Fixed income markets have seen some big swings in recent months, as markets recalibrate the new normal on long-term bond yields. The 10-Year U.S. Treasury yield hit a 16-year high in October driven largely by a repricing of the term premium. Yields have since come off their highs but are still contributing to tighter financial conditions and doing some of the Fed's heavy lifting. Even so, the U.S. economy is the poster child for resilience. A slowdown is inevitable, but economic outperformance to peers is likely to remain a key theme. In contrast, the Canadian economy is showing clear signs of running out of steam as higher interest rates bite into housing and a more highly leveraged household. Unfortunately, inflation has not gotten the memo, presenting a particular challenge for the Bank of Canada against a weakening economic backdrop. This has left the door open for further rate hikes. We doubt the Bank of Canada will walk through it but still think the possibility cannot be dismissed by the Federal Reserve just yet. We explore these themes in our latest list of questions, while tackling other topics such as renewed geopolitical instability.
- Q1. What does renewed geopolitical instability mean for commodities and the economic outlook?
- Q2. What has driven global bond yields over the last few months?
- Q3. The new question for the Federal Reserve: how long to keep rates high?
- Q4. Why is the U.S outperforming its peers?
- Q5. Is Canada already in a recession?
- Q6. How will Canadian consumers fare under the weight of higher rates?
- Q7. Is Canada headed for an even bigger housing price correction?
- Q8. How is the leg higher in interest rates going to effect U.S. real estate?
- Q9. How much gas does the U.S. consumer have left in the tank?
- Q10. Is inflation slowing similarly in Canada and the U.S.?
Q1. What does renewed geopolitical instability mean for commodities and the economic outlook?
However, the global landscape has certainly become a more difficult space to navigate under the weight of another war. The human toll of the conflict in Israel and Gaza is heart-wrenching, but thus far the economic impacts for the global economy have been limited. Geopolitical instability in the region typically propagates to the global economy through oil markets and a rise in the risk premium on prices. On this point, after initially spiking, oil prices have faded as diplomatic efforts have helped to limit the escalation of violence to surrounding regions. In fact, oil markets have returned to prioritizing a slowdown in economic momentum within advanced economies as the primary driver of oil prices, pushing momentum back down to the mid-$70s level.
That said, the mere existence and persistence of the conflict raises the risk profile on oil and the global economic outlook (Chart 1). Escalation can take many forms, including a tightening of U.S.-imposed sanctions on Iranian oil exports all the way to a broader regional conflict restricting traffic in Strait of Hormuz – a thoroughfare for nearly 20% of the world's oil. In the event of a wider regional conflict, we estimate that oil prices could average over $110/barrel for a quarter (staying above $100 through much of next year). In turn, the supply side constraint would dominate the potential for weaker demand, and inflation would reaccelerate by more than 1 percentage point early next year.
Beyond oil, the broader commodity space should be relatively unaffected by the Israel-Hamas conflict. Commodities excluding oil have been range bound for the last few months, as investors try to gauge the outlook for next year. Global demand concerns continue to cap upside, while supply constraints and tight inventories provide a floor.
Q2. What has driven global bond yields over the last few months??
Even though the Federal Reserve hasn't raised its policy rate since July, the U.S. 10-year Treasury yield continued to rise over the subsequent months, ultimately hitting a 16-year high of 5% in October (from 4% in July). Yields have retraced some of that increase, but remain elevated. This has kept many investors cautious that another lurch higher could dash hopes for a soft landing.
Where yields are headed depend on two main drivers: (1) the expected path of the Fed's policy rate and (2) the term premium for locking into fixed payments. Between when the Federal Reserve first started hiking its policy rate in early 2022 to when it last hiked, the 10-year Treasury yield rose by over 200 basis points (bps). The shift higher in the expected path of the fed funds rate (higher for longer) accounted for nearly all of this rise. But since July, the expected path for the Fed has stabilized, while the term premium has taken over as the driver of the 10-year yield (Chart 2).
Term premiums rise when investors judge there is greater upside risk on the future trajectory of the long bond yield. These could include perceptions around higher inflation volatility, unexpected rate hikes by the Fed, or even the default risk of the U.S. government. While it is impossible to know which of these factors have played the biggest part in lifting the term premium in recent months, we believe all are in play and offer a logical foundation.
This is one reason why our yield forecast has increased over the last year. We still think that the Fed will have to cut rates in 2024, which will lower the expected path of the fed funds rate, but the term premium risks will remain. Likewise, although the central bank will maintain a commitment to anchoring inflation at 2%, the geopolitical landscape has shifted the economic paradigm to create more inflation and interest rate volatility than in the years prior to 2019. This includes factors like the rotation of global supply chains in response to wars, climate transition implementation, and other security priorities. Combine that with the unsustainable path of U.S. government finances, and higher premiums for committing to Treasuries on a long term basis are likely to keep yields elevated relative to recent history (see report).
Q3. The new question for the Federal Reserve: how long to keep rates high?
When the Federal Reserve updated its economic forecast in September, it made waves with its higher for longer expectation for the policy rate. Not only did it anticipate that it would hike rates again by year-end, but it also pointed to a 5%+ policy rate through next year. Since then, Fed members have shown less urgency to follow through with another hike, but haven't backed away from the higher for longer rhetoric. As we have been arguing regularly, this hawkish talk is necessary to prevent a premature easing in financial conditions.
This is even more important now that the economy has been accelerating over the last few months. Consumer spending has defied even the most optimistic of expectations, causing us to upgrade the near-term forecast. The Fed has commented that inflation has eased off peak levels, despite a resilient economy, but it does leave the question open on whether inflation can get all the way back to the central bank's target of 2% if demand growth again outstrips expectations and pressures the economy's capacity. At this juncture, the Fed could still justify another hike within the next few months if financial conditions loosen more than their preference. After that, the path for policy will depend on whether the economy can show that interest rates are working to dramatically lower employment gains, which is still deemed a necessary condition to sustain inflation at 2%. We penciled in that timing for the second half of 2024, envisioning a policy rate ending the year at roughly 4.75%. This would leave it in restrictive territory, with the bulk of rate cuts on the path of normalization slated for 2025 (Chart 3).
The more elongated window does not exist for the Bank of Canada. GDP has already flatlined since the spring, led by weakness in consumer spending, the real estate market, and a cooling in the labour market. The structure of Canada's mortgage market makes it more interest rate sensitive than its neighbour to the south, and that's exactly what's playing out. Canadian economic underperformance and a lagging BoC policy rate will continue to widen Canadian interest rate differentials against their U.S. equivalents. In turn, the loonie may yet come under more downside pressure over the coming quarters.
Q4. Why is the U.S outperforming its peers??
The U.S. economy expanded by a blistering 4.9% quarter-over-quarter (annualized) in the third quarter and is on track to grow by 2.4% for 2023 as a whole. This will far surpass any of its G7 peers, and essentially matches its 2019 performance despite having a federal funds rate 2.5 times higher. There are a few actors underpinning this outperformance. The first and most significant is a Teflon consumer. In two of the last three quarters, consumer spending expanded by just under 4% or roughly double the pace of trend growth. Households continue to unwind excess savings, complimented by healthy wage growth in a historically tight labor market (see question 9 for more detail). In fact, a recent paper published by the Federal Reserve shows both the degree of accumulation and subsequent drawdown of excess savings has been far greater in the U.S. than most other advanced economies. The U.S. implemented some of the largest fiscal support measures during the pandemic and was also one of the only G7 countries to send direct payments to households, irrespective of whether their employment situation was impacted by the pandemic (Chart 4). This windfall for households has cushioned the blow from high inflation and rising borrowing costs.
U.S. households have also benefited from the fact that their mortgage structure is very different than most of its peers. Because American's tend to lock-in to a 30-year fixed rate mortgage in great numbers, homeowners have been insulated from higher interest rates. Mortgage debt accounts for two-thirds of overall household debt holdings. Moreover, it is estimated that 14 million borrowers – or one-third of the outstanding mortgage balances –refinanced between Q2 2020 and Q4 2021 at ultra low rates. In addition to lowering their monthly mortgage payments, borrowers also used refinancing as a tool to cash in on the equity in their homes, freeing up money to spend. The story is very different across other advanced economies, where debt burdens are higher and mortgages tend to reset more frequently, thereby exposing homeowners to higher interest costs earlier in the business cycle to create a more meaningful headwind to household spending.
Beyond the consumer, business investment has remained surprisingly resilient through the tightening cycle. Much of this is due to generous incentives in legislation enacted in late-2022 aimed at greening the economy, reshoring the production of semiconductors, and improving America's infrastructure (see report). While other countries have also implemented tax incentives and subsidies to compete in similar areas, they have not rivaled the lucrative incentives offered in the United States.
These initiatives don't prevent interest rates from working, but do slow down its transmission, creating longer and more variable lags relative to past cycles. In fact, there are some signs of late-stage dynamics playing out. Specifically, household financial strain is becoming evident in rising delinquency rates across products while more workers seek multiple jobs. In addition, the pricing power of firms is waning, with more noting difficulty in passing on higher costs at a time when labor input costs remain elevated. This squeeze on corporate profit margins should intensify over the coming quarters, acting as a catalyst for a more pronounced slowing in hiring activity and upward pressure on the unemployment rate. Economic growth is expected to slow to 1.4% in 2024, before returning to a trend pace of growth of 1.8% in 2025.
Q5. Is Canada already in a recession?
It's common for analysts to cite an economy in recession when there are two back-to-back quarterly GDP contractions. And Canada may, in fact, produce this outcome when the third quarter data is released at the end of this month. However, the country would still not be in recession. Three conditions need to be met: depth, breadth, and duration. In terms of depth, growth came in at -0.2% quarter-on-quarter annualized in Q2 2023 and is tracking close to zero in Q3. Small negative prints for GDP growth are statistically insignificant, and can easily be revised away in subsequent months. At the same time, employment has been growing at +26k jobs per month. The economy isn't in a recession when it is generating net new jobs. The weak GDP prints are partly capturing idiosyncratic factors such as wildfires and strikes rather than recession.
The second factor is breadth. This too speaks to the importance of economic weakness seeping into the labour market. But even here, historical context is helpful. In 2015, falling oil prices caused a massive hit to employment in western Canada. GDP contracted for two straight quarters. This still wasn't marked as a recession because the shock didn't spread to other provinces. Right now, 50% of industries, which account for 60% of the total economy, have seen positive GDP growth since the start of Q2. Over that same time, 60% of industries are adding jobs. In a recession, this share typically drops to just 20%.
The last factor is duration. Yes, there have been two quarters of weak economic growth. No argument there. But two quarters of weak growth is not the same as two quarters of significantly negative growth that impacts a large group of industries. Depth and breadth requirements are often met before duration comes into scope.
Although Canada isn't in recession, it is definitely showing weakness and the risk cannot be dismissed for 2024. Already, there is little margin for error within our forecast with GDP growth of 0.5% in 2024, a sharp mark-down from an already weak pace of 1.2% this year.
Q6. How will Canadian consumers fare under the weight of higher rates?
More so than their U.S. neighbours, Canadian consumers are feeling the pinch from higher interest rates. Consumer spending slowed to stall speed in the second quarter. This was partly due to various special factors, but the third quarter is not raising our hopes for a rebound (Chart 5). Heavily indebted Canadian consumers have reacted strongly to higher borrowing costs, slowing their pace of borrowing to around 3% annualized in recent months (Chart 6). Apart from a brief period early in the pandemic, that is the slowest pace of debt growth since the early 1980s.
Even though we expect interest rates to come off peak levels next year, it will likely be a slow descent (see question 2). The 38% of Canadian households with mortgages will continue to feel the impact of higher rates as their mortgages come up for renewal. According to the Bank of Canada, roughly 50% of mortgages that were initiated before interest rate hikes began will face rates that will be 1.5-3.5 percentage points higher than what they signed up for. For an average household with a mortgage, the cumulative increase in payments will be 28% by the end of 2024. We estimate that increased mortgage payments have already reduced real consumer spending by roughly 1.5% in 2023, and will shave an additional 0.1-0.4% per year between 2024 and 2027. This is a key factor behind our anemic outlook for consumer spending, which lags that of the U.S. over the medium term.
Still, without a deeper labour market downturn, the mortgage renewal cycle is unlikely to trigger an economic crisis. In addition, roughly 70% of all mortgages initiated in the past five years have been subjected to income stress test gives some confidence in this. Lastly, in contrast to their American counterparts, Canadians still have $140 billion in excess deposits in less liquid term products. This suggests that Canadians may have put money aside anticipating higher debt payments. Channeling these savings to offset any upcoming income shock would also soften the blow and support an orderly renewal cycle.
Q7. Is Canada headed for an even bigger housing price correction??
In September, our forecast called for Canadian average home prices to fall around 5% from their third quarter level through the early part of next year. We've had to magnify that drop to around 10%. There are two main culprits underpinning this change. The first is our upgraded bond yield forecast. The second is the larger-than-anticipated loosening in B.C.'s and Ontario's housing markets. Ontario's sales-to-new listings ratio has plunged to 39% in October from 63% in May (Chart 7). A sudden surge in supply is largely behind the deterioration in the ratio, abetted by a more prolonged drop in sales.
However, some perspective is warranted. A 10% decline in average home prices would still leave them 15% higher than pre-pandemic levels. Our expectation that the Bank of Canada will be cutting rates towards the end of the second quarter of next year prevents a steeper decline. In addition, robust population growth cushions the downside potential on prices. Lastly, Ontario's and B.C.'s experience is not that of Canada, where other provinces have benefited from tighter markets and better affordability. Most importantly, we expect job markets to bend (but not break) under the weight of high borrowing costs, underpinning demand and limiting forced selling.
The potential for weaker growth or higher-than-expected interest rates are important downside risks to the outlook. On the upside, there's the possibility that the 16% jump in new listings observed in Q3 unwinds by more than what's built into our forecast. In a scenario where new listings post a small decline through the first half of next year (compared to the modest gain we expect), Canadian average home prices would still fall, but the decline is about 1 percentage point shallower.
Q8. How is the leg higher in interest rates going to effect U.S. real estate?
The march higher in Treasury yields has pushed mortgage rates roughly 1 percentage point above where they were before the Fed's last hike in July. This resulted in existing home sales falling 2.7% between July and September, to a thirteen-year low. Affordability has deteriorated on the combination of higher mortgage rates, and the appreciation in housing prices over the past three years vastly outpacing income growth (Chart 8). Despite the draining effect this has had on demand, significant supply constraints are keeping prices elevated.
Many homeowners hold mortgages with rates that are nearly half the level of prevailing rates. This creates a financial barrier for those wishing to move, dampening listing activity. Unfortunately, relief is unlikely to come from the new homes market as residential construction has also been strained by high financing costs. Both single-family and multi-family housing starts have declined over the past few months, drifting to near pre-pandemic levels. While this would be good news for many other indicators, it is less positive for new housing supply given the population has grown by 2% since then, and resale listings are roughly 38% lower.
Although mortgage rates have fallen more recently, further downward movement is expected to be limited over the near term as the Fed seeks to guard against a rebound in inflation. This is expected to keep existing home supply low and new home construction constrained, ultimately allowing prices to sustain their gains for now. However, as the labor market softens through 2024, we expect prices to begin to capitulate, ending the year down 2.5% on a fourth quarter over fourth quarter basis.
Q9. How much gas does the U.S. consumer have left in the tank?
Surprisingly, still a fair bit and this is a source of upside risk to our forecast. As discussed in question 4, the U.S. consumer has already been a key part of the outperformance in recent quarters. However, we shouldn't dismiss the risks stemming from the largest increase in interest rates in forty years and an increasingly worrying geopolitical backdrop. So far, spending has been supported by three pillars – a drawdown of pandemic-era savings, a strong job market with accompanying real wage gains and access to credit. These tailwinds are carrying less force, and in some cases, changing direction.
Consumers are estimated to still hold just north of $800 billion in "excess savings" (calculated as the difference between income and spending above the pre-pandemic trend) as of 2023 Q3, down almost 65% from the peak in 2021 Q2. This is estimated to run out by mid-2024. If, instead, we estimate excess savings via bank deposits, the amount is larger at about $1.3 trillion. But here too, the speed of drawdown suggests it would be depleted by Q2 2024 (Chart 9). That cushion is also concentrated in wealthier households (Chart 10) with lower marginal propensities to consume out of savings and wealth. So while the well isn't dry, the distribution and the amounts of excess savings should become less impactful with time. When combined with an absence of pent-up demand and an uncertain economic environment, the excess savings may not translate into as robust spending in the future.
The second source for consumers' spending power is a tight labor market. It has been cooling recently, but remains strong enough to support healthy income growth. Both average hourly earnings and the employment cost index show that workers are still receiving raises, even if not as sizeable as last year. This should continue to be the case unless there is a more significant deterioration in the labor market. Even so, consumer spending has been outpacing income growth in recent months, and this could force some to rein in spending despite wage gains.
The third support to consumer spending, credit, is definitely under pressure and the winds have changed direction. New York Fed data shows that credit card balances experienced a large jump in the third quarter, as consumers relied on credit to boost expenditure. This occurred simultaneously with banks tightening lending standards (as reported in the Feds SLOOS survey). More worrisome is the fact that delinquency rates, particularly for credit cards and auto loans, are rising, suggesting some consumers are increasingly stretched. While the growth in auto loan delinquency has moderated over recent quarters, credit card delinquency rates have risen at a sharper pace. Consequently, transition rates into serious delinquencies (90+) are seeing a further leg up for credit cards and auto loans (Chart 11).
Ultimately, a decent job market means consumers still have gas in the tank to keep spending, but the spending impulse is getting tapped down by high prices and rising debt balances with the associated interest payments. And, high interest rates are also expected to bite even more in the coming months. Putting the pieces together, we think consumers will be able to thread the needle and not retrench on spending, but the thrust to economic growth should lessen with each quarter.
Q10. Are higher rates having any effect on U.S. consumers yet?
For much of the last year, we have been talking about how Canadian inflation has been much more behaved than in the U.S. Not only did Canadian headline CPI peak below the U.S., but Canadian inflation had led the decline through June 2023 (Chart 12). Since then, headline inflation rates on both sides of the border have converged.
Previously, the difference in shelter inflation explained most of the deviation between the two countries. Methods in how the U.S. calculates rent prices kept shelter inflation elevated. But now with rent prices in Canada rising swiftly and mortgage interest costs on a record setting track, shelter prices have converged with the U.S. At the same time, Canadian food and energy inflation has outpaced the price increases that Americans are experiencing.
On the core side of things, the Fed's preferred metric – core PCE inflation – fell to the mid-3% level in September. This is where Canadian core CPI has been since May 2023. And if Canadian inflation is anything to go by, U.S. inflation will likely be stuck around this level for some time. This is due to two factors. One, core goods prices have already seen heavy discounting. Just ask anyone looking to buy furniture - deals are out there. The issue is that goods prices have now fully corrected from their pandemic surge, leaving little room to provide another thrust on downward momentum. And secondly, past inflation increases are keeping wages around the 5% level in both countries, which is putting pressure on prices for services. Indeed, services inflation in Canada is tracking 4% y/y, while core goods inflation is closing in on 2% y/y. Given these trends, we expect both headline and core inflation in Canada and the U.S. to remain above 3% for the rest of 2023 and into early 2024. No wonder the Fed and BoC are preaching the higher for longer narrative!
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