January 15, 2021 | 13:31
Yielding to Reality
After blasting out of the gates to start the year, bond yields took a bit of a breather this week; 10-year Treasuries slipped a touch following a 20-bp leap last week. A variety of factors weighed in—some constructive, some less so. Risk sentiment broadly paused after a rip-roaring start to 2021, and the S&P 500 is now little-changed in the first two weeks of the year. A pair of weak U.S. economic releases played a big role in this sober re-assessment, specifically a jump in weekly jobless claims to 965,000 and a second hefty drop in retail sales in December, both much weaker than consensus.
The main message is that the U.S. economy may be struggling much more heavily with renewed restrictions than widely expected. No doubt, the uncertainty surrounding fiscal support—right up until the end of the year—may have also caused some short-term havoc with the economy. Note, too, that small business sentiment took a big step back in December, with the political backdrop likely playing an important role there as well. After what we expect will be a surprisingly perky Q4, with GDP growth north of 4%, the economy will likely struggle to post any growth in Q1. And, that’s even with the big helping hand of the $900 billion stimulus package. We suspect that the extra dose of stimulus spending proposed by President-elect Biden will be watered down and will ultimately have more impact on Q2 than the opening three months of the year.
The more constructive factor restraining yields this week was a run of dovish commentary from the Fed, first from Governor Brainard (low forever?), and then from Chair Powell. The key, and simple, message was that it simply was far too early to be even discussing tapering QE—although apparently not too early for some regional Presidents. While we expect a lively debate at the FOMC later this year on the pace of QE, actual tapering is expected to be a story for 2022. And, as Powell suggested on Thursday, the Fed will provide plenty of advance warning for the markets before they make the first cut in what has been an exceptionally aggressive and supportive bond-buying spree.
Notably, even with the modest pullback in Treasury yields this week, underlying inflation expectations imbedded in the market continued to grind higher. The so-called breakeven rate for 10s has climbed to 2.09%, up 10 bps just since the start of the year and well above the pre-pandemic level of around 1.8%. Rising oil prices have played a role; even with a late-week pullback, WTI is still above $52, up 25% from just two months ago and not far from a year ago. But there are plenty of factors gradually lifting inflation expectations (which Sal details in this week's Focus). Perhaps most importantly is the Fed itself, which has clearly committed to letting inflation run a bit above their 2% target for a spell before tightening policy. On that front, there is still work to do, as core CPI was flat at 1.6% y/y in December, while the core PCE deflator (and the Fed’s target metric) remains a few ticks lower.
Our overall view is that yields will continue to grind higher on balance this year, with the ultimate destination highly dependent on the ongoing race between the virus and the vaccine, as well as just how much of Biden’s proposed $1.9 trillion stimulus ever sees the light of day. The official forecast of a 1.25% level for 10-year Treasuries by end-2021 is clearly on the cautious side, and has yet to factor in additional stimulus measures above those already signed into law. At the same time though, we believe that ongoing heavy support from the Fed, and opportunistic foreign buying of Treasuries, will keep the rise in yields in check. Simply, the markets have largely priced in a solid and sustained economic recovery—while that mostly aligns with our view, there is little doubt that there is plenty of room for at least some modest disappointment to that sunny outlook.
We’ve said it before, but it always seems to come back to housing in Canada. The sales data just never fails to top already frothy expectations, with the number of homes changing hands surging 47% y/y last month. Factoring in a 17% spurt in average transactions prices, and the value of home sales soared 72% y/y. For all of last year, both the volume and value of homes sold reached record highs, with the latter jumping 27%. We haven’t seen such a big annual jump since 1988, when the housing market and economy were in a full-on boom, and the Bank of Canada was beginning an aggressive tightening campaign.
It’s pretty safe to say that the Bank of Canada has no urge to begin tightening anytime soon in response to the housing boom. First, policymakers are probably welcoming any growth at this point, no matter its source. Second, in earlier speeches the Bank has indicated that the onus will be on regulatory (or macroprudential) measures to rein in housing, not interest rates. In fact, financial markets and the Bank are openly musing about the possibility of micro rate cuts (i.e., a 15 bp shave)—largely in response to the strength in the Canadian dollar—and certainly not rate hikes at this point.
That’s the picture for overnight rates. It may be a bit different for longer-term bond yields. The Bank may not lean too heavily against a moderate back-up in yields in this hot-house environment, if that back-up is being driven by global factors. The challenge there is that rising long-term rates will, of course, lift the cost of the massive fiscal support currently underway, and potentially dull the ability of fiscal policy to broaden further.
As a final comment on the outsized strength of Canada’s housing market, we’ll point to two stats that really bring things home. Even before this surge in sales in Q4, the share of nominal GDP due to residential investment soared to a record high of just over 9%. That compares with a long-run average of less than 6%, and more than double the 4.3% level for the U.S. economy in the same quarter. The second, somewhat related, stat is that average home prices in Canada were just above $600,000 last month. In contrast, the average home price in the U.S. in November was US$343,000 (or just under C$440,000 at today’s exchange rate). In other words, average home prices are almost 40% higher in Canada than the U.S. adjusted for the currency—we’ll leave the many reasons behind this yawning gap for another week, but now accepting your best guess(es).