expectations, the Fed may lock in the anticipated 50 basis point cut.
The Fed has been pressured to move off script and cut rates by 50 basis points in the past, such as during the Asian financial crisis in 1998, the dot-com bubble in September 2001, the start of the housing bubble in late 2007, and the policy u-turn in 2018 due to stock market volatility. In each of these cases, there were common themes of increasing financial market instability and weakening economic fundamentals.
Where are interest rates likely to go?
The market has gotten ahead of the Fed in the easing of rates across the yield curve. Recent declines have been compounded by a flight to quality, with a sell-off in the equity market. This sell-off has been further intensified by the unwinding of the Yen carry trade – where investors borrow at very low rates in Japan and then invest in higher-yielding foreign assets – as the Bank of Japan has started to raise rates.
| The carry trade is a strategy used to profit from differences in interest rates between two regions. It involves borrowing, or shorting (selling), a currency with a low interest rate to invest in or buy a currency with a higher interest rate.
For example, if US interest rates are 5.5% and Japanese interest rates are 0%, a trader could borrow Japanese yen at 0% to buy U.S. dollars at 5.5% This would theoretically yield a 5.5% annual profit. The foreign exchange market offers relatively higher leverage than other asset markets, which can amplify profits by 20-50 times. However, this leverage also increases the risk of significant losses if the exchange rate moves unfavorably, potentially exceeding the trader’s initial investment. In this example, the trader faces risks if the yen strengthens in value or if the Bank of Japan raises interest rates, which can reduce or eliminate the expected profit. |
If the market stabilizes and the Fed does not push against the current level of rates, we should expect US rates to remain where they are until significant market news emerges.
For Canada, this stability will translate into lower bond rates, as our market tends to trade in sympathy with the US and has gone through the same equity-to-bond repositioning by traders. This move has been large enough that we should see some easing in term mortgage rates.
Canadian analysts suggest that weak US jobs data will prompt the Bank of Canada to cut rates more quickly. My view is that the Bank will consider lowering rates if it sees the US economy weakening relative to its current forecast. However, this single data point is unlikely to shift the Bank’s view at this time. If global inflation continues to ease and further signs of a softening US economy emerge, the Bank could move more aggressively with rate cuts. If it does cut rates more aggressively, it is likely to do so by implementing three additional 25-basis-point cuts this year rather than making larger cuts. Even with these cuts, a surge in home prices is unlikely.
Housing Affordability Watch
CMI monitors the latest developments and offers insights on solutions to Canada’s housing affordability crisis
Today’s mortgage products are relatively homogeneous. Most are fixed-payment products where both the rate and payment amount are fixed, or where the rate can vary but the payment stays the same. The problem with this modern mortgage design is that it places an unnecessarily high payment burden on borrowers. But it hasn’t always been this way: Over the past 50 years, the housing market has introduced various mortgage products to address a range of challenges faced by homebuyers. In the latest Housing Affordability Watch, we review some of these innovative offerings and discuss how they might be adapted to address today’s housing market challenges. Read it here: Can Mortgage Product Design Help to Address Housing Affordability?
Independent Opinion
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