Andrew Pyle
July 13, 2023
When in doubt, just keep hiking
Depending on who you talk to, Canada’s economy is either faltering or is a beacon of resilience. The latter view is clearly driving the agenda at the Bank of Canada and was key to Wednesday’s decision to raise the key overnight rate by a quarter-point to 5%. This is the highest the target rate has been since 2001 and represents a cumulative tightening of 475 basis points since the Bank started its inflation-fighting battle last March.
The move has prompted criticism from the camp that sees the economy already teetering on the brink of recession, with an inflation picture that has improved markedly. Since the Bank’s last meeting on June 7th, when it surprised markets with a quarter-point hike, the data has been mixed. Real GDP in April stalled, and employment fell in May, however we saw a surge in employment in the month of June and retail sales grew by 1.1% in April and a further 0.5% in May. Housing indicators also point to a stabilization in the sector from last year’s correction, which is adding to the persistent strength in domestic demand.
This is not what the textbook said would happen following such a massive move in interest rates and the Bank is as confused as everyone else. Part of the problem is that this is not just a fight against leftover pandemic excess demand. The federal government and provinces have done nothing to pare back spending, which is adding to the demand for goods and services. At the same time, the significant growth in population from an immigration wave is also creating for demand at the consumer level. In the Bank’s policy statement and the Q&A session, there was no attribution to fiscal policy and the issue of immigration was dealt with in a fairly balanced manner. According to the Bank, higher immigration is also a source of relief in terms of labour supply bottlenecks, but most economists agree that the upward impact on demand outweighs the positive influence on labour supply (presumably leading to slower wage growth).
The resilience as of late has also caused the Bank to revise its economic projections. Instead of inflation coming back to the 2% area next year, the outlook now sees this happening in 2025. With this higher-for-longer trajectory for inflation, the Bank’s major concern is that inflation expectations become unanchored and prevent core inflation from getting back to target. This threat has only increased the urgency of creating a situation of excess supply in the economy and Governor Tiff Macklem stated that that “cost of delay (in raising rates) exceeded the benefit of waiting for additional data. If households were expecting the Bank to Canada to announce a pause or an end to tightening, they were disappointed as officials are prepared to hike again if needed.
Given that traditional policy lags have been thrown out the window, it is difficult to take this week’s decision and infer what impact, if any, it will have on economic activity. There is, however, likely to be some sticker shock for those who have mortgages or other loans coming due. With the Bank rate now at 5%, the prime rate moves up to 7.20%. That means that typical prime+1 loans are now going to be above 8%. Early last year, that same loan cost about 3.5% so we are talking about more than a doubling in the cost of borrowing.
This is already having an impact on debt management decisions being taken by households. Where some may have been comfortable with carrying debt and leaving capital in investments, in the hope of generating a return well in excess of the rate of interest on that debt, that strategy is now tougher with a hurdle rate above 8%. We are also likely to see an acceleration in debt paydown from still high levels of deposits, not to mention a delay in big-ticket purchases in favour of moving capital towards getting debt under control. If these shifts in behaviour develop in the coming weeks, then the data should start to reflect this by the end of the summer. In fact, the market believes this to be the case as the December future for the Canadian overnight repo rate average (CORRA) is still basically unchanged from where it was after the June 7th surprise.
It is ironic that on a day where we got another bout of tightening by the Bank of Canada, we actually saw a rally in both Canadian equities and bonds. The 10yr Government of Canada yield fell on Wednesday by more than a tenth of a percent to 3.42%, while the 2yr yield dropped even more from a 22-year high of 4.80%, reached on Tuesday. Stocks were also healthy and the TSX outperformed the broader U.S. market with more than a 1% gain. Now, there was a very good reason for the healthy moves in both markets and that was the friendly U.S. CPI report for June. Headline inflation fell from 4% to 3% and core inflation (excluding food and energy) dropped to 4.8% from 5.3%. This reinforced the view that even if the Federal Reserve hikes rates by a quarter-point at its July 26th FOMC meeting, it might be the last.
Of course, as the Bank of Canada has shown, a pause doesn’t mean an end to tightening and there are similar patterns emerging in the U.S. as here at home, such as rising home prices and resilience in consumer spending. The only thing the U.S. doesn’t have is strong population growth. We believe that the equity market response to U.S. CPI is a little overdone and that stocks haven’t fully priced in the impact from rates being held high for a prolonged period. For that reason, we remain underweight equities in general and fully invested in the bond portfolio.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.