Douglas Porter

May 6, 2022

It’s getting real now. Financial markets are fully coming to grips with the extent of the inflation fight central banks have on their hands. The Federal Reserve’s 50 bp hike on Wednesday was the showpiece event, and was initially greeted warmly by investors, with Chair Powell playing down the threat of even bigger moves, for the time being. However, the reality of the task ahead quickly began to dawn more fully, reinforced by a wave of rate hikes globally—each of Britain, Australia, India, Brazil and Chile chimed in as well this week. After the briefest of rallies, stocks and bonds succumbed to new waves of selling, a recurrent theme so far in 2022. Renewed weakness left the S&P 500 at its lowest ebb in 13 months by Friday morning, and down 15% from its peak on the opening day of the year. Even the previously sturdy TSX has sagged more than 7% from its record high (of just five weeks ago) and is at a seven-month low.

What’s really rattling equities is the behavior of their bond cousins. The 10-year Treasury yield reached the 3% threshold early in the week, took a short breather after the FOMC, and then charged above that key level with gusto. In just the past two months alone, these yields have now surged more than 135 bps. Such a rapid rise in long-term rates has not been on offer since the big and fast tightening in 1994/95. And this latest back-up in 10-year yields was in spite of the fact that 2s actually dipped modestly, due to Powell’s disavowal of 75 bp steps. Thus, after inverting just weeks ago, the 2s10s spread is back to around 30 bps. The bulk of the recent rocket ride in 10s has been driven by rising real yields—the glimmer of good news, such as it is, is that markets are not getting even more concerned about the inflation outlook.

One of the big drivers of the rapid back-up in long-term yields, and especially real yields, is the other part of the Fed’s double-barreled tightening assault. Alongside the well-telegraphed rate hike was the start of quantitative tightening, beginning on June 1. While, again, there was no particularly large surprise in the details, it reinforced the message that the Fed is now proceeding with the most rapid pace of tightening seen in decades. Arguably, this will be even more aggressive than the 300 bps in a year in the mid-1990s, because this episode will see QT riding shotgun. We nudged our Fed forecast after the FOMC to reflect a faster policy response—three more 50 bp hikes in succession, and then two spaced 25 bp moves to bring policy rates to the high end of the 2%-to-3% neutral range by early 2023.

Canada’s bond market was fully pulled along for the uncomfortable ride. In fact, 10- and 30-year GoCs vaulted even more forcefully this week, jumping almost 20 bps, to breach the 3% threshold. No GoC yield had been north of 3% since 2013 prior to this week, and 10s have now doubled in the past year. Adding to the inflation angst in Canada is a sagging loonie, which has famously failed to benefit from the broad-based strength in commodity prices. Even with natural gas hitting a 14-year high above US$8 and oil pushing back up to $110 this week, the currency still retreated (in volatile trade) to around 77.7 cents (or almost $1.29/US$). The loonie is simply unable to overcome the sweeping strength of the U.S. dollar, which has kicked into overdrive in recent weeks. In fact, the Canadian dollar has appreciated by nearly 2% against currencies other than the big dollar so far in 2022. However, for the exchange rate that really matters to Canada, it’s always tough to make headway when financial markets are reeling.

Probably the single biggest factor that could help break the fever in markets would be a calming of inflation. Next Wednesday’s U.S. CPI release for April thus looms extraordinarily large. It just happens to have a few factors leaning in its favour, as the early read on both gasoline and used car prices were lower in the month—and, of course, these two items have been two of the leading causes of the inflation wildness of the past year. However, even with those two large helping hands, the headline number is expected to still hold above 8% y/y while core is likely to remain north of 6%. If so, that would definitely be a step in the right direction, but we need a whole series of steps before anyone, mostly the Fed, will truly relax.

And note that the U.S. consumer inflation pace has been the hottest of the hot, partly due to the specific impact of used vehicle prices, as well as an earlier reopening price pop. So, even a few milder months would really only bring U.S. trends into better alignment with Europe and Canada (where inflation is closer to 7%). Meantime, inflation is still sparking elsewhere. A bit away from the headlines, Japan reported on Friday that inflation in Tokyo fired up to 2.5% y/y in April, a good leading indicator for the nation. While 2.5% inflation is going to scare precisely no one, note that it is, oh, 2.4 percentage points above the average inflation rate over the past 25 years in deflation nation. China will also release its April CPI next week, and even its tightly controlled prices are expected to rise by nearly 2% y/y in the month.

Calmer commodity prices would certainly help in taming broad global price pressures. But even in that friendly event, there is still the fundamental need for policy more broadly to tame demand. From the incredibly easy position of looking in the rear-view mirror, it is now staggeringly obvious that policy overcooked the goose in 2021—whether it was a last blast of unnecessary fiscal stimulus, or rates overstaying their welcome at zero even as prices were flaring. The unfortunate reality is that the bill has now come due for that excess, and the price is the need for tighter-than-comfortable policies. And, the reality is that the process has really only just begun.

As somewhat of an antidote to that cheerful missive… there is so much to be grateful for. Spring is finally here, after four months of January, the Leafs are competitive with the reigning champs, Canada’s own Jeopardy! rockstar is still tearing it up, and North American unemployment rates are probing the lowest levels in decades. In fact, job growth is now ebbing as the lack of available workers has become the binding constraint. This theme is explored in greater detail in this week’s Focus Feature, but this point requires reinforcing—this is not due to the so-called Great Resignation. Note that the U.S. participation rate for those aged 16-64 returned all the way back up in April to precisely match its pre-pandemic high, after having long since accomplishing that feat in Canada.

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.