Date Published: September 21, 2017
French version available here.
There seems to be no stopping Canada of late. Robust growth of 3.7% (annualized) in the first quarter was followed by an eye-popping 4.5% expansion in the April-June period. What’s more, the higher frequency data again point to an economy likely to maintain above-trend growth in the second half of the year (Chart 1). Accordingly, we have further bumped up our GDP growth forecast for 2017 to 3.1% (from 2.8% previously). Given the Bank of Canada’s emphasis on data evolution and dwindling economic spare capacity, we believe the central bank will continue to remove monetary stimulus. The policy interest rate is expected to reach to 1.50% by early next year, before a longer pause to evaluate the effects.
Economies can only grow above their natural running-speed for so long, and Canada is no exception. Growth is expected to moderate to a still-respectable 2.1% in 2018 and decelerate to roughly its trend pace, growing 1.7% in 2019. Getting from here to there is not guaranteed to be a smooth process. There are many risks that can throw the growth trajectory off track, including NAFTA renegotiation, the evolution of key housing markets, and the response of indebted Canadians to rising borrowing costs.
A complete U-turn has taken place at the Bank of Canada since the spring. A neutral-to-dovish tone of communication around the outlook for monetary policy rapidly gave way to a hawkish bent, resulting in hikes at both the July and September decisions. The latter increase, which brought the overnight rate to 1.00%, is notable for the signal it sends: it occurred at a meeting with no press conference or updated forecast. This is not terribly unusual, but is a break from the post-crisis experience, and the communication style conveyed by other central banks. Within a six-week period between Bank of Canada policy meetings, there were no speeches or other public communication. It was this element that resulted in a surprise-factor for financial market participants, rather than whether the rate-hike itself was justified. Bond yields and the Canadian dollar took flight. The only question now is whether consumers are getting the message to ease up on spending, which ran at a 5% pace through the first half of the year – the likes of which has not been seen since the early 2000s.
In addition to a growing unease about excessive borrowing by households, policymakers are signalling concern that a significant inflationary impulse could make an appearance down the road, in light of the recent and rapid absorption in economic slack. Our research suggests that inflation is being weighed down by a number of structural factors that are unlikely to abate quickly. What’s more, the recent run-up of the Canadian dollar introduces another counterweight to the demand-pull forces that come from an absence of economic slack. With core inflation forecast to make only gradual progress towards to the 2% target in the coming quarters, the Bank of Canada is likely to move more slowly in removing stimulus beyond Q1 2018.
Canadian economic growth has not just defied expectations of its strength, but also the source. Consumers are in the driver’s seat (Chart 2), propelled by healthy job market gains across much of the country and modest, but improving, wage gains. If this was the sole explanation, then we would have more comfort with the risks around the baseline forecast. But, these influences alone do not fully explain the magnitude of strength over the first half of the year. We believe the ‘wealth effect’ of past gains in housing and other wealth (alongside low borrowing costs) is having an outsized impact on consumer behavior, beyond historical experiences.
By our estimates, this wealth effect may have accounted for as much as 2 percentage points of the 5% annualized growth-surge in household spending in the first half of 2017. A look at the regional landscape adds credence to this view. In Ontario, where home price gains have been the hottest over the past few years, retail sales gains have surpassed the national average despite job gains that have largely run in line (or slightly below) average.
The slowdown in housing activity in Ontario – which began this spring following the implementation of the provincial government’s Fair Housing Plan – is thus a significant game changer. Importantly, the adjustment in home prices in the region is not expected to lead to a broader financial distress among households (see report), and offsets reside in other parts of the country that continue to enjoy rising home valuations, alongside tightening labour markets. But, the spending-impulse from the wealth effect in Ontario, and also B.C., is destined to fade with time, particularly when combined with higher borrowing costs. This should reconnect consumption behaviour with income and job fundamentals. Ultimately, this supports spending growth of roughly 2% through the forecast, which is healthy by most standards.
Headwinds to exports may be tailwinds to investment
The Bank of Canada’s one-two punch on interest rates may be a vote of confidence on the economic fundamentals, but it has come with a currency that strengthened roughly 7% on a trade-weighted basis from the lows seen earlier this year. While some of this strength is likely to be reversed over 2018 and 2019 as central banks in other advanced economies (U.S. and Europe) tighten monetary policy, it will serve as a near-term headwind to an already challenged export sector. Consequently, we have revised down the outlook for net trade.
It goes without saying that as a relative price, moves in the currency aren’t universally negative. For firms looking to expand or update their (often imported) capital stock, a stronger dollar can help make the decision easier, particularly for industries that tend to have a relatively larger domestic customer base. At the same time, manufacturing capacity utilization rates ticked up to pre-crisis levels in the most recent data, and momentum in investment-related categories of output, such as capital goods production and imports remains healthy. Resource investment is also expected to continue its gradual recovery from the commodity price shock in 2014/15. All of this paints a backdrop supportive of ongoing strength in business investment, which is expected to contribute positively to overall growth in 2017 – the first time in two years (Chart 3).
Any forecast will carry uncertainty and risks. In addition to risks around NAFTA negotiations and a number of large housing markets, the path for consumer spending is notably uncertain. On the plus side, its performance so far this year and the relative difficulty of quantifying the impact of wealth effects may imply more near-term strength than expected. The converse can also be true. There is also uncertainty surrounding how highly indebted households will react to rising borrowing costs – examples of ‘goldilocks’ deleveraging episodes are few and far between. That said, such a scenario is clearly top of mind for the Bank of Canada, which has indicated that it will take this rate sensitivity (and the impact on the currency) into account in setting monetary policy.
The Federal Reserve took yet another step to remove monetary accommodation this month with the start of balance sheet normalization. It was a widely expected announcement, but an important one for Treasury yields, mortgage rates, and deposits in the banking system (see report). Nonetheless, fixed income markets shrugged off the news and Treasury yields remain at the low end of our fair value range. After four rate hikes and now a reduction of reinvestment of maturities, long maturity Treasury yields are around the same level today as when the Fed started its normalization process.
The paradox of low Treasury yields amidst rising rates can be explained by a couple of factors. The first is an adjustment lower in expectations for future fed policy. Recent weakness in inflation (notwithstanding nascent signs of an upturn in August) have pushed down expectations for the pace of rate hikes and kept downward pressure on the anticipated terminal fed funds rate.
What is more, some of the market’s pricing of future rate hikes is building in the risk of an economic downturn. With the economic expansion now heading into its 9th year, the risk of a turn in the business cycle is influencing the market’s pricing of future policy rates.
The second factor weighing on yields is a low term premium – the compensation investors demand for holding longer-term Treasuries, instead of rolling over shorter-term debt. This is currently negative and implies no compensation for interest rate risk. Low inflation is also a factor here. Typically, interest rate risk is dependent on risks to an inflation overshoot. With inflation disappointing policy makers the world over, investors appear to see little risk of a sudden move higher in inflation and are, therefore, demanding very little in the way of compensation.
A third factor weighing on term premiums is the still-high level of demand for U.S. Treasuries as a result of quantitative easing (QE). This is where the Fed’s normalization process will matter. As the Fed slows its pace of reinvestments and allows maturing securities to run off its balance sheet, the fall in demand will abate the downward pressure on the term premium.
For the first time in a long time, the balance of risks around these three forces are all conspiring in the same direction – to pressure yields higher. Despite the market rumors, the Phillips curve is not dead, just a little sleepy. Our research suggests that the relationship between economic slack and inflation is smaller and more drawn out than in the past, but certainly still exists (see report). As long as labor markets continue to tighten, inflation should grind higher. As it does, the two factors weighing on current yields – diminished expectations for future fed policy and compensation for inflation risk – will begin to move higher.
All of this will impact foreign exchange markets. While markets over the last two years have serially underpriced the Fed, less dovish commentary from the ECB, as well as outright hawkishness from the Bank of Canada and Bank of England, have caused sovereign yield convergence with Treasuries. Consequently, major currencies are up around 10% versus the U.S. dollar (Chart 10). These major currencies have a lot of optimism built into them and could be vulnerable when the Fed reasserts itself over the coming quarters. Unfortunately, in the near-term, the data will be noisy due to Hurricane Harvey and Irma effects, and this may keep financial market expectations remaining in the shadows longer than is otherwise warranted. We believe the Fed is still prepared to hike one more time before the year is out, but markets will need some convincing.
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|Commodity Price Outlook|
|Canadian Economic Outlook|
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|Global Economic Outlook|
|Economic Indicators: G7 and Europe|
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