ECONOMIC & FIXED INCOME COMMENT -"Higher for Longer"
While the global economy started off better-than expected in the first quarter of 2023, it is beginning to slow down. Specifically, growth in the eurozone remains constrained by steep declines in bank lending while China’s eagerly anticipated reopening has been underwhelming. It is unlikely China will provide a full counterweight to the growth deceleration elsewhere in the world.
Turning to North America, the Canadian economy grew 3.1% in Q1 2023, significantly ahead of the Bank of Canada’s (BoC) 2.3% forecast. Also, preliminary estimates from Statistics Canada indicate Q2 2023 is off to a positive start; although at a slower pace. As a result, the BoC upgraded its GDP forecast for 2023 to 1.4%. The Canadian economy has benefited from a record surge in immigration with population reaching a milestone of 40 million. The uptick in immigration has helped relieve labour-force tightness and raised aggregate spending, supporting economic growth. However, it has also increased the demand for housing adding to the insufficient housing supply. With respect to the US economy, it continues to be supported by consumers. US GDP was revised upward to 2.0% for Q1 2023 and is forecast to expand 1.5% in Q2 2023. For calendar year 2023, the US economy is forecast to grow 1% as US consumer demands are expected to slow working their way through excess savings from the pandemic.
Both the Canadian and US economy withstood higher interest rates during the second quarter due to exceptionally tight labour markets and strong domestic demand. During the month of May, the US economy added 339,000 jobs well above the estimate of 190,000. The unemployment rate rose to 3.7% from 3.5%. On the other hand, the Canadian economy unexpectedly lost 17,300 jobs with the unemployment rate increasing to 5.2% from 5%. This was the first time the unemployment rate rose in 9 months. Going forward, we anticipate further softening in the North American labor market as slower hiring, additional layoff announcements and moderating wage growth will put upward pressure on unemployment rates. However, it is important to note that both Canada and the US are currently at historic low unemployment levels.
Since the onset of the global synchronized monetary tightening cycle by central banks, there has been some signs of monetary policy traction. However, higher interest rates have not combatted inflation or slowed economic activity as much as expected in the first half of the year. Globally, consumer price inflation has moved meaningfully lower but underlying core inflation remains elevated. Consequently, several central banks have continued their monetary tightening cycle or resumed after taking a “pause.”
The BoC surprised markets at the June 7th, meeting with its decision to raise the overnight bank rate by 25 basis points to 4.75%. The BoC believes the persistent excess demand in the economy is still too high suggesting that monetary policy is not sufficiently restrictive. The main factors that drove the BoC to raise interest rates included:
Consumption remained strong and broad based
Demand for services continued to rebound
Spending on interest-sensitive goods increased
Housing market activity rebounded
The next BoC meeting is July 12th, when the BoC is expected to raise the overnight rate 25 basis points to 5% before pausing for the remainder of the year. Nevertheless, the BoC will remain highly data dependent and will be closely monitoring consumer demand, core inflation and the labour market (i.e., wage growth).
On June 14th, as expected the Federal Reserve (Fed) held the Fed Funds rate unchanged at 5.25%. The pause will allow the Fed time to assess additional information and monetary policy implications on the economy. The next Fed meeting is on July 26th, where market participants are pricing in an 88% chance of a 25-basis point increase to 5.5%. The FOMC committee will continue to consider the cumulative tightening of monetary policy, the lags with which monetary policy may affect economic activity, inflation, and financial developments. Currently, the bias is still to the upside with the new Federal Funds Terminal rate at 5.75%; implying two more rate increases from the Fed. However, the Fed must navigate a balancing act supporting the banking system with liquidity on one hand, and battling inflation with interest rate increases on the other.
Year-to-date, outside the volatility induced in March by the US regional bank failures, the interest rate backdrop has been more subdued, The Canadian 10-year bond yield has been roughly rangebound between 2.65% and 3.50% year-to-date (see chart). Ongoing recession risks have limited 10-year yield upside potential.
Although the BoC and Fed largely remain hawkish, we continue to believe they are nearing the final stages of rate hike cycles. Our expectation remains that rate cuts will be appropriate in the next 12 months. As a result, we expect Canadian and US yields to gradually trend lower; therefore, we are repositioning our bond portfolios into longer-dated securities to lock in higher yields.