ECONOMIC & FIXED INCOME COMMENT - Tailwinds to Headwinds
After a stronger-than-expected start to 2023, supported by lower energy prices and the reopening of China, global growth continues to moderate. Economic tailwinds from the first half of the year have shifted to headwinds. These include: tighter financial conditions, stubborn inflation, and the breakdown in Chinese growth due to the collapse in the property sector. Consequently, global GDP growth is projected to remain below trend in 2023 and 2024, at 2.8% and 2.9% respectively.
In North America, the U.S. economy has remained remarkably resilient in the face of 11 consecutive rate hikes by the Federal Reserve (Fed) and is on track to post solid growth in Q3. Accordingly, the Fed revised upward U.S. GDP growth forecasts for 2023 and 2024 to 2.1% and 1.5% respectively. Still, there is concern U.S economic growth could be jeopardized in Q4 and into 2024. Specifically, weakness could be seen in the resumption of student loan payments starting October, along side the auto workers’ strike and a potential government shutdown in November. U.S. Congress passed a stopgap funding bill that would fund the government for 45 days at which time the House of Representatives will have to go back to the negotiating table. Currently, there is increased uncertainty surrounding the near-term U.S. political landscape as the Republican party recently ousted Speaker Kevin McCarthy and there is no consensus on who should be the new Speaker of the House of Representatives.
At the September meeting, the Fed held the Fed Funds rate steady at 5.5%, which was widely expected. As well, the Fed kept the option of an additional rate increase on the table. Currently, interest rate futures are pricing in a 30% probability of an additional rate hike at the November meeting. Furthermore, the Fed released a revised Summary of Economic Projections (SEP). A SEP is a summary of the Fed Committee’s projections for GDP growth, unemployment, inflation and policy interest rates. The revised set of projections meaningfully reduced potential rate cuts for 2024 from 1% to 0.5% implying an elevated interest rate environment for longer.
The Canadian economy contracted 0.2% in Q2 and early estimates are forecasting further economic slowdown in Q3. At the September meeting, the Bank of Canada (BoC) held the overnight rate steady at 5%. While headline inflation reaccelerated for the second month (mostly due to higher energy prices) evidence is building that earlier rapid and aggressive interest rate hikes are finally having their intended impact on the broader economy. Specifically, consumer spending is pulling back, housing activity is slowing and the labour market is softening. Specifically, job vacancies, a proxy for the demand for labour, fell 5.8% m/m in July (-28% y/y) (see chart below), while the unemployment rate has risen 60 bps to 5.5% in August from the cycle low. The next BoC meeting is in October and market participants expect the BoC will remain on hold.
At the start of the monetary tightening cycle, both the Fed and BoC moved in tandem. However, as we near the end of the cycle, we are starting to see monetary policy divergence between the two central banks. There are three main factors. 1. the Canadian economy is slowing more than the U.S. economy. 2. The Canadian economy is more interest rate sensitive than the U.S economy (5-year mortgages vs. 30-year mortgages). 3. the Canadian unemployment rate has been trending higher while the U.S. unemployment rate has held steady. As a result, many economists believe the BoC will be the first out of the two central banks to cut rates. The speed and magnitude will be dependent on the path of inflation and overall strength of the economy.
Last quarter, we noted Government of Canada 10-year bond yields ranged between 2.65% and 3.5% and would likely stay below its prior high of 3.68%. Nevertheless, Canadian 10-year yields broke the 4% threshold in September. The sharp repricing in the bond market can be attributed to several factors affecting bond supply and demand. Specifically, the U.S. Government recently ramped up bond issuances to finance its large budget deficits putting downward pressure on bond prices (increasing yields). In addition, the Fed has continued to increase its quantitative tightening QT thereby reducing their balance sheet. This monetary tool increases the supply of bonds available to the market which invariably results in higher interest rates. Finally, Japanese investors have reduced their demand for U.S. debt as the Bank of Japan removed its yield curve control mechanism allowing domestic bond yields to move higher encouraging local investment. While these events directly impact U.S. bond yields, Canadian bond yields tend to move alongside U.S. bonds (see graph).
We believe interest rates in Canada are at restrictive levels, and any further rate increases from the BoC will remain highly data dependent. While firmer-than-expected inflation data have increased the odds of another BoC rate hike by year-end, it’s improbable. Specifically, inflation lags the economic cycle, and a softening labour market should ease price pressures and reassure the BoC. Therefore, we expect rate cuts in the next 6-12 months are appropriate. Given the wide range of potential economic outcomes in the near-term, we favour intermediate-term bonds that lock in improved yields while providing a cushion to future volatility without taking on excessive interest rate risk.
