Over the summer, U.S. Core inflation has slipped down to 1.7% year over year from over 2% in the spring. The Federal Reserve is calling this a transitory situation and expects Core CPI to return to their 2% target this fall. As a result, the Fed has felt comfortable enough to begin reducing the size of their balance sheet from $4.5 trillion to $2.5-3.0 trillion over the next few years. They are unwinding the massive Quantitative Easing (QE) Program of the past years which was designed to support the economy. The program purchased Treasury bonds to inject the cash proceeds into the economy thus producing more liquidity and lower long term interest rates. Reversing this program will require the sale of bonds that they have accumulated which will take liquidity out of the economy and possibility increase long term interest rates. While the Fed is saying they are “normalizing” monetary policy from an extremely easy position, it still is a tightening of policy. Given this situation, the great unknown is the impact this change in monetary policy will have on the economy. As a result, the Fed did not increase the Fed Funds Rate at their September 20th meeting. Clearly, they are taking a cautious - wait and see approach. Currently, the probability of a Fed Funds increase at their December meeting is 60%. The decision will depend on the status of inflation data and economic growth.
The Canadian Bank Rate is now at 1% which is 0.25% below the Fed Funds Rate. With the two Bank of Canada interest rate increases this summer, the Canadian dollar has increased over 11% from the May low. The lower Canadian dollar has helped our exports and our economy generally in 2017. Our second quarter GDP was 4.5% at an annualized rate (AR) versus 3.7% in the first quarter. Year over year to July 31st, our economy grew at a 3.8% AR. With the increase in the Canadian dollar and the uncertainty of the NAFTA negotiations, GDP growth for the balance of 2017 and 2018 is expected to slow. Our GDP growth is expected to be 3.1-3.3% in 2017 and 1.9-2.1% in 2018.
Inflation in Canada has been well contained and is below the Bank of Canada’s policy of 2%. As a result, we find it difficult to believe the Bank of Canada would increase the Bank Rate ahead of the Federal Reserve. This action would result in our dollar increasing further and slowing our economy more quickly. We expect the Bank of Canada will follow the Fed Rate increase in December. If the Fed Rate increase is delayed to early 2018, the Bank of Canada will hold fire until then.
We expect the Bank Rate to increase slowly over the next 18 months to their target rate of 2%. Given their style of increasing the Bank Rate at 0.25% increments this would suggest 4 more increases. Our economic growth and NAFTA negotiations will all play into the timing.
The abovementioned has not included comments on Trump, NAFTA or North Korea. The press has been 24/7 on anything Trump tweets and is distracting from his lack of getting any laws through Congress. We can listen to his comments but they are not central to the economy or capital markets. While we cannot ignore him altogether, we must be guarded not to read too much into his statements.
The American approach to the NAFTA negotiations so far as Canada is concerned is to attack all past trade issues which were settled by arbitration. They want to remove the arbitration court (Chapter 19) from the new agreement and then push to overturn previous settlements. Our concern is if the Americans continue to play “Hard Ball” and remove Chapter 19, Canada would walk away from the table. This would be a reasonable negotiating tactic as the economic impact to a number of U.S. states would be significant. So far the negotiations have been messy and not encouraging for Canada- a risk to our stock market.
North Korea, without the help of China, Russia or Iran, would be crazy to pursue such a provocative nuclear program and carry out the threats they have made. Our take on the situation is that North Korea is the pawn in the chess game called “keep the western world off balance”. The game has been mastermind by China and Russia with a little nuclear help from Iran. China is pursuing mineral rights in the South China Sea with the building of islands. Russia, with their occupation of Ukraine, is playing cat and mouse with NATO countries with flyovers. The end game is to slow Western economic growth and influence-more power and control for China and Russia in their regions. This is clearly a dangerous game and if a mistake is made, hostilities are likely to breakout. This is the big risk for the capital markets at this time.