Central banks not claiming victory yet, but has inflation turned the corner?

Investors are getting some pretty clear signals from central banks that, after nearly a year of aggressive rate hikes, it seems that inflation is pulling in the right direction. So what does that mean for the path of rates in the economy this year? Joining us now, Chris Whelan, Senior Canada Rates Strategist at TD Securities. Great to have you back on the program.

Thank you. Thanks for having me.

So clearly the big show of the week was the Fed. That was yesterday afternoon. But we heard from our Bank of Canada last week. Heard from the Bank of England today. I guess the big question becomes, do we feel that, after all those aggressive rate hikes and the pain that was felt across so many asset classes, that the battle against inflation is starting to show us some results?

I think that's exactly what the market's telling us right now. I think the Bank of Canada led off with the pause. They signaled pause. We're taking them at face value here that they are pausing-- nervously at face value. But we are taking them at face value that they're pausing.

Then we roll forward to the Fed yesterday, and it wasn't easy to discern what kind of meeting that was at first. And then, when you take a step back and you look at the market's reaction, we have stocks positive. We have bond yields pushing lower. This is kind of-- it has a mission accomplished, kind of like we're doing pretty good here feeling.

The economy is showing us that-- the stock market is telling us that the economy might have a bit more left in the tank to hold up for longer. I think everyone's kind of scratching their head on, are we going to go into a recession or not? Is it going to be a bad recession? I think we're all confused on how that's going to evolve, and we're going to have to see.

And I think the bond market right now is pushing yields lower. And I think that the bond market is reading as the Fed shifting to more data dependence, and that's kind of what they leaned-- they nodded towards. And I think that's why we're seeing a large reaction in yields yesterday. That is holding today and with some follow through.

So I think that the hikes are working. Inflation is slowing down. I think it is becoming consensus, and I think with good reason. Consensus isn't always isn't always a fade, I think with good reason, that inflation is going to fall. And I think that that's for now we're going to-- we'll take that as a healthy sign, and that things are things are OK for now.

Yeah, the Fed did signal that even though they felt-- and Chairman Powell used the word "disinflationary" at some point during this press conference. But he did say there's more work to be done, that they're not done. They didn't give that same signal that the Bank of Canada gave, so we're going to sit here and figure things out. They said they're going to have to do a little bit more on rates to the upside.

So based on what we're seeing, and based on some of the data that's coming in, I'm not going to get you to give a prediction, but when does the Fed consider it safe to move to the sidelines? Is it one more? Is it two more? We got to feel the same.

Yeah, so we're in the one to two more camp right now. We'll see. There's risks. Well, this sensitivity to data picking up-- we have a lower sensitivity to data in Canada for the next month or two in Canada because the Bank of Canada has kind of said pause. So they're going to take stock of what the next two months look like. We've had a lot of backward-looking data. We're going to start to get that 2023 data starting to come in as we move our way through February and into March. So banks in Canada were taking stock.

In the US, they're a bit more data sensitive because a big shock lower in data is more risk of one or done. And then the big beats on data is it shifted two, or maybe even more than that. So I think there's a high data-dependent scenario in the US right now and a lower one in Canada. And I think that that's kind of the regime we're heading into over the next month or two. So I think it really depends on your kind of view.

And if we look at the stock market, the stock market is probably telling us the data holds up a little bit longer. And so that favors our one to two more scenario versus an imminent done. So that's kind of where we are in strategy at TD.

So it's clear from the monthly reports we get that we do have an inflation moving in the right direction, which is lower, although it's still high. We heard as much from the Fed. We've heard as much from other central banks. What could ignite inflation again? What gets, say, our central bank, after taking that pause, saying, uh oh, we have a little further to go?

I think the economy holding up longer as we're seeing-- as the stock market may even be nodding towards. So just the general strength in the economy can make it difficult for inflation to push lower. And then I think the other thing is the oil story. The oil is a big driver in the inflation equation from-- not necessarily a big driver on its own, but it tends to be very highly correlated to inflation.

So if you have a larger rally in oil on the China reopening story, on the economy holding up for longer story, on the reserves being drawn down to a larger extent-- there's a lot of large narratives that they talk about on your show often that could drive that further-- that's kind of your double top in inflation type scenario that's at play.

And I think right now, whether you're confused right now or not, I think the bond market is getting a sign that it's OK to jump back into bonds. The stock market's liking that yields are probably starting to get capped out. And we're unsure about the economy, but we're not overly scared about the economy. So I think that that's why we're getting the market reaction we're getting-- positive for stock, positive for bonds.

Well, it's been sort of fascinating through all this and all these aggressive rate hikes to try to bring down inflation by cooling the economy. So many central bankers, including our own, have said, we need to see some pain in the labor market. We really haven't seen that pain, so it starts to make me think, can we actually get a cooling of inflation, bringing it back towards that target range without severe damage to the labor market? Can those two things coexist?

Without the damage-- I think that's the question right now. Can you have the sustained pain in the economy? Can the labor market sustain where it's at? Are we coming from an overly strong point in the labor market? We are seeing layoffs in the headlines, but we're also starting to understand that those laid off are starting to get-- are getting a job quite quickly.

And so you have a tight-- we have layoffs from this economy slowing our concerns about it, and then you have a tight job market meaning they can replace their job right away. That's a dynamic we don't have a lot of recent historical precedents on. So can they coexist? I mean, it's hard to argue that they can't, and it's hard to see how they can.

[LAUGHS] It's a tricky one.

So I don't think that's an easy question to answer, but I can see how they can coexist. And I think one thing to understand is we're coming from a pretty high level of economic activity. A recession is a rate of change. So you can go from a high level to a medium level, still have a recession.

But I think, in that context, why is the stock market so positive right now? That may be a positioning story, and a lot of people may be overly defensive and caught right now. But then that also may be telling us that economic activity might slow, but it's not going to be so dire-- deep recession, job losses, that dark, gloomy picture. So maybe they can coexist, and maybe it's a decrease in economic activity. Maybe a soft landing is in play. And these positive economic trends can go on for a lot longer than we think sometimes. [AUDIO LOGO]

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