Andrew Pyle
February 17, 2023
Which central bank does the market want to get into the ring with?
For those of you acquainted with the Rocky franchise, you no doubt are familiar with all those scenes where Balboa is repeatedly hit, falls to the canvass and then keeps getting up for more. Today, a similar boxing match has taken place between the markets and the Federal Reserve (the Fed) and, while the Fed continues to land jabs with a reaffirmation of continued tightening, we are not seeing as much staggering as one would expect. What’s more surprising is that the TSX is pretty much neck and neck with the S&P500 since the start of the year, even though the Bank of Canada has apparently hung up its gloves. One would think that if dovish interpretations meant stronger equity performance, then Canadian stocks would be well ahead.
Before I get into a comparison of the paths that investors think the Fed and BoC will take this year, let’s first examine recent economic data. To put it mildly, it has come out swinging. First, there was the jobs explosion for both the US and Canada in January. Last Friday, the University of Michigan preliminary consumer sentiment report indicated that 1-year inflation expectations rose to 4.2% this month from 3.9% in January. This followed more than a 1% decline from October, but is definitely not going in the direction that Fed officials would like. Then came a US CPI report that, while showing a further decline in the deadline rate of inflation, revealed a disturbing persistence in services price pressures. Wednesday’s January retail sales report also highlighted strength in the US economy, with a 3% gain on the month (up 2.3% excluding vehicle sales). On Thursday, it was reported that producer prices advanced by 0.7% in January, resulting in a smaller-than-expected decline in annual PPI inflation to 6% from 6.2% in December.
Put all of this together and the argument in favour of a more relaxed Fed stance on rates has started to vanish. Instead of a pivot, some Fed officials actually came out later in the week talking about potentially having to raise rates half a percent at the next meeting. Even if this view doesn’t represent a majority among voting Fed members, it does seem likely that the spectrum of views could be shifting in a hawkish direction. In other words, those that may have voted in favour of the 25bp hike at the last meeting might be re-thinking that decision; and those that may have felt there was no need for additional hikes could also be changing their minds.
This next round in this match with the Fed isn’t looking good for stocks, despite their earlier resilience, and it hasn’t been a treat for bonds either. Yields had travelled lower since the start of the year to levels that were well below the highs that were hit back in the fourth quarter. That decline was predicated on the same two things that lifted stocks. The economy was cooling off, allowing inflation to fade, and the Federal Reserve was about to take its foot off the brake. This month, the 2yr US treasury yield has bounced by more than half a percent to above 4.6% - less than a tenth of a percent from its high in November. The 10yr yield has backed up to near 3.90% - matching the levels reached at the end of December, though still a third of a percent below the October highs.
What really captures the shift in Fed expectations embedded in the market is the extreme of the curve. As the chart shows, the 6-month T-bill hit 5% this week, reflecting pricing of additional tightening by the Fed in the next couple of meetings. Keep in mind that the 6-month T-bill is also giving us a glimpse as to where traders see rates in the second half of the year and it does not speak to a pivot or reduction in rates. Further evidence of the market’s shift can be seen in the fed funds futures market. The December future came close to testing 95 back in November (implying a 5% fed funds rate at the end of 2023), but it recovered back to above 95.50 as recently as the start of this month. This suggested that the street saw the Fed lowering rates by at least a quarter of a percent in December. This week, the price of this futures contract fell to as low as 94.85. That is pricing in a fed funds rate above 5%.
This week on BNN Bloomberg (link), I suggested that equities had become overbought because of its sanguine view on the Fed, and that the broader market would likely reverse gains made since the start of the year or, at worst, go back and re-test the October lows. Unless upcoming data counter the inflationary signals that we have seen recently, stocks are likely to suffer a pullback that could be heavier than what bonds have gone through.
Now, what of the Bank of Canada? Well, it would have been nice if Canadian economic data this month supported the Bank’s guidance that it could take a break from braking. Unfortunately, our economy doesn’t appear to be cooling enough to allow the Bank to do so. Employment has risen by more than 200,000 in the past two months and the unemployment rate is holding at 5%. Hourly wage growth has cooled, but is still firm at 4.5%. The manufacturing sector racked up some dismal numbers in December (shipments down 1.5%), but sentiment appears to have improved in January. The Ivey Purchasing Managers Index jumped to 60.1 last month from 33.4 in December. This morning, the January producer price data showed a 0.4% increase in January. We get CPI figures next Tuesday and it looks as though the headlines could be higher than earlier predicted.
When the Bank of Canada suggested that it was pausing after taking its key rate to 4.5%, there was immediate speculation that the Bank was comfortable with a divergence from what the Fed was doing. Now that the street is coming to grips with the possibility of even more rate hikes from Washington, the Bank will find itself in a difficult position when it sits down three weeks from now. It could decide to reflect on recent data and renege on its January 25th pause guidance. If that meant another quarter-point increase, and the Fed refrained from moving its rate by more than that, then the spread between the two would stay the same. If the Bank were to hold to its pause guidance, then there is a risk that it’s key overnight rate would fall further below the Fed fund target.
To illustrate, if the Bank holds steady and the Fed ends up moving a quarter point, then the Bank’s overnight rate will be half a percent below. If the Fed were to actually go half a percent, then the spread grows to 0.75% - matching the largest negative spreads seen since the financial crisis. Even though the Bank’s Deputy Governor commented Thursday that the Bank wasn’t concerned if it deviated from the Fed, foreign exchange investors might beg to differ and sell the Canadian dollar. That raises the prospect of a return to the 70 US cent level for the Loonie, which would help import even more inflation from the US.
Initially, a weaker Canadian dollar might be good news for the broader equity market north of the border and investors may position that way on anticipation that the Bank remains the dovish of the two central banks. Of course, there is also a risk that the Bank decides its commitment to 2% inflation is stronger than its concern over the impact of yet higher rates on an indebted Canadian consumer. That could lead it to either follow the Fed or raise rates beyond where the Fed ultimately goes. In that case, Canada’s equity market could take the same jabs to the chin as the US and potentially come out worse for wear given that housing is already on the ropes.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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