The weekly drop in bond yields extends a key theme for all of Q2, which ran precisely counter to the Q1 upswing. But bonds were a bit of an outlier, as most markets broadly continued their early-year performance into Q2. Here is a very brief wrap of how various major markets fared in the quarter, and for the first half as a whole:
Bonds: Of all major markets, this is the one that pulled a clear about-face in Q2. The main move was a moderation in yields amid growing signs that supply constraints were acting as a dampener on growth, notably for U.S. jobs and global manufacturing. After surging 82 bps in Q1, 10-year Treasuries fell 27 bps in Q2, while Canadian figures for 10s were +88 bps, then -17 bps. But perhaps more notable was the swing from extreme steepening in Q1, to pronounced flattening in Q2. For example, the Treasury market saw 2-year yields rise 9 bps in Q2, while GoCs spiked 22 bps in the quarter, mostly owing to a hawkish BoC early in the quarter. As a result, the 10s/2s spread narrowed 36 bps in the U.S. (after jumping 79 bps in Q1), and by 39 bps in Canada (vs +85 bps in Q1). In contrast to these sharp turnarounds, credit spreads continued to narrow slightly in Q2, after a big move tighter in Q1.
Currencies: The foreign exchange market has also seen some twists and turns this year, albeit not nearly as dramatic as for bonds. The main theme here is that the movements have been much less unidirectional than the due-south trend seen for the U.S. dollar through most of last year. Indeed, the big dollar is actually now up slightly in 2021 on a trade-weighted basis, even with a 1% dip for all of Q2. The greenback has been especially firm against the safe havens, rising 7.6% against the yen this year (but just +0.4% in Q2). On the flip side, the Canadian dollar is still among the strongest among the majors, with gains of about 1.3% in each of the first two quarters of the year. However, like other commodity currencies, it has lost an edge recently. After peaking at just above 83 cents (or nearly touching $1.20/US$) in early June, the loonie has since sagged almost 3%.
Commodities: The leadership may have changed, but the bigger picture of commodity price strength didn’t. Oil, gas, and some crop prices popped in Q2, pulling the CRB index up 15% in the quarter, following a 10% Q1 gain. Base metals generally stayed firm but lost some steam late in the quarter on the global supply chain issues, as well as on China’s steps to cool demand. Still, bellwether copper rose 7.6% in Q2, after a 13.5% Q1 sprint. On the downside, lumber retreated almost 30% following its historic run early in the year and is now one of the few commodities lower on a year-to-date basis. Gold and silver are also in that territory, even with a small rebound in Q2. At the other end of the spectrum, oil is now topping the leaderboard for the year, with a gain of more than 50%—and this week’s pop to $75 on some discord in OPEC+ suggests there may be more to come.
Equities: Not unlike commodities, the leaders may change from week-to-week, but the broader story barely blinked in Q2. The MSCI World index advanced a solid 6.5% in Q2, actually accelerating slightly from the 6.0% Q1 gain (and thus up 13.0% for H1). North American markets were even more robust, with the S&P 500 rising 8.2% in Q2 (and up 14.4% for the half-year). Tech roared back in the quarter after a sluggish Q1, as the Nasdaq jumped 9.5% (12.5% for H1), while the Dow was up a milder 4.6% (but 12.7% YTD). Meantime, Canadian markets managed to hang on to a slim lead for all of 2021 (up a strong 15.7% in H1), thanks to a still-sturdy 7.8% Q2 gain. This puts Canada near the top of the board for the year, trailing the three (diverse) leaders of Argentina (up 21.8%), Taiwan (20.5%) and France (17.2%). At the other extreme, Malaysia is an outlier (-5.8%), but China (+0.2%) and Japan (+4.9%) are not far away, all struggling with supply chain challenges.
Economic Forecasts: So how do these market moves interact with adjustments in the economic outlook over the past three months? While bond yields may have pulled back in Q2, our growth forecast for the U.S. and the global economy actually nudged higher since April 1. At that point, we were looking for U.S. GDP to rise 6.5% this year and global growth to reach 5.7%. Even with a small trim in our U.S. call just this week, we are still looking for 6.8% now (very close to current consensus), and 6.0% for global growth—so both up a moderate 0.3 ppts from a quarter ago.
In contrast, we have slightly clipped our Canada GDP call for the year from 6.5% three months ago to 6.0% and are slightly below consensus now (after being starkly above such for almost all the past year). The big number for Canada this week was a 0.3% drop in April GDP, and a flash estimate of the same for May, fully revealing the hit from the third-wave restrictions, which were only beginning a quarter ago. But even with those back-to-back declines, the setback in April was lighter than expected and, if anything, there is a bit of upside risk to our call, especially with the economy now finally opening aggressively across most of the country.
But by far and away the biggest adjustment in the economic forecast over the course of Q2 was in the inflation forecast for 2021. Driven by the big and ongoing rise in energy prices, soaring home prices, and some one-time lurches in specific goods (autos) and services (airfares), inflation has taken a large step higher. For the U.S., we now look for headline CPI inflation to average 3.9% this year and stay firm at 3.4% in 2022. Both are up more than a point from three months ago (2.6% and 2.2%). The upswing has been a bit less extreme in Canada, with prices held back by a strong loonie, and the used car spike not affecting the local CPI. Even so, inflation is still expected to average 3.1% this year and 2.9% next (versus 2.3% and 2.2% three months ago). Yet to reiterate, this big step up in the inflation outlook has had precisely zero effect on pushing long bond yields higher, as the market is buying into the Fed’s transitory narrative.
In summary, we also largely agree that the surge in inflation will eventually pass, but view the risks as heavily tilted to this episode lasting longer than widely expected. The broader picture is that demand remains smoking hot almost everywhere, and supply is clearly struggling to keep pace—producing shortages in labour, supplies, or goods. In turn, this simply means that nominal spending gains are translating into some real volume gains, but also into some hefty price gains as well. For monetary policy, we will pound the same drum we have been banging on for weeks—an ultra-loose policy can do nothing to ease supply constraints, while adding fuel to already raging demand. A fundamental error made by policymakers in the 1970s was to fully accommodate a supply shock, triggering a powerful burst of inflation; history may not repeat, and here’s hoping it doesn’t even rhyme.