Talking Points

May 26, 2023 | 13:20

The “R Word” is Resilience, not Recession

Economist

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience ana... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience ana... (Read more)

Bond yields forged higher again this week, partly in anticipation of a debt ceiling deal, but also partly in the face of still-high inflation and still-sturdy growth. In fact, one could make the argument that if the big forecasting mistake almost everyone made in 2022 was to underestimate inflation—present company excluded, of course—the big mistake 40% of the way into this year appears to be that almost everyone has underestimated the resiliency of the economy—present company included. And this reality is dawning on markets, which are now fully priced for an additional 25 bp rate hike by both the Fed and the Bank of Canada in the summer. Two-year Treasuries jumped 30 bps this week alone, after a similarly sharp rise last week, taking them above 4.6%, a level not seen since SVB failed. It’s a broadly similar picture in Canada, where 2s surged above 4.3%, up 75 bps in a mere three weeks and nearing the cyclical highs hit in early March.

The big and broad rise in yields in recent weeks and the increasing odds of further central bank rate hikes reflects three forces: a resilient economy, sticky inflation, and a challenging fiscal backdrop. On the first point, the latest batch of U.S. data landed almost completely on the strong side of the ledger. Consumers are still doing their thing, as personal spending thrashed expectations with a 0.8% rise in April, and even 0.5% when adjusted for inflation. This sets consumer spending on course for another positive quarter, after the strong 3.8% advance in Q1. Along with the Chicago Fed’s National Activity Index printing positive last month (signaling above average growth), and it looks like the long-awaited recession has been delayed by another quarter.

Next week’s key payrolls report may have a different opinion on recession risks, but given the downward revision in jobless claims to modest levels and underlying momentum, we are expecting a solid 200,000 rise in jobs. And the jobless rate is flagging precisely zero weakness, matching 70-year lows. While no one would mistake the current situation for a strong economy—after all, real GDP was up just 1.3% in Q1—for every sour note, a positive signal pops up somewhere else. The blow-out quarterly report from Nvidia, driven by AI demand, is but one example of pockets of real strength. Even the housing market is showing a pulse, with new home sales grinding higher from last summer’s lows. That fledgling recovery may yet reverse on the renewed back-up in borrowing costs, but the bigger picture is that the economy is holding up surprisingly well.

The second major factor driving yields back up again is the stickiness of inflation. April’s core PCE deflator topped expectations with a 0.4% m/m rise, nudging up the annual pace in this key metric a tick to 4.7%. Even the Fed’s supercore measure was up by a similar amount last month and is showing no signs of breaking lower. Meantime, the tailwind of lower energy prices may be coming to an end: oil and gasoline prices are still well below the lofty levels of a year ago, but have been drifting higher more recently. With underlying trends in inflation settling into the mid-4s range, the Fed may well become impatient, particularly if the job market doesn’t buckle.

The third and final factor putting some upward pressure on yields is the ugly fiscal picture. The reality is that even with a quasi-bipartisan debt limit deal, and the obligatory Kumbaya moment, the U.S. fiscal situation is troubling. Early reports suggest the deal will include a two-year freeze on program spending. That is a welcome drop in the bucket to be sure, but Washington’s deficit is currently running at a cool $1.9 trillion over the past 12 months, or more than 7% of GDP. The debt held by the public has taken a giant $7 trillion step up in the three years since the pandemic began, an increase of more than 40%. Combined with the rise in borrowing costs, and public interest payments are already up by more than 50% from 2020 levels. As we have opined before, while one can decry the tactics of using the debt ceiling as a fiscal bargaining chip, one can still agree with the goals.

It’s been a long time since the so-called bond vigilantes rode into town on fiscal concerns. But note that the bulk of the recent back-up in Treasury yields has been in real yields, not in the implied inflation premium. This rise in real yields to close to levels not seen in more than a decade suggests that private Treasury buyers are a little more demanding amid fiscal risks, especially since the Fed is busily offloading its holdings. And, there’s the small matter that as soon as we do have a debt deal, there will be flood of issuance (albeit mostly T-bills). The bottom line is that above and beyond the short-term factors of a surprisingly resilient economy and sticky inflation, the tough fiscal picture is alone a solid argument for a higher-for-longer rate outlook.

Meantime, Canada’s federal budget deficit looks small when set beside that of the U.S., but the path toward balance appears to have stalled. Ottawa’s fiscal monitor for March reported a budget deficit of $41.3 billion in the twelve months through March, consistent with the $43 billion shortfall for FY22/23 last estimated in Budget 2023. While that’s a moderate 1.5% of GDP, Ottawa continues to spend with some force.

Otherwise, it was a light week for Canadian economic news, with most of the attention on the slew of quarterly bank earnings (which broadly disappointed). But that didn’t stop the market from pricing in higher odds of a Bank of Canada rate hike this summer. That was partly in sympathy with the shifting outlook on the Fed, but domestic news did little to dissuade the trend. A strong 1.6% rise in the flash reading for April wholesale trade, and a small rise in consumer confidence, hint that the Canadian economy is also holding up so far in Q2. However, that underlying reality may be blurred by the one-two hit to growth from the public sector strike in April, and the wildfire drag on Alberta oil production in May.

The big news for Canada next week is the GDP release for Q1 and the preliminary read on April. Output is expected to start Q2 on a soft note after a surprisingly sturdy 2.5% rise in Q1. But after the dust settles on the special factors, Canadian growth is likely to emerge with more underlying firmness than previously expected. And a key source of that resiliency is the housing market; accordingly, we will be watching the earliest reports on home sales for May which will begin flowing in late next week. If the market shows more signs of recovery, that will fuel the growing odds that the Bank of Canada gets back in the tightening game.