March 19, 2021 | 12:44
Springtime for Yields
The remorseless grind higher in bond yields continued apace this week, with 10-year Treasuries hitting 1.75% for the first time since January 2020. Fed Chair Powell’s ultra-dovish remarks after the FOMC meeting provided only fleeting succor, as inflation concerns soon re-emerged as a counterpoint to the easy-money message. These yields have now more than doubled in the past four months alone and are currently working hard on an eight-week “winning” streak. Other markets have warily eyed the back-up, buoyed by the rapidly improving economic outlook, but also concerned about the speed of the yield surge. The latter eventually dominated this week, pulling equities down from post-FOMC record highs, and chopping oil nearly 10% to around US$60. Rising yields and a brighter U.S. growth backdrop have turned the greenback around; it is now up almost 4% against a listless euro since the first week of the year.
The backward-looking data suggested the U.S. economy had a clunker in February, with each of retail sales, industrial production and housing starts falling heavily last month. However, markets shrugged at the results since harsh weather played a role, and January had printed powerful gains in all cases. And, the reports seem dated, given the sudden reopening of major portions of the U.S. economy in recent days, including a rush of air travelers. Some forward-looking indicators are fully flashing green, notably the venerable Philly Fed Index. The headline metric surged to 51.8 in March, the highest print since 1973, led by new orders and employment, but also by prices paid and delivery delays. Look for a wave of impressive economic readings in the next few months—after all, if we are going to print the best growth in decades, a wide variety of indicators are going to be boom-like. Even the normally cautious Fed forecasters are now calling for U.S. GDP growth of 6.5% this year (Q4/Q4; we are at 7.0% on that basis).
Canadian economic forecasts, and thus yields, continue to be largely pulled along for the ride. This week’s bond back-up was milder than the U.S. version, for a change, but 10s still hit 1.60% for the first time in 14 months. While Canada’s vaccine roll-out, and the likely timing of a more complete re-opening, lags well behind the U.S., the economy is faring surprisingly well. Even faced with tough restrictions at the start of the year, retail sales volumes fell “just” 1.6% in January, and managed to rise from year-ago levels. And the initial read on February is for a 4% snap-back in nominal sales (almost the mirror image of the U.S. pattern to start the year). Combined with the recent jobs data, and firmness in resources and manufacturing activity, this suggests that our Q1 estimate of 3.5% GDP growth may be on the cautious side.
Then there’s housing. Robust homebuilding activity at the start of the year will provide some growth support, as will the record level of home sales. But this is one sector where strength is not fully greeted with open arms. Indeed, the debate over a possible Canadian housing bubble has broken wide open, with the MLS Home Price Index soaring 17.3% y/y in February, amid widespread double-digit gains. Even the normally staid new home price index jumped 1.9% m/m (and 7% y/y), the largest monthly increase since the late-1980s—a time of a true bubble. Part of the debate may in fact revolve around the very definition of a bubble; from our perspective, it’s when prices drive far above fundamentals (check), prices are rising mostly on the perception that they can only rise further (approaching that terrain), and the increase poses a broader danger (heading in that direction). Suffice it to say that if these were remotely normal times for the economy, we would be strongly advocating for some policy tightening to address the housing heat. Alas, these are far from normal times, and any growth is ultimately welcome by policymakers for now, even if it does carry with it the side effect of resurgent home prices. Not wanting to kill the proverbial golden goose, any near-term policy steps will be of the mild variety. However, the longer the price surge continues and bubble chatter builds, the pressure to act will intensify.
The back-up in Canadian yields, which has taken 5-years up 60 bps to above 1% in just seven weeks, has also nudged up some mortgage rates. However, we suspect this moderate move will do little to dampen the raging inferno in the resale market. Even the previously chilled condo space looks to have turned the corner in many key markets. On balance, the bubble debate looks to also rage for some time yet.
Curiously, the extreme heat in housing is having next to no impact on the official inflation readings. That’s not a big surprise, as large swings in the housing market affect CPI in an indirect and delayed fashion. Yet it’s almost comical that shelter costs overall in February reportedly rose a mere 1.4% y/y, actually down a point from a year ago. This surprising restraint reflects four factors: 1) home prices directly only have a 19% weight in shelter costs; 2) rent costs have receded to nearly flat in the past year; 3) electricity costs have dropped 3% y/y; and 4) mortgage interest costs have dropped 5% y/y. The latter moves very slowly over time, and will eventually turn higher as yields bounce. But note that even with the recent snap-back, yields are still well below the average level of the past five years. The bottom line here is that booming home prices will begin to add modestly to inflation in the year ahead, but the impact will be barely perceptible.
This seeming disconnect between soaring home (and other asset) prices on the one side, and mild underlying inflation readings on the other, will only reinforce the perception that CPI doesn’t reflect reality. Even the coming 3%+ headline CPI figures won’t impress, given that gasoline prices are almost 50% above last spring’s levels. Certainly bond investors are heavily leaning to the view that regardless of current readings, the inflation risks are tilting higher.