Dollars and Sense

In the span of just eight weeks, the U.S. 10-year Treasury yield plummeted by 50 basis points, pushing below an important psychological threshold of 2%. This downdraft reflected the combination of falling inflation expectations, a greater risk premium related to an eroding global backdrop, and more dovish central bank communications. Importantly, this led financial markets to aggressively reprice the Federal Reserve’s policy path. Depending on the day, data, and tweet, financial market participants generally leaned towards 100 basis points in Fed cuts by the end of 2020. Finally, a modest reprieve came on July 5th when a strong employment report offered financial market participants a sober second look at the degree of their dovishness. However, one strong report of 224K jobs is certainly not enough to materially remove the shadow hanging over the economic landscape. There are real risks to the expansion and the Fed will want to get in front of them. This leaves the question, how much monetary stimulus is needed to shore up confidence in the economic expansion? 

The trend is not our friend

The answer to our question lies in the forces that first led to a fraying in market confidence. There’s little doubt anymore that the global economy is mired in a sharp manufacturing slowdown, with successive bouts of trade friction further obscuring the outlook. This is most apparent in measures of manufacturing business sentiment, which have deteriorated steadily for months on end (Chart 1). It’s also observable in the hard data through a collapse in global trade flows. Even U.S. industrial production has not withstood the headwinds.

Through every past business cycle, manufacturing sentiment has been an important barometer for where the broader economy is headed. It doesn’t always call it right when it comes to recessions, but it does a good job predicting the general direction of economic momentum due to its sensitivity to the external environment, along with supply and labor ties into the domestic economy. The key now is to assess whether this deterioration in manufacturing activity is spreading into other sectors of the economy.

To get at this, we turn to our TD Leading Economic Indicator (Chart 2), which captures the intersection of production, labor markets and consumer patterns. The aggregate index has a good track record paralleling and predicting overall momentum within the economy. The zero line captures the historical average performance of these indicators, and a push below that threshold means the economy has entered into a period of below-trend growth. We stand at attention when the index not only crosses the zero threshold, but at a minimum reaches -0.4 standard deviations from the norm. Doing so runs the risk of hitting a point-of-no-return, but still doesn’t represent a finite outcome, as evidenced by the false-signal in 2016. Today, this index tells us that the negative sentiment permeating the manufacturing sector has indeed bled through to other segments of the economy, but not in a pervasive way, as of yet. An economic cushion remains, albeit thinner and warranting of some caution.

The Fed Response

The warning signal inherent in our Leading Indicator now offers some clarity as to why Chair Powell took a more dovish stance at the most recent FOMC meeting on June 19th. The emphasis then was on the weakened global backdrop, coupled with more cautious domestic business investment behavior. In a low interest rate world, the Fed has less ammunition to combat a slowdown and therefore needs to act quicker when risks become elevated. We only need look back to 2015/2016, when Fed members acknowledged the risks to the outlook by hitting pause on an interest rate hike cycle that had only just begun with a single move. At the time, the upper bound of the policy rate was only at 0.50%, which was still very simulative and left little room for a cut. With the policy setting now at 2.50%, the Fed has considerably more scope to guard against emerging risks.

The only question is: how much do they need to cut? To assess, we simulate a number of economic scenarios (Chart 4). Should trade tensions and negative business sentiment ease, U.S. growth would keep chugging along around 2% and inflation would gently grind higher over the next year. In this scenario, the Fed would have more confidence that the economy remains on firm footing and a simple monetary policy rule would argue to leave interest rates unchanged. However, hindsight is 20/20 and a luxury that is not available. All the Fed can judge is current developments and the balance of risks. It’s reasonable to assume negative sentiment will persist over the next year. In such an environment, we estimate that economic growth could head towards 1% by early next year. A precautionary rate cut of 50 basis points would help to bring growth back to the 2% mark. This is our current position on the central bank outlook. The alternative would risk a further deterioration in sentiment and having to play “catch-up” in shoring up economic momentum.

Now, if economic activity proves worse than we are expecting and heads towards zero (temporarily) within the next year, the counterfactual argues that a cut of around 100 bps would be justified to hold the economy closer to its trend pace in order to head-off that outcome. This view is closer to what the markets are pricing. At this stage, however, a 100 basis point cut would not reflect insurance, but more aggressive action to guard against the recessionary floor. 

For this to materialize, we would expect to see a much deeper push lower in our Leading Economic Index below the -0.4 threshold. One key reason it has not done so is because the service side of the U.S. economy is proving resilient. Nothing drives this point home more than a U.S. consumer that is tracking in the 3-4% range in the second quarter.

So in a nod to the domestic and global risks, a preemptive strike is the most logical step at this stage in the cycle, with cuts of 25 bps in July and September. This would bring the U.S. 3-month Treasury Bill yield to about 1.85%, lower than the current yield of the U.S. 10-year Treasury Note. In other words, should markets believe that insurance cuts will have a positive economic impact, the 10-year to 3-month segment of the yield curve would no longer be inverted. In fact, the nature of the cuts being “insurance” means the action actually adds fuel to the economy and we would not be surprised if the Fed found itself in a position to unwind some or all of this insurance. We put 2021 as the placeholder on this timing, but recognize that this is a gamble considering there are a lot of hurdles to jump between now and then, including trade tension resolution, the lifting of budget caps this fall and the next U.S. election cycle…to name a few that fall into the world of “known, unknowns”.

Bank of Canada to exert more patience

At the moment, the Canadian economy stands a bit at odds to global trends. It suffered through a weak patch from September 2018 to about February 2019, but economic momentum has staged a strong comeback in the second quarter. This was acknowledged in the Bank of Canada’s July Monetary Policy Report (MPR), which revised the real GDP forecast to 2.3%. On top of this, inflation and wage growth are both running higher in Canada than in the U.S., and the policy rate is already at a lower starting point. For this reason, it is less compelling for the Bank of Canada to follow the Fed, as is often conventional wisdom. In addition, the mere act of cutting in the U.S. means that Canadian yields will import the downdraft of their U.S. equivalents, as we’ve already seen. 

Canada is proving unique in other ways that goes beyond the recent rebound in activity. The decline in global yields has pushed the Canada 10-year yield to a level below the yield on both the 3-month and the 2-year. This means that unlike the U.S., Canada has full yield curve inversion. Often economists debate over which part of the yield curve offers the more predictive signal of an impending recession. Some emphasize the 10-year to 3-month spread and others on the 10-year to 2-year spread. This debate is irrelevant when both sections of the curve invert. However, the shape of the curve requires several qualifiers. First, it’s a far better predictor of the U.S. business cycle than the Canadian one, particularly since Canada’s curve is more sensitive to external forces and bond supply-side issues. This has led to a higher frequency of false signals (1986, 1992, 1998, and 2000). Nevertheless, it should remain a closely watched indicator, because it does embed some degree of market sentiment. A single interest rate cut would likely be sufficient to undo the inversion. But at this juncture, the Bank of Canada is discounting this signal. 

Some market commentators believe that the Bank of Canada will need to cut rates in order to prevent an escalation in the Canadian dollar from choking off exports. This view is too simplistic. There are two main drivers of the loonie: interest rate spreads and commodity prices. With the Bank of Canada in wait-and-see mode, markets are pricing that the spread between Canadian and U.S. overnight interest rates will be -10 bps by the end of 2020 versus a current spread of around -70 bps. That large swing should be already largely reflected within the exchange rate. On the commodity side, the Bank’s price index is still 9% above its late 2018 lows and has been on an uptrend since 2016. Putting both of these pieces into our model framework suggests that the Canadian dollar should be at least 78 US cents. So, the current spot price at 76 US cents indicates that traditional fundamentals are not fully playing through, and the loonie continues to reflect a risk premium dominating global sentiment and the greenback. 

All in all, the Bank of Canada continues to echo patience. Should the global economy weaken further and the Federal Reserve responds by cutting more than we expect, than it would be reasonable to expect the Bank of Canada to join the global coalition of central banks and easy monetary policy. 

Bottom Line

The next few months are crucial. The manufacturing sector in the U.S. is steadily decelerating and the erosion is happening on a quicker and larger scale internationally. Trade tensions are a major source of pain here. A period of trade stability combined with cuts to monetary policy would help stabilize business confidence. However, with each passing month where business confidence erodes and investment intentions become sidelined, the biggest concern becomes one in which the global economy is on a moving train that cannot be easily halted by the central bank.