Focus
April 14, 2023 | 13:34
Rate Cuts? Maybe Next Year
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Rate Cuts? Maybe Next Year |
|
|
“The implied expectation in the market that we’re going to be cutting our policy rate later in the year, that doesn’t look today like the most likely scenario to us.” — Bank of Canada Governor Tiff Macklem, April 12, 2023 |
Why does Governor Macklem push back at the prospect of rate cuts this year? After all, the Bank of Canada itself projects that headline inflation will drop to 2.5% by the end of 2023, and that the economy will be in “excess supply” by the second half of the year (i.e., operating below potential). This, at a time when the overnight rate is at 4.5%, or two full percentage points above the BoC’s estimate of a neutral interest rate, indicating a very restrictive stance. And, despite the Governor’s comment, the market continues to price in solid odds of a rate reduction later this year. While one can’t fully rule out a change of heart by the BoC, we believe that the Governor’s caution is well warranted. Here are five reasons to believe that rates are unlikely to be cut this year. 1) Housing is at risk of being rekindled. The closely-scrutinized housing market began to show signs of stability right at the moment the Bank of Canada signalled a pause early this year in its rate hike campaign. Resale housing volumes are still bouncing around low levels, down by almost half from the 2021 peak and 35% from a year ago. But activity seems to be finding a floor, held back only by a lack of inventory. Indeed, new listings saw the weakest monthly flow for any March in 20 years, ordinarily a month that sees a significant seasonal jump (new listings typically rise further in April and then peak in May). Even if demand is only improving incrementally off the bottom, the lack of new listings is quickly tightening markets in many areas of Canada. As a result, the national sales-to-new listings ratio is back into balanced/tight territory consistent with the pre-COVID period (Chart 1), and price declines in some markets have levelled off, if not begun to nudge higher. |
|
On the listings side, there is no apparent forced selling, which is what would cause an orderly asset price correction (which we have seen) to evolve into something much worse. The job market has held up strongly, limiting unemployment and delinquencies; most variable-rate mortgage holders are not seeing their payments rise in real time; borrowers that took mortgages at historically-low rates were stress tested around levels that exist in the market today; and, investors have a strong rental market to fall back on. On balance, most probably don’t want to sell into a down market, and most don’t have to. Meantime, demand continues to build in the background as millennial household formation and record international immigration combine to drive a still-strong demographic picture. Stressed affordability due to high interest rates is really the only thing keeping the market in check at this point. Not only would Bank of Canada rate cuts increase purchasing power, they would also be a powerful signal that housing has indeed bottomed—and psychology has been an important aspect of this cycle. For example, it’s no coincidence that the market strengthened significantly in the second half of 2020 after the Bank cut rates to 0.25%; it then exploded when the Bank promised to keep rates low for an extended period. And, yes, the market immediately cracked in early 2022 alongside the first Bank of Canada rate hike, before finding a floor almost immediately after they guided to a pause. Our broad view on housing has called for a 20% peak-to-trough decline in national home prices, and the market was down 16% as of March, putting us close to where we think it needed to get to from a valuation perspective. By some measures, like inflation-adjusted prices, the market appears to be where it needs to be. By others, such as affordability, there looks to be some more downside. That said, the bulk of the forecasted asset-price correction is likely in place, and the path forward will be dictated by how well the economy holds up. Our base-case view of only a moderate downturn later this year would suggest that prices drift sideways, or modestly higher for some markets, into and through 2024. But a turn by the Bank of Canada could speed up the recovery; and if even the most interest-sensitive portion of the economy is gathering momentum, how restrictive is policy? |
2) Household finances remain sturdy. One of the big debates at the start of this year was which of two great forces would dominate consumer behavior in 2023: The huge pandemic savings cache and strong pent-up demand, or still-strong inflation and the historically rapid rise in borrowing costs? Frankly, these two clashing forces were so unusual that forecasters didn’t know how to properly judge the next phase of this unique cycle and, on balance, have underestimated the consumer. Consumer insolvencies, while rising, remain below pre-pandemic trends. Personal deposits remain roughly $150 billion above trend. Household net worth to income also remains above pre-pandemic levels despite the body blow to all asset prices last year. |
|
Some of this resiliency reflects the fact that many households were shielded from the steep rate rise, since they were either in fixed-rate mortgages or their variable rate mortgage payments were fixed (at least initially). However, this week’s Monetary Policy Report warned of the hit from mortgage renewals, and mapped out a scenario that pointed to the highest mortgage interest service ratio since the late 1990s (Chart 3). However, what the BoC didn’t mention is that the broader debt service ratio, for all household debt and including principal payments, is not yet particularly high. And even with some further deterioration this year, the ratio will only be pressing up to levels seen prior to the pandemic. In other words, even the most vulnerable point of the economy will not look unusually stressed. |
3) The job market remains incredibly resilient. One of the reasons why the household financial position remains sturdy is that the underlying income picture is solid. And that rests on the foundation of a strong labour market. After a lull last summer, job growth has roared back with 370,000 net new jobs (or +1.9%) in the past six months alone. Prior to the pandemic, that’s the fastest increase in decades in raw numbers and since 2002 in percent terms. The share of the prime working age population (15-64) with a job has been at an all-time high of 76% in the past year (Chart 4). That’s more than a percentage point above pre-pandemic highs, making a mockery of talk of a Great Resignation. While some measures of labour market tightness have backed off from the extremes—notably the job vacancy and finding rates—the other six of the BoC’s eight primary employment gauges remain above the high end of their normal range. 4) Underlying price pressures continue to bubble. The strong job market is translating into firmer wage pressures. While it’s true that robust population growth has acted as a relief valve for wages, at least compared with U.S. trends, there is still a notable upward drift in Canada. The BoC often points out that the combination of modest productivity gains and wage growth in the 4%-to-5% zone is not consistent with 2% inflation. In fact, with productivity growth having all but stalled in the past three years (up just 0.2% annually, versus 1.4% in the U.S.), unit labour costs have surged at a 4.6% clip over that period, and are up 5.7% in the past year alone (Chart 5). To put those meaty figures into perspective, unit labour costs rose at a mild 1.8% annual average pace in the 30 years prior to the pandemic, or precisely in line with CPI inflation. 5) Fiscal policy is rowing in the opposite direction. While monetary policy is leaning hard against inflation, fiscal policy is still adding stimulus (Chart 6). Net new measures announced by Ottawa in the 2023 budget amount to $13 billion at the tail end of FY22/23 (fiscal year ended in March), $4.8 billion this fiscal year, rising to $7.3 billion by FY25/26 when a number of business tax credits kick in more significantly. At the same time, provincial governments announced at least $6 billion of direct support or tax relief in their 2023 budgets, in addition to any incremental program spending increases—combined provincial program spending is expected to rise 2% this fiscal year after a more significant jump in FY22/23. All told, there is easily about 0.5 ppts of stimulus coming from the government sector this year, and the BoC’s latest MPR builds in an even larger assumption of 0.9%. At the end of the day, so-called inflation support measures (i.e., cash transfers to households that have been very popular at both the federal and provincial levels) are inherently inflationary, and will just leave interest rates higher than they otherwise would be. Thought of another way, these fiscal policy measures push against potential rate cuts. |
|
The end result of these five forces is that core inflation is likely to remain stickier than widely expected. True, headline inflation is poised to tumble further in coming months due to friendly base effects, improved supply chains, and easing food and energy costs. For example, next week’s CPI could see a 1-point slice in headline inflation to little more than 4%, as last March reported the single biggest rise in prices in more than 30 years (+1.4%). And, the three-month trend in headline CPI has already dropped below 2% on a seasonally adjusted basis, largely thanks to fading energy costs (Chart 7). However, the short-term trend on most core metrics remains stuck above 3%—the average of the BoC’s two favoured measures is running just above 3.5% in the past three months, which is higher than anything seen in the 30 years up to mid-2021. Even with much milder headline inflation ahead, we believe core inflation will still grip a 3-handle by year-end, or above the top end of the Bank’s target zone. And that, in a nutshell, is why the Governor pushes back at the thought of rate cuts in 2023. |
|
