ECONOMIC & FIXED INCOME COMMENT - Balancing Act
2023 started off better-than-expected, resulting in the International Monetary Fund (IMF) upgrading its global growth outlook in January. Specifically, global GDP is now forecast to expand 2.9% in 2023. Three factors are driving the prospect of improved growth. These include: a stronger China reopening, material easing of the European natural gas crisis and the surprising resilience of US consumers.
Turning to North America, Canadian GDP is on track for a modest increase in Q1 2023 (2.5% annualized) after zero growth in Q4 2022. Currently, the Canadian economy is forecast to expand 1% in 2023. With respect to the US, their economy continues to be supported by the consumer. US GDP is forecast to expand 2.0% in Q1 2023. For calendar year 2023, the US economy is forecast to grow 1%. However, headwinds of higher borrowing costs and reduced purchasing power is expected to dampen demand and slow growth in the second half of the year as monetary policy works with a 12-to-18-month delay.
To date, both the Canadian and US economy have been able to weather higher interest rates due to tight labour markets and strong domestic demand. Both Canadian and US employment data for March remained solid. The Canadian economy added 34,700 jobs and the unemployment rate was unchanged at 5%. The US economy added 228,000 jobs and the unemployment rate stayed steady at 3.6%. However, survey data (job openings and recent hiring) points to a cooling in labour shortages thus softening labour markets moving forward. Additionally, the recent collapse of Silicon Valley Bank, Signature Bank and Credit Suisse in mid-March have highlighted the vulnerabilities and potential financial instability of the global financial system. Bank balance sheets will be more scrutinized and thus retain more liquid assets to insulate against a potential rush of deposit withdrawals. As a result, tighter financial conditions will likely ensue going forward. Although the impact of these conditions is uncertain, analysts are predicting a similar effect of a 25-50 basis point rate increase by the Federal Reserve (Fed).
The debate in recent weeks is how will central banks respond to the current financial situation. The Bank of Canada (BoC) maintained its overnight rate of 4.5% at the March 8th meeting and reiterated a conditional pause in its tightening cycle. However, the BoC said it could resume raising interest rates if it sees an “accumulation of evidence” that inflationary pressures are not subsiding as expected. The annual inflation rate has eased to 5.2% in February and core CPI continues to decelerate. Furthermore, the breadth of inflation pressure has stabilized but remains elevated compared to the pre-pandemic period. Currently, capital markets are pricing in another rate hold at the April 12th meeting.
Regarding the US, as expected, the Fed raised the Fed Funds rate 25 basis points at its March meeting. The FOMC committee maintained its outlook for a peak Fed Funds rate of 5.1%, suggesting one more 25 basis point increase in Q2. Although headline inflation has been moving lower since its peak in June 2022 (5.0% as of March), it remains well above the Fed’s 2% target. Going forward, the Fed has a balancing act to navigate: supporting the banking system with liquidity on one hand, and battling inflation with interest rate increases on the other.
The bond market has seen dramatic moves over the past month due to shifts in market expectation concerning the trajectory of interest rates. Specifically, 2-year US Treasury yields went from a high of 5.1% to a low of 3.8%. Similarly, in Canada, the 2-year Government yield went from 4.3% to under 3.5%. The decline in yields have been driven by investors seeking safe-haven assets such as government bonds and growing expectations of rate cuts from central banks by year-end.
Our expectation remains that rate cuts will be appropriate in the next 12 months. As the bond market is forward looking, both short-term and long-term bond yields are likely to decline over 2023 as weak economic activity and tighter financial conditions increase the expectation for policy rate cuts. Finally, the inverted yield curve should become less inverted as short-term rates will decrease faster as it is associated with central bank policy expectations.
