Strong economic data has some investors believing more interest rate hikes may be on the way. But is there a case to be made for holding at current levels? MoneyTalk Live’s Greg Bonnell discusses with Alexandra Gorewicz, Portfolio Manager for Active Fixed Income at TD Asset Management.
- Cost of living pressures continue to ease in Canada. Headline inflation coming in at 5.9% in January. But with the labor market and consumers continuing to show resilience, what does it all mean for the path of rates?
Joining us now with more, Alexandra Gorewicz, Portfolio Manager for Active Fixed Income with TD Asset Management. Alex, great to have you back on the show.
- Thanks, Greg. Great to be here.
- So let's talk about this report today. Obviously, headline inflation has been moving in the right direction for a while now, but we have a few other things that leave, at least me-- I don't know about you-- scratching my head a little bit about what impact rate hits have had so far, and where we might be headed. How do you read it all?
- OK. So headline-- the 5.9% that you mentioned-- we're seeing the high food inflation still, but this isn't a Canadian story. This is globally. We continue to see food prices continue to rise at pretty decent clips.
But if we strip that out and we look at core-- so core excludes energy and excludes food prices-- core is absolutely continuing the disinflationary trend that we've seen for several months now. The problem is that maybe the pace at which it's decelerating is a little bit slower than what we would have anticipated, and not just us, but probably Bank of Canada, as well.
And on top of that, we did see some revisions to the upside for prior months' core numbers. That's probably not what you want to see. And this time of the year is known to have pretty strong seasonal upside surprises in core inflation, but if we look through the numbers and see which components are strong and which ones are weaker, housing-related components are the ones that are resilient.
And we expect that to happen. Rent, mortgage, servicing costs-- these are all higher versus last year. And we know that they respond much slower to monetary policy tightening. So I think what we're seeing right now is not surprising, and it does nothing to really change the Bank of Canada's outlook.
- Yeah, because you get the headline inflation coming off. And you dug nice underneath the headline there, but then we also got a retail sales report. And we spent, in December, but that traditionally is a month that we do spend.
But stats can't say-- looks like we kept it up in January. The labor market's been strong. So yeah, the Bank of Canada said we're on pause. We're going to see how this plays out through the economy.
It's interesting lately, the conversation has gone from-- when they start cutting, it's like, would they actually get off pause and hike another time? What are they seeing in the data?
- Yeah, so mixed data, right? That's effectively what you're pointing at. And the fact that the labor market in particular has been so resilient and we continue to add jobs at a really high clip suggests that consumption, while slowing versus prior year, will still remain, call it, resilient enough, perhaps to even help us avoid or eke out a small positive economic growth for the first quarter of this year.
But it doesn't change the fact that the trend continues to show deceleration in consumption, in housing-related components, which are a big contributor to the Canadian economy. And this is before we've seen the full effect of the rate hikes that Bank of Canada has delivered over the last 12 months.
So when we think about what's really necessary here, it's time. We need to see the full effect of the Bank of Canada's tightening through the next couple of months, maybe even the next couple of quarters, at current level of interest rates. And that's really one of the reasons why Bank of Canada has said, we're comfortable to pause here and wait.
- All right. Let's talk south of the border. The Fed-- seems that there have been some changing of expectations there in the market as to what we're going to get from, arguably, the world's most powerful central bank. Now, people are starting to throw 50 basis points around for the next hike. How are we reading that situation?
- Again, very similar to Canada in the sense of the deceleration in inflation, or the disinflationary process. I think that's what Chair Powell said repeatedly in his most recent speech. He referred to disinflation many times.
That process is still underway. Again, is it happening at a slower pace than maybe what we would have anticipated? Yes. But we've known for quite some time that, let's say, the road from 8% inflation-- headline inflation-- to about 4% inflation would be relatively quick.
And we can still get there by the end of this first quarter-- so let's say March, April. But with how the data has come through, particularly around service PMIs, labor market obviously continuing to show a lot of resilience-- and not just resilience, perhaps. There could even be a reacceleration, although it's still too early to call it that.
All of that is pointing to the fact that the road from 4% inflation to the Fed's target 2% inflation is probably going to be more of a grind. It'll be slower. And what that really means for the bond market is that they have to price what the Fed has said, which is we're not going to cut rates this year.
Does it mean that the Fed needs to go higher? I don't think that the data's supporting the thesis that the economy is reaccelerating, but rather that the deceleration is decelerating.
- That's interesting you say that the bond market now has to price what the Fed is saying, because I think we went into this year, and definitely into last year with a bit of a disagreement between the Fed saying, listen, we're doing this, we're doing this, we're doing this, and the market's like, nah, come on. But I'm looking at it on my screen right now. I've got a US 10-year bond yield at 3.9%. This has been creeping higher.
- It has been creeping higher, but believe it or not, it's plus or minus where we started the year. So we did see interest rates fall noticeably in January. And they've since come back, particularly on the back of strong labor prints.
But this notion of anticipating the pivot from the Fed, where the pivot means they're going to cut rates in the second half of the year, none of the economic data in the last couple of weeks have supported that narrative. So the bond market has had to basically take that fall in interest rates back, so to speak. So we're plus or minus where we started the year.
And again, from our perspective, it just means that-- supports this notion that the Fed is right to say we're not going to cut rates this year. But do they really need to hike further? Are we going to split hairs here about-- is it 5.25% that they should hike to, or 5.5%? The reality is, again, time is what we need at this level of policy rates to work its way through the system and actually take stock of the full impact of monetary policy tightening on the economy.
- Does the fact that the bond market is actually believing the Fed now really change anyone's investment thesis as to how they perhaps saw bonds playing out this year? Obviously, last year with the aggressive rate hikes, a bond portfolio wasn't looking great. But now you've got these yields being offered, and maybe even a pause. Does it really change our idea about what bonds are going to do this year?
- It depends which bonds we're talking about. So if we think about shorter bonds-- let's say two-year, one-year type of interest rates-- those can still move higher. And those should move higher if we're going to price the full extent of the Fed, including the-- get to 5.25% and be on pause for the rest of the year.
But if we think about, call it, further out the yield curve, when we look at 10-year interest rates, 30-year interest rates, the real question we have to ask ourselves is do we think the Fed will ever cut rates again? And if the answer is yes, then you have to answer, well, to what level?
And if we think that 10-year rates at 4% is aggressive relative to where the Fed has continually communicated it intends long-term interest rates to be for the US economy to be in equilibrium, which they're saying is about 2.5%, that 4% today is quite high relative to that longer-term policy rate that the Fed intends to get to.
So that's just a long way of saying there is room, as time goes on and the economy continues to decelerate, for longer-dated interest rates to come down.