The stall before the fall?

By: Patrick O’Toole, Adam Ditkofsky and Pablo Martinez

Economic data

Markets continued to be focused on inflation data this week, causing interest rates to move higher as investors feared more aggressive rate hikes by central banks to achieve their targets. But like we saw earlier in the year with financial conditions easing and markets getting ahead of themselves, we may now be seeing an overly hawkish stance by investors, with markets pricing in more hikes than what has been previously guided by the Fed. In Canada, the Bank has already announced a conditional pause, so the bar is likely high for Governor Macklem to change his tune quickly. Still, markets may be looking for strong evidence of cooling inflation and weaker economic data to justify the argument that central banks are close to the end of their tightening cycle. As central banks tell us, it takes time for rate hikes to have their the full effects on the economy, so further near term volatility should be expected.

This week, we learned that the Canadian economy surprisingly stalled in the fourth quarter, with GDP coming in well below expectations at 0%, in addition to Q3 being revised lower from 2.9% to 2.3%. And while the flash estimate for January was solid at +0.3%, the collective average of Q4 and Q1 data is still below the Bank of Canada’s forecast, which continues to support the current pause in rates.

Looking at the details, consumer spending did have a decent rebound, however, it was offset by a drag in business investment and a material drop in inventory investments. Household disposable income was also part of the release and rose by 3.0% in the quarter, but this was due in part to non-recurring enhancements in government benefits, such as a 10% increase in Old Age Security payments and one-time GST tax credits. This works counter to the central bank’s ongoing efforts to cool inflation, as it helped boost the savings rate to 6% from 5%. In the U.S., data was more of a mixed bag. While core capital goods orders and shipments exceeded expectations, supporting a stronger business investment contribution to GDP in Q1, the Institute for Supply Management’s (ISM) manufacturing survey came in lower than anticipated, signaling ongoing concern with the economy.

Also, while retail inventories were strong in January, wholesale inventories were well below expectations. And although vehicles sales continued to improve, coming just shy of 15 million vehicles, sales are still below pre-pandemic levels. On the inflation front, we saw stronger than expected unit labor costs, which were revised to 3.2% in Q4, from 1.1%. This higher-than-expected data point adds to the list of items supporting the argument that while inflation is easing, it will take time for levels to normalize. The question remains: how aggressive will the Fed be at its March 22nd Federal Open Market Committee (FOMC) meeting, and will it take a more hawkish stance in response to the data we’ve been seeing?

Bond market reaction

Bond yields continued to move higher on the week, as markets became increasingly convinced that central banks would need to take a more hawkish stance to cool the economy and inflation. In the U.S., the 10-year Treasury bond yield moved above 4.0%, and 10-year Canada bonds touched 3.5%, both for the first time since November of last year. Markets are now pricing in an additional 75 basis points (bps) of rate hikes by the Fed over the next 6 months, with a terminal rate of 5.5%. As for Canada, futures markets see 25 bps of additional hikes bringing the overnight rate to 4.75%.

Again, let’s not forget that the Bank is on “conditional pause,” so the move in rates north of the border may be overdone, especially with the softer data we’re seeing relative to the U.S. Both investment grade and high yield credit spreads were stable on the week, as investor demand for corporate bonds remained strong, and was further supported in Canada by limited new supply. Still, let’s not forget that if a recession does materialize, it will likely be met with credit spreads moving higher.

Stock market reaction

Global equity markets were mostly flat this week. Noteworthy developments included Tesla’s Investor Day which left investors disappointed. Some had expected to receive more details on the “Model 2”, Tesla’s long-awaited low-cost model. The company has promised a nearly 50% price reduction vs. previous models, which would make the car affordable for a new cohort of potential customers. In other news, economic uncertainty looms in the U.S. with banks continuing to shed jobs; Citigroup announced hundreds of layoffs, mostly in the investment banking division.

Total jobs lost equate to <1% of the total workforce. This announcement comes a few weeks after J.P. Morgan announced cuts in its mortgage division as well. On the Canadian banks front, earnings season was mixed. Some banks guided for net interest margin expansion while others surprised to the downside. Cost and expense pressures remain a headwind for all banks across the board.

What to watch next week

Next week we’ll see the February employment reports for both Canada and the U.S. We also see Canadian trade, Q4 capacity utilization, and the next Bank of Canada rate decision. In the U.S., we’ll see factory orders, durable goods orders, wholesale trade, consumer credit, the Job Openings and Labor Turnover Survey (JOLTS) report, ADP Employment data and the monthly budget statement.