Douglas Porter

June 3, 2022

It’s probably not wise to take economic forecasting tips from someone as mercurial as one Elon Musk. But the man does run a large, globally integrated manufacturing company, and if he thinks the outlook is “super bad”, it’s probably also not wise to ignore that comment. It may well be that his company is uniquely affected by the recent lockdowns in China, both on the demand and the supply side. However, it’s also true that the one major clunker of economic releases this week was a dud U.S. auto sales figure for May—they slumped to just a 12.7 million annual pace, versus an average of 14 million in the prior 12 months and around 17 million pre-pandemic. The renewed drop may reflect ongoing supply shortages, but it could also be an early sign that U.S. consumers have been chilled by the run-up in inflation, and especially record gas prices.

Despite those misgivings, as well as a certain banker’s early “hurricane” warning, financial markets mostly held last week’s strong rally and bond yields pushed higher. The bulk of May readings on the U.S. economy were generally positive this week, with payrolls topping expectations at +390,000, the ISMs both holding firm at solid levels around 56, and consumer confidence holding up better than expected. The jobs data also revealed a decent advance in total hours worked, which are on pace for nearly a 3% annualized rise for all of Q2, which lines up with our GDP call for the quarter. So far, so good.

However, amid those blue skies, the very obvious black cloud is towering inflation, and the pressing need for the Fed to dispel it, with haste. And the ongoing, relentless upward march in oil prices may be the single most ominous development for the broader outlook. Even with OPEC+ agreeing to ratchet up its production increase to 648,000 bpd, WTI still rose by more than $4 to $119, while gasoline prices hit record highs. Even as many are talking about/hoping for a peak in inflation, the remorseless rise in energy prices threatens to make a mockery of such. The reality is that the inflation fever is not going to break until oil prices break, and we simply are not there yet.

The combination of further energy price strength and the solid jobs data, as well as generally hawkish Fedspeak, drove Treasury yields higher across the board. Governor Waller suggested that a whole series of 50 bp rate hikes may lie ahead, until inflation is brought to heel. Even Vice Chair Brainard quashed talk of a September pause—for the record, we are looking for a 50 bp hike at that meeting. Breaking a three-week rally, yields rose by at least 20 bps from 3s to 10s, with much of the curve moving within reach of the 3% threshold again.

But those U.S. moves in yields were almost mild in comparison to their Canadian counterparts. In the wake of a hawkish 50 bp hike and Deputy Governor Beaudry’s warning that rates may need to go above neutral (pegged at 2%-to-3%), 2- and 5-year GoCs bounced more than 35 bps on the week, while 10s jumped more than 25 bps to above 3%. At one point on Friday, the important 5-year yield also hit 3%, its first visit to that level since 2010, while 2s are at the highest since 2008. The latter have jumped more than 250 bps in the short space of a year, the fastest such rise since the mid-1990s. We believe that the Bank’s strong message is mostly aimed at containing inflation expectations. Nonetheless, we are accelerating our view on rate hikes, and adding an additional 25 bps to the overall move—we now look for 50 bp moves in the next three meetings, bringing the overnight rate to 3.0% by October (previously we had the rate peaking at 2.75% early next year).

The rapid rate rise is a clear and present danger to the teetering housing market. And the early results from major Canadian cities for May vividly show that conditions are cooling in real time. Sales in Toronto tumbled 38.8% y/y, while Vancouver was down 32%, and prices are starting to moderate notably. The pullback in sales has now gone far beyond simply reversing the outsized strength a year ago, and is now in well-below-average terrain, with inventories building quickly. (We can’t help but wonder how loud the cries for “more supply” will be in the months ahead amid fading sales and swelling listings.)

The full retreat now underway in housing and the threat of an even more hawkish BoC has also prompted a downgrade of the Canadian growth outlook. Even the starting point for this year is weaker than expected, as StatCan revealed that Q1 GDP growth was 3.1%, versus their flash estimate of 5.6%. While we believe Q2 will still post solid growth on a reopening bounce for travel and entertainment, the second half has been shaved to a mild 1.5% pace. For all of this year, we now look for 3.5% growth (previously 4.1%), fading to 2.3% in 2023 (from 3.0%).

The U.S. outlook does not escape from the scalpel. Note that we were already below consensus on GDP growth, and above consensus on inflation, for this year and next. But the ongoing strength in food and energy prices points to the need for somewhat more Fed tightening—we have added 25 bps on that front as well, with Fed funds now seen peaking at 3.0%-to-3.25% by year-end. And, as a result of the greater pinch from higher energy costs and higher borrowing costs, we are also trimming the second-half U.S. growth outlook. The full-year growth rate is now expected to be 2.4% in 2022 (from 2.5%) and a mild 1.5% in 2023 (from 1.7%). That may not rate as super bad, but the risks are still tilting to the downside, especially if oil prices continue to forge higher.

Douglas Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.