Dollars and Sense

Searching for the Bottom 

Beata Caranci, SVP & Chief Economist | 416-982-8067

James Orlando, CFA, Senior Economist | 416-413-3180

Date Published: April 25, 2019

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Highlights

  • We knew that the first quarter would be a rough ride for global economic data, ultimately becoming the make-or-break period for momentum. Nearly four months in, and we are landing on the side of “make” amidst early signs of a bottom forming. 
  • Chinese stimulus and a united front by central banks on stating a dovish tone helped ease financial conditions and stabilizing measures of confidence.
  • We do not expect the Federal Reserve to raise rates, but the markets may still be leaning a bit too dovish in their pricing of yields and the policy rate.
  • The Bank of Canada has echoed our view to keep the policy rate at 1.75%; we think this setting will be a “long game” with an economy that needs firmer footing. For the Canadian dollar, there isn’t a lot of scope for a sustained upward push. It will likely remain range-bound between 73 and 77 U.S. cents, which is where it has been since late last year.

Since the closing months of 2018, we noted that the first quarter of 2019 would be make-or-break for the global economy. The slowdown that took root was a reflection of overlapping event risks colliding with mature business cycle dynamics. Financial market volatility set in play rampant talk of recession, which risked undermining business and household confidence. Fortunately, improved financial conditions are now being followed by early signs of stabilization in the economic data that are closing out the first quarter. Even though the data are not blowing our socks off, we’ll settle for a bottom forming in economic momentum. 

Stable growth is enough to push risk assets higher

Table 1: Central Banks 2019 Real GDP Forecasts
  Tightening Bias "Patience"
  6 months prior 3 months prior Today
U.S. (Q4/Q4) 2.5 2.3 1.9
Canada 2.1 1.7 1.2
ECB/European Commission 1.8 1.7 1.1
Bank of England 1.8 1.7 1.2
Source: Central Banks      

Overall sentiment towards risk assets has improved due to two main factors. The first was an easing in negative economic data surprises, and the second was the quick response by major central banks towards a dovish tilt (Table 1).

By the time March economic data began to roll in, a handful of key leading indicators, like manufacturing sentiment, offered some confidence in stabilization. At the same time, the service side of major advanced economies proved solid, as did labor markets. Importantly, there are two call-outs on this front. When the going gets tough, China gets going on fiscal stimulus. A large injection of stimulus has underpinned market confidence that it’s only a matter of months before real economic activity responds in kind. In turn, this will help shore up global trade flows. Across the pond, the U.S. economy was defiant in the face of negative market sentiment. The tracking for real GDP growth in the first quarter is coming in at around 2.5%. This is more than double initial estimates, despite a number of negative temporary factors hitting the quarter, such as a lengthy government shutdown and weather disruptions. The consumer was not in fine form, but did make a late-quarter appearance that will help propel economic momentum again towards the 2% mark in the second quarter. 

Chart 1: Equities jumping with dovish monetary policy

Market sentiment received a second boost from the decisive action of central banks, led by the Federal Reserve, to respond to deteriorating sentiment by putting future rate hikes on ice. This monetary support spurred risk taking, evidence by an S&P 500 Index that is now at a record high (Chart 1) and corporate credit spreads that have dropped below their average since 2010. 

Not only did the Federal Reserve use forward guidance to remove any market pricing for higher interest rates, it also announced an earlier end to the normalization of its balance sheet. Several Fed members went further in also hinting an openness to cutting interest rates. The U.S. 10-year Treasury yield responded by dropping to 2.34% on March 28th, causing the yield curve to invert against the 3-month yield. This held for no more than a handful of days. Given the yield curve’s strong track record of predicting recessions, its inversion captured significant market attention. However, a look back at history shows that inversions need staying power to have predictive power. In the U.S. and Canada, the yield curve has inverted for short periods (of less than a week) and not resulted in a recession on several occasions. The better recession signal occurs on yield inversions over the course of months.

The direction of bond yields

Chart 2: Market pricing for U.S. inflation stabilizing

Nonetheless, the Federal Reserve’s dovish tilt has prompted market participants to believe that the next move in the policy rate will be a cut. We view this as premature. In our view, the current level of the policy rate is right around the neutral level. If economic growth continues to stabilize as our tracking implies, then the Federal Reserve has got it right on rates just as they are. On the inflation front, market based measures have clearly bottomed (Chart 2) and with wages increasing above 3% on average, we forecast that core measure of inflation will begin to improve in the next couple of months. As the data begin to confirm this trend, market pricing for the policy path and inflation should unwind the pricing for a cut and offer some slight upside for Treasury yields. We maintain our year-end target of roughly 2.85% for the 10-year Treasury yield. 

A sustained break above this mark would likely need a few conditions to materialize. Importantly, inflationary pressures would have to become significantly more threatening. By extension, economic momentum would have to heat up much more than we are currently expecting. Likewise, global risks would need to recede. Europe is front and center in our minds. With Italian bank weakness, populist disruptions in France, and Germany’s dependence on trade flows, growth in Europe is treading water. It would not take much of a data miss to undermine confidence once again in the region’s prospects. And, it may get worse for them yet. As progress occurs with U.S./China trade talks, the U.S. Administration is now lining Europe and Japan within its sights as the next target. China had the luxury of high growth during the tit-for-tat tariff inflictions, which is not afforded to the economies of either Europe or Japan. Lingering economic threats will ultimately cap the upside for yields globally.  

Taking Canada’s pulse

The Canadian economy has also showed some signs of stabilization. The first quarter was a blow-out in terms of job creation, even with the slight pull back that occurred in March. China’s fiscal stimulus announcements have caused a rebound in broader commodity prices. Likewise, Alberta’s initiatives to narrow oil spreads via production curtailments have proven successful, alongside a rebound in oil prices more broadly due to global developments. Lastly, the Bank of Canada has tempered investor nerves. It too followed in the footstep of the Federal Reserve by tilting to a more dovish stance and downgrading the outlook in alignment to the reality of the data. Government yields have subsequently dropped and mortgage rates are starting to follow. This will help highly levered Canadian households, particularly as the housing market remains stuck in a cooling pattern. 

Chart 3: CAD stuck between oil and yield spreads

For the Canadian dollar, there isn’t a lot of scope for a sudden upward push. It has been largely range-bound between 73 and 77 U.S. cents since last summer. Several dominant factors play into why this is the case. In a typical econometric model, a handful of variables capture the bulk of the movement of the loonie. These are energy prices, U.S.-Canada yield spreads, and the market’s perception of risk. When movements in these variables fail to largely “explain” changes in the value of the dollar, the residual gets larger, indicating that there’s more going on than meets the eye. Over the last few months, there have been offsetting push and pull forces coming from the main variables. Commodity prices and risk-on sentiment have supported the loonie, while yield spreads have pushed against this dynamic (Chart 3). More interestingly, the residual has captured a greater-than-usual amount of significance. We suspect this is likely due to political risk and related economic uncertainty, stemming from both the international front, as well as domestic issues related to developments in the energy sector. So just like we think there’s some, but limited, upside to yields, the same holds true on the Canadian dollar, as long as U.S.-Canada interest rate spreads remain constrained (and we think it will) and geopolitical risks remain in play.

Bottom Line

The global economy is starting to show signs of improvement. This is good news, but it’s premature to get excited given its early days and now the test will be on evidence that momentum can indeed strengthen into the second half of this year. Despite firming economic momentum, the multitude of significant global risks will likely continue to limit the degree to which bond yields can make any significant headway.  

Tables

Interest Rate Outlook
  Spot Rate 2018 2019 2020
  Apr-24 Q1 Q2 Q3 Q4 Q1 Q2F Q3F Q4F Q1F Q2F Q3F Q4F
CANADA                
Overnight Target Rate  1.75 1.25 1.25 1.50 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75
3-mth T-Bill Rate  1.68 1.10 1.26 1.59 1.64 1.67 1.65 1.65 1.70 1.75 1.75 1.75 1.75
2-yr Govt. Bond Yield  1.51 1.77 1.91 2.21 1.86 1.55 1.65 1.75 1.80 1.85 1.85 1.85 1.85
5-yr Govt. Bond Yield  1.49 1.96 2.06 2.33 1.88 1.52 1.70 1.80 1.90 1.95 1.95 1.95 1.95
10-yr Govt. Bond Yield  1.68 2.09 2.17 2.42 1.96 1.62 1.80 1.90 2.00 2.10 2.10 2.10 2.10
30-yr Govt. Bond Yield  2.00 2.23 2.20 2.42 2.18 1.89 2.05 2.15 2.25 2.35 2.35 2.35 2.35
10-yr-2-yr Govt Spread 0.16 0.32 0.26 0.21 0.10 0.07 0.15 0.15 0.20 0.25 0.25 0.25 0.25
U.S.                 
Fed Funds Target Rate  2.50 1.75 2.00 2.25 2.50 2.50 2.50 2.50 2.50 2.50 2.50 2.50 2.50
3-mth T-Bill Rate  2.37 1.70 1.89 2.15 2.40 2.35 2.40 2.40 2.40 2.40 2.40 2.40 2.40
2-yr Govt. Bond Yield  2.32 2.27 2.52 2.81 2.48 2.27 2.45 2.50 2.50 2.50 2.50 2.50 2.50
5-yr Govt. Bond Yield  2.31 2.56 2.73 2.94 2.51 2.23 2.50 2.60 2.60 2.60 2.60 2.60 2.60
10-yr Govt. Bond Yield  2.52 2.74 2.85 3.05 2.69 2.41 2.70 2.75 2.85 2.85 2.85 2.85 2.85
30-yr Govt. Bond Yield  2.94 2.97 2.98 3.19 3.02 2.81 2.95 3.00 3.10 3.10 3.10 3.10 3.10
10-yr-2-yr Govt Spread 0.20 0.47 0.33 0.24 0.21 0.14 0.25 0.25 0.35 0.35 0.35 0.35 0.35
CANADA - U.S SPREADS                          
Can - U.S. T-Bill Spread -0.70 -0.60 -0.63 -0.56 -0.76 -0.68 -0.75 -0.75 -0.70 -0.65 -0.65 -0.65 -0.65
Can - U.S. 10-Year Bond Spread -0.84 -0.65 -0.68 -0.63 -0.73 -0.79 -0.90 -0.85 -0.85 -0.75 -0.75 -0.75 -0.75
F: Forecast by TD Economics, April 2019; Forecasts are end-of-period. 
Source: Bloomberg, Bank of Canada, Federal Reserve.
Global Stock Markets
  Price 30-Day YTD 52-Week 52-Week
  Apr-24 % Chg. % Chg.  High Low
S&P 500 2,927 4.5 16.8 2,934 2,351
S&P/TSX Composite 16,587 3.1 15.8 16,669 13,780
DAX 12,313 8.4 16.6 13,170 10,382
FTSE 100 7,472 3.7 11.1 7,877 6,585
Nikkei 22,200 2.6 10.9 24,271 19,156
MSCI AC World Index* 525 3.7 15.1 528 436
*Weighted equity index including both developed and emerging markets. 
Source: Bloomberg, TD Economics.

Commodity Price Outlook
  Price 52-Week 52-Week 2018 2019 2020
  Apr-24 High Low Q1 Q2 Q3 Q4 Q1 Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Crude Oil (WTI, $US/bbl) 66 76 42 63 68 70 59 55 62 60 62 64 65 65 66
Natural Gas ($US/MMBtu) 2.53 4.80 2.53 3.08 2.86 2.93 3.80 2.92 2.70 2.70 2.60 2.50 2.51 2.53 2.54
Gold ($US/troy oz.) 1275 1341 1174 1329 1306 1213 1229 1303 1325 1350 1375 1375 1375 1425 1425
Silver (US$/troy oz.) 14.94 17.17 14.00 16.74 16.56 15.02 14.58 15.58 17.00 17.25 17.50 18.00 18.00 18.75 18.75
Copper (cents/lb) 290 333 259 316 312 277 280 282 284 293 293 302 302 311 311
Nickel (US$/lb) 5.62 7.14 4.85 6.01 6.56 6.02 5.21 5.60 6.01 6.06 6.10 6.12 6.35 6.58 6.58
Aluminum (Cents/lb) 85 107 82 98 102 93 89 84 90 93 93 95 100 99 99
Wheat ($US/bu) 6.19 7.98 6.03 7.42 7.46 6.70 6.85 7.08 6.50 6.83 7.03 7.06 7.08 7.11 7.14
F: Forecast by TD Economics, April 2019; Forecast are period averages; E: Estimate. 
Source: Bloomberg, USDA (Haver).
Foreign Exchange Outlook
Currency Exchange
rate
Spot Price 2018 2019 2020
Apr-24 Q1 Q2 Q3 Q4 Q1 Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Exchange rate to U.S. dollar                          
 Chinese Yuan CNY per USD 6.72 6.27 6.62 6.87 6.88 6.71 6.80 6.80 6.80 6.80 6.80 6.80 6.80
 Japanese yen JPY per USD 112 106 111 113 110 111 109 108 107 106 105 105 104
 Euro USD per EUR 1.12 1.23 1.17 1.16 1.15 1.12 1.14 1.14 1.15 1.16 1.17 1.18 1.19
 U.K. pound USD per GBP 1.29 1.40 1.32 1.31 1.28 1.30 1.31 1.32 1.33 1.34 1.35 1.36 1.37
 Swiss franc CHF per USD 1.02 0.95 0.99 0.98 0.98 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
 Canadian dollar CAD per USD 1.35 1.29 1.31 1.29 1.36 1.34 1.33 1.33 1.33 1.33 1.32 1.32 1.31
 Australian dollar USD per AUD 0.70 0.77 0.74 0.72 0.71 0.71 0.71 0.71 0.72 0.73 0.73 0.73 0.73
 NZ dollar USD per NZD 0.66 0.72 0.68 0.66 0.67 0.68 0.68 0.69 0.70 0.71 0.71 0.71 0.71
Exchange rate to Euro                          
 U.S. dollar USD per EUR 1.12 1.23 1.17 1.16 1.15 1.12 1.14 1.14 1.15 1.16 1.17 1.18 1.19
 Japanese yen JPY per EUR 125 131 129 132 126 124 124 123 123 123 123 123 124
 U.K. pound GBP per EUR 0.86 0.88 0.89 0.89 0.90 0.86 0.87 0.86 0.87 0.87 0.87 0.87 0.87
 Swiss franc CHF per EUR 1.14 1.17 1.16 1.13 1.13 1.12 1.14 1.14 1.15 1.16 1.17 1.18 1.19
 Canadian dollar CAD per EUR 1.50 1.59 1.53 1.50 1.56 1.50 1.52 1.52 1.53 1.54 1.54 1.55 1.56
 Australian dollar AUD per EUR 1.59 1.60 1.58 1.61 1.63 1.58 1.61 1.61 1.60 1.59 1.60 1.62 1.63
 NZ dollar NZD per EUR 1.69 1.70 1.72 1.75 1.71 1.65 1.68 1.65 1.64 1.63 1.65 1.66 1.68
Exchange rate to Japanese yen                          
 U.S. dollar JPY per USD 112 106 111 113 110 111 109 108 107 106 105 105 104
 Euro JPY per EUR 125 131 129 132 126 124 124 123 123 123 123 123 124
 U.K. pound JPY per GBP 145 149 146 148 140 144 143 143 142 142 142 142 142
 Swiss franc JPY per CHF 110.0 111.4 111.6 116.3 111.6 111.1 109.4 108.4 107.4 106.4 105.4 104.9 104.4
 Canadian dollar JPY per CAD 83.2 82.4 84.3 87.8 80.4 82.8 82.0 81.2 80.5 80.0 79.5 79.5 79.4
 Australian dollar JPY per AUD 78.7 81.7 81.9 82.1 77.3 78.6 77.4 76.7 77.0 77.4 76.7 76.3 75.9
 NZ dollar JPY per NZD 74.0 76.9 75.0 75.3 73.6 75.5 74.1 74.5 74.9 75.3 74.6 74.2 73.8
Exchange rate to Canadian dollar                          
 U.S. dollar USD per CAD 0.74 0.78 0.76 0.77 0.73 0.75 0.75 0.75 0.75 0.76 0.76 0.76 0.76
 Japanese yen JPY per CAD 83.2 82.4 84.3 87.8 80.4 82.8 82.0 81.2 80.5 80.0 79.5 79.5 79.4
 Euro CAD per EUR 1.50 1.59 1.53 1.50 1.56 1.50 1.52 1.52 1.53 1.54 1.54 1.55 1.56
 U.K. pound CAD per GBP 1.74 1.81 1.73 1.69 1.74 1.74 1.74 1.76 1.77 1.78 1.78 1.79 1.80
 Swiss franc CHF per CAD 0.76 0.74 0.76 0.76 0.72 0.75 0.75 0.75 0.75 0.75 0.75 0.76 0.76
 Australian dollar AUD per CAD 1.06 1.01 1.03 1.07 1.04 1.05 1.06 1.06 1.04 1.03 1.04 1.04 1.05
 NZ dollar NZD per CAD 1.13 1.07 1.12 1.17 1.09 1.10 1.11 1.09 1.07 1.06 1.07 1.07 1.08
F: Forecast by TD Economics, April 2019; Forecasts are end-of-period. 
Source: Federal Reserve, Bloomberg.
International Interest Rates Outlook
  Spot Rate 2018 2019 2020
  Apr-24 Q1 Q2 Q3 Q4 Q1 Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Germany                          
ECB Deposit Rate -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.25 -0.25 -0.25
3-mth T-Bill Rate  -0.52 -0.79 -0.65 -0.58 -0.84 -0.55 -0.50 -0.50 -0.50 -0.43 -0.35 -0.35 -0.23
2-yr Govt. Bond Yield  -0.59 -0.62 -0.67 -0.53 -0.62 -0.61 -0.57 -0.50 -0.42 -0.33 -0.12 0.07 0.23
5-yr Govt. Bond Yield  -0.43 -0.11 -0.30 -0.09 -0.32 -0.46 -0.13 0.00 0.24 0.44 0.64 0.84 1.02
10-yr Govt. Bond Yield  -0.01 0.49 0.30 0.47 0.24 -0.07 0.30 0.50 0.90 1.20 1.40 1.60 1.80
30-yr Govt. Bond Yield  0.63 1.15 1.02 1.08 0.87 0.57 1.05 1.35 1.55 1.75 1.95 2.15 2.35
10-yr-2-yr Govt Spread 0.58 1.11 0.97 1.00 0.86 0.54 0.87 1.00 1.32 1.53 1.52 1.53 1.57
United Kingdom                      
Bank Rate 0.75 0.50 0.50 0.75 0.75 0.75 0.75 0.75 0.75 1.00 1.00 1.25 1.25
3-mth T-Bill Rate  0.77 0.51 0.59 0.75 0.70 0.75 0.75 0.75 0.88 1.00 1.13 1.25 1.38
2-yr Govt. Bond Yield  0.76 0.81 0.71 0.82 0.73 0.64 0.88 1.10 1.26 1.42 1.57 1.73 1.88
5-yr Govt. Bond Yield  0.90 1.11 1.03 1.17 0.90 0.69 1.26 1.48 1.65 1.83 2.01 2.19 2.37
10-yr Govt. Bond Yield  1.18 1.35 1.28 1.44 1.14 0.99 1.65 1.85 2.05 2.25 2.45 2.65 2.85
30-yr Govt. Bond Yield  1.71 1.71 1.74 1.91 1.82 1.55 2.00 2.20 2.40 2.60 2.80 3.00 3.00
10-yr-2-yr Govt Spread 0.42 0.54 0.57 0.62 0.41 0.35 0.77 0.75 0.79 0.83 0.88 0.92 0.97
F: Forecast by TD Economics, April 2019; Forecasts are end-of-period. 
Source: Bloomberg.

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