October 29, 2021 | 12:50
World Serious… About Tightening
Amid this week’s many moving parts, the dominant story was a back-up in short-term bond yields in a wide variety of markets. And there’s little mystery behind that move—inflation continues to bubble, bubble, and cause all sorts of toil and trouble. Even as growth figures broadly disappointed in many key economies in Q3 and the early fall, rate hike expectations are mounting as supply-related price pressures simply appear much stickier than policymakers initially expected. Equity markets have mostly managed to sail through these choppy waters, with the S&P 500 reaching a new high, but even some of the mighty, mighty tech giants were blunted in Q3 by supply chain issues. And while stocks are mostly thriving on strong earnings, they continue to cast a sideways glance at inflation, and the implications of a central bank shift.
Probably the most dramatic shift was by the Bank of Canada. Instead of gently tamping down aggressive market pricing for 2022 rate hikes, the Bank tossed a few more logs on the raging inferno in this week’s Statement. Not only did it call a hard stop to QE, it bluntly offered the possibility of a rate hike as soon as April, and solemnly pledged to keep inflation in check. With the BoC giving that inch, the market promptly took a mile, rapidly building in nearly a 100% chance of a rate hike by January (yes, just a bit more than two months from now). While backing off a touch from the initial shock move, 2-year GOC yields still vaulted 18 bps on the week (to 1.05% as we speak), doubling in the course of October alone. Unlike the Treasury market, the sell-off extended right out to the 10-year space, with such yields again flirting with their highest level since 2019 at almost 1.70%.
Curiously, just as the Bank of Canada has started to breathe fire on its inflation concerns, growth is turning into a proverbial pumpkin. The latest estimates from StatCan suggest Q3 GDP managed to rise at only a 2% annual rate, barely reversing the deeply disappointing 1.1% drop in Q2. Just three short months ago, the BoC had been expecting Q3 growth to clock in at a 7.3% pace, and they then revised that to 5.5% in this week’s forecast—whoops. The big miss in the summer is due, in roughly equal parts, to supply constraints, the Delta variant, and the ongoing drought in the Prairies. Normally, such a big downside miss in growth would push back the timing of rate hikes, but these are most certainly not normal times. All of the growth dampeners are hitting the supply side, crushing potential output, and thus making no impact on BoC policy. Instead, the Bank is now focused squarely on inflation, and the CPI figures in coming months are absolutely critical to the ultimate timing of when rate hikes commence.
For now, we are officially expecting the first BoC rate hike in mid-2022, followed by a series of 25 bp moves each calendar quarter until the overnight rate is back to the pre-pandemic level of 1.75%. Clearly, the risk to each is earlier (liftoff), faster (cadence), and ultimately higher (end point). While the CPI will be the major driver, the job market will also weigh in, and we look for another solid employment gain in next Friday’s report for October. Recall that jobs had already returned to pre-pandemic levels in the prior month, as had the participation rate. Wages will also be a key; note that most broad measures are still posting moderate gains, and the latest CFIB survey looks for an increase of 2.5% in the year ahead.
Poised to join the BoC on the hawkish bandwagon are the BoE and the RBA. Expectations of at least a tweak in the BoE’s rate at the November meeting is mounting—unlike most others, the Bank has the option of nudging rates 15 bps, given their key rate was last cut by a similar tally to 0.10%. A bit more surprisingly, the RBA also sent a hawkish signal this week. After being mostly a holdout for months, the RBA did not step in to keep 3-year bond yields in check, suggesting a coming shift at next week's meeting. In both economies, inflation eased a touch in the latest release, but also stayed right around an uncomfortably-high 3% clip.
And then there is the Fed. There is now zero debate that next week’s FOMC meeting will mark the beginning of the end of QE (i.e., the start of tapering). But there is still plenty of debate on when rate hikes will begin, and that issue will be the primary focus for markets. Alongside the rapidly rising rate expectations almost everywhere, markets are now pricing in more than two rate hikes for the Fed in 2022. We, too, have pulled forward our view to a move in September and December next year, but the risks to that call look much more evenly balanced than our (admittedly cautious) BoC call. After all, the Fed hasn’t even officially begun tapering, and Chair Powell has been adamant that there will be some time between QE and rate hikes.
As is the case in Canada, soggy U.S. growth numbers have made little mark on rate expectations, with inflation concerns looming large. Markets barely even blinked at the downside miss in Q3 GDP of just 2.0%, with most viewing the lacklustre result as due to Delta and a lack of supply (most notably autos). There were three secondary indicators that caught our eye this week: 1) a fast drop in jobless claims, pointing to a further labour market tightening; 2) a big pop in Q3 employment costs to 3.7% y/y, and to 4.2% on wages & salaries (the fastest in three decades); and 3) a dip in the Chicago Fed’s National Activity Index to -0.13, indicating below-trend growth in September. Not unlike Canada, the overall message is that broad growth is disappointing, but because this is largely a supply issue, wage and price pressures are nevertheless mounting.
An outlier to the hawkish central bank/sluggish growth theme has been the Euro Area. GDP growth there actually did just fine in Q3, rising at roughly a 9% annual rate, led by powerful gains in France and Italy. The region has not yet quite returned to pre-pandemic levels of real GDP—it’s still 0.5% light of 2019Q4, while the U.S. is 1.4% above that metric. For Canada, the initial estimate of Q3 would leave it still 1.5% below the prior high, notably further from norms than most major economies, yet with one of the most hawkish central banks. In contrast, the ECB pushed directly back at market pricing of rate hikes in 2022, which helped further dim the euro to just above $1.15.
One thing the Euro Area does have in common with North America, though, is a serious bump in inflation. The initial estimate for October points to an uptick in CPI to 4.1% y/y. That would match the fastest pace in the 22-year history of the series, equaled only in the summer of 2008, when oil prices were approaching $150. And that brings us to the bottom line: Almost regardless of whether GDP has been good, bad, or indifferent in recent quarters, almost every major economy is grappling with much more virulent inflation pressures than previously expected. And central banks are taking note.