Andrew Pyle
May 19, 2023
The week the central banks won the airwaves
Coming out of last weekend, we knew the attention of most investors would be focused on the debt ceiling debacle in Washington and, with President Biden about to set sail for Asia, market participants believed that anxiety over a possible government debt default would only go up. At the same time, we knew that the calendar was jammed with announcements, interviews and reports by officials from the Federal Reserve and the Bank of Canada. Normally, traders may not pay much heed to a deluge of appearances by central bank officials, but this isn’t a normal time.
In the case of the Fed, the anticipation ahead of this week’s remarks was heightened by the fact that the next FOMC meeting is just four weeks away on June 14th. A week ago, the probability implied by markets that the Fed would raise rates another quarter of a point at the next meeting was less than 25%. As of Thursday, it was closer to 50%, following remarks by a number of officials that progress on lowering inflation hasn’t reached the threshold where a pause from hiking is warranted. It’s not that there hasn’t been any progress. After all, U.S. headline inflation was 9.1% last summer and is now down to 4.9%; however, the pace of decline is starting to flatten out and services inflation remains extremely sticky.
Indeed, investors had become so focused on debt ceiling issues that they forgot that inflation is still a problem and that the battle to bring it down wasn’t over. This lack of attention or denial has led to one of the largest divergences between market view and central bank guidance in memory. While officials may not be unanimous on a rate hike at the next meeting (or additional rate increases beyond June), they are on the same page when it comes to the timing of rate cuts – i.e., no time soon.
As I discussed on the call, this isn’t just an issue of another quarter-point rate hike or not, but a larger re-pricing of what is currently embedded in the yield curve. What I mean by this is that the Fed funds target ceiling is currently 5.25% and the market is pricing in a decline of 0.5% or more by the end of the year so that we end at 4.5%. Now, if we were to see another hike on June 14th this will also reinforce the notion that the Fed is intent on keeping the pressure on longer. What if there are no cuts by year-end? Well, we end up at 5.5% on the ceiling rate and not 4.75%. That would require a re-pricing of bonds and also those sectors of the equity market most sensitive to yields (think technology).
What is interesting is that the notion of a June rate hike started this week with the Bank of Canada. I know that sounds surprising, given that the BoC has been in pause mode for the last two meetings already and has been viewed as the dovish of the two central banks. As such, the Bank has found itself in a position where it has lagged behind the Fed in terms of rate adjustments, even though Canada’s inflation situation hasn’t exactly justified it. April’s CPI report this week showed an actual increase in the year-over-year inflation rate to 4.4% from 4.3% in March, even though economists had called for a drop to 4%.
Last year was interesting in terms of the pattern of rate adjustments between the two central banks. Technically, Canada was the first to move to a half-point increase (in April), but the Fed leapfrogged in June with a 0.75% move. That led to the BoC hiking by a full percent in July to match the Fed’s overnight rate target at 2.5%. The Bank fell behind the Fed in November, then again in March after it hit pause. The gap between the two central banks is now 0.75% and so the odds have shifted in favour of the BoC moving a quarter point, either to match a possible similar move by the Fed a week later or to simply make a deposit in the inflation credibility bank regardless of what the Fed does.
One of the more closely watched reports this week was Thursday’s release of the Bank of Canada’s Financial System Review, or FSR. If one wanted a peaceful long weekend, they probably would avoid reading the report given the headlines extracted from it and the following news conference. Most of the points raised were pretty much known, though this year’s report was a bit of a departure from previous years in that it combined financial system vulnerabilities and risks across categories.
The report highlighted that financial conditions have tightened after a year of rising interest rates and stress fractures in the U.S. banking system and Switzerland. It also spoke to the potential for a return to extreme volatility in financial markets and the risk that this posed to Canadian banks in terms of their ability to fund from wholesale sources (issuing debt). Finally, it commented on the increased risk faced by Canadian households in the face of re-mortgaging in a higher rate environment and how many have turned to credit cards to help bridge the gaps between disposable incomes and the rising cost of living.
These risks are very intertwined as you would imagine. Canada’s banking system is solid and, while banks do rely on institutional markets to borrow in order to support lending activities, the majority of funding still comes from retail and commercial deposits. Personal deposits, as reported by the Bank of Canada, were just over $1.4 trillion at the end of March. Yet, the report does highlight how a shock to global financial markets could impede the ability to borrow in the wholesale funding market, which could prompt banks to rein in lending. That would raise the probability of a sharper contraction in economic activity versus what economists expect based solely on the tightening in conditions from higher rates so far.
Then there is the consumer. To this day I’m still amazed at how policymakers didn’t see this coming. If you start with an already high level of debt relative to income, inject cash into the bank accounts of individuals (working or not), and then take interest rates to generational lows just before said cash injections were to stop. Individuals were not going just stop spending, so credit card usage went up. Now, to be fair, there are a number of items that we have to use credit for (like travel) which were not tapped during the shutdown. Still, the key vulnerability is that revolving credit balances have grown alongside non-revolving (i.e., mortgage) balances as borrowing costs rise. The servicing of these balances now represent a larger share of disposable income and, as low-rate mortgages come up for renewal in the next few years, the challenge grows.
Where does this leave us in terms of the outlook for the economy and markets? On the U.S. side, we definitely need to be mindful that rates may go up a little more or stay high longer and neither of those argue for soaring stock markets. They may also prompt a minor hiccup in bonds, however, they also point to an increased likelihood of a marked slowdown in the economy or recession, only later than we thought. Keep in mind also that if the debt ceiling issue is resolved, there is going to be a near-term surge in U.S. government bond issuance, which technically should drain cash from the system.
For Canada, the above developments will be reflected here to some degree. A further increase in official rates will add to the pressures on households, but not every mortgage renews tomorrow. The BoC’s FSR talks about how mortgages renewing over the next 2-3 years will face sharply higher rates, however, that’s only if rates stay where they are. If you have an economic slowdown, that will eventually bring inflation down and allow for rate cuts. You see, the market isn’t wrong about policy easing, they just have the timing wrong. No, interest rates probably aren’t going back to where they were in the pandemic, but even a 1-2% drop in rates will reduce the risk of a major household credit issue. Demographics will also provide some insulation, at least for the housing sector, and that also alleviates some of the risk on banks.
As Ally and I have been telling clients, we are in a situation where there is a shared frustration between bullish and bearish market participants. We call this confusion and central bankers didn’t really do much to diminish that confusion this week. That doesn’t mean that individuals should exit the investing arena and, in fact, there are more opportunities available now to lower risk, enhance yield and remain liquid. And being liquid and net defensive is where we need to be as we go into the June FOMC, Bank of Canada and debt-ceiling timelines.
On behalf of the Pyle Group, have a wonderful long weekend.
Andrew Pyle
Conference call replay: | |
Toll-free dial-in number (Canada/US): | 1-800-408-3053 |
Local dial-in number: | 905-694-9451 |
International dial-in numbers: | |
Passcode: | 3734741# |
Expiry date: | 17-Jun-2023 23:59 |
CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. “CIBC Private Wealth” is a registered trademark of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2023.CIBC Wood Gundy, a division of CIBC World Markets Inc. Insurance services are available through CIBC Wood Gundy Financial Services Inc. In Quebec, insurance services are available through CIBC Wood Gundy Financial Services (Quebec) Inc.
The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.
These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.