For the past twelve months the market narrative has centered around the rapid tightening of monetary policy as rates were lifted fast and furiously from the zero lower bound. This week the Bank of Canada (BoC) announced its second rate pause of this hiking cycle. It maintained its overnight rate at the 4.5% level and Governor Macklem admitted that “we know our job is not done”. After one of the swiftest hiking cycles in modern financial history, the market narrative is shifting to its natural subsequent phase, which should see rates on hold at these restrictive levels.
Monetary policy works in long and variable lags, meaning that it takes time (one to two years according to economists) for higher rates to flow through the financial system before its effect is fully felt. Considering the first two BoC rate hikes were announced roughly one year ago, this suggests that these higher policy rates may need further time to marinate.
While rate sensitive sectors (such as the housing market) are showing signs of deceleration, the broader diversified economy has yet to show meaningful signs of weakness. Annual inflation in Canada, as measured by the consumer price index, has slowed from the 8.1% peak in June 2022 to 5.2% in February 2023. While the declining trend is encouraging to see, the year-over-year (y/y) rate of change in the mid single digits is still well above the BoC’s 2% target rate. A stubbornly persistent factor that is contributing to this is wage growth.
A large chunk of the inflation normalization we have seen can be attributed to a deceleration in goods inflation (input prices, commodity prices, etc.). Despite this, core services inflation, which is influenced by wage growth, has remained strong.
As of March, most wage growth measures remain elevated in the 4% to 5% range (as seen in the chart below) and are inconsistent with the BoC’s inflation target. With wage growth still persistently hot in our services dominant economy, Ottawa admits that this is a key factor to returning inflation back to target.
Source: Statistics Canada, Bank of Canada Monetary Policy Report April 2023
The Canadian labour market has been robust with job gains absorbing the over 1 million population influx in 2022. As a result, the unemployment rate remains near historically tight levels with the most recent reading in March reported at 5.0%. In this week’s rate announcement, Governor Macklem affirmed the labour market as tight. He also noted that we will need to see some job rebalancing take place and wage pressures moderating to help corral inflation back to target. A similar message was repeatedly publicized by Fed Chairman Powell, proving an overly tight employment backdrop is a common theme in North America as a whole.
If the upward pressure on prices can be simply put as “too many dollars chasing too few goods”, then central bankers want to ensure the “dollars” side of that equation is held in check relative to the “goods” side. Allowing wage growth to persist at elevated levels could result in uncontrolled price pressures and a greater loss of central bank credibility. With policy rates already so high, and sensitive sectors showing some normalization, a wait-and-see approach continues to be justified. This allows for the lagged effects to fully flow through. But if father time does not show enough correcting evidence, the BoC may have to adjust policy rates higher from here.
EVOLVING MARKET EXPECTATIONS
Markets are forward looking. The daily flow of new information is constantly feeding into evolving market forecasts. As shown below in the orange dots, market participants are currently pricing in a 25bps rate cut in December from the Bank of Canada. The market is also currently expecting about two rate cuts from the U.S. Federal Reserve by the end of the year. Whether these forecasts transpire is yet to be seen.
As mentioned, new information comes in every day and market forecasts adjust as a result. Should inflation continue to be stubbornly persistent, we may see Ottawa hold restrictive policy higher for longer, or even hike further to ensure their inflation target is reached.
Source: Bloomberg, QV Investors Inc.
We think most market historians would agree, it would be rare to avoid an economic slowdown after how high and how fast policy rates have been brought up. Generally, a 12-month period of pause has been seen in earlier cycles before policy rates had to be lowered. With that said, this cycle that began in the depths of 2020 is unique and historical precedent may not apply. Regardless, market prices infer that rate cuts are expected by the end of the year. While it may be premature to consider cuts in the face of above average wage pressures, it’s reasonable to forecast a pause for most of the year.
We will never know the future with exact precision. However, that does not mean we cannot prepare our investment strategies for what could be rougher seas ahead. Thankfully, bond yields have risen to levels that make them decently attractive alternatives to equities within the context of a balanced strategy.
When it comes to QV’s Canadian Bond Strategy, we continue to adjust and improve liquidity, as well as its potential for price appreciation should our economic downside case materialize. In the meantime, bond investors can earn a decent return that they have not been able to achieve in well over a decade. The classic benefits that fixed income provides in diversification and capital preservation are available, and we have defensively positioned our balanced strategies as a result.
As central banks play the waiting game, investors can prepare their portfolios and better position themselves for potential market repricing should the future unfold differently than what is currently priced in.