Douglas Porter

June 24, 2022

It seems that almost no one now believes that the economy can achieve a soft landing in the face of the current inflation battle—not Chair Powell, the local Uber driver, Cardi B, nor the majority of Canadians. Each has opined in their own unique communications style in recent days that the expansion is at serious risk in coming months. In his testimony to Congress this week, Powell suggested that the path to a soft landing is becoming “more and more challenging”, and that bringing down inflation without driving up joblessness will be “significantly more challenging”. In turn, financial markets are building in those rising risks—this week saw yields and cyclical commodity prices retreat meaningfully, following last week’s savaging in equities.

Amid mounting recession concerns, markets have had a serious rethink on central bank pricing and have moved off the most extreme levels from a little more than a week ago. For example, after pushing up close to 3.5% on two occasions last week, Treasury yields have since tumbled across the board, with 2s even temporarily dipping below 3% at one point. While another 75 bp hike appears almost locked in for the late July meeting, it gets fuzzier thereafter. The latest dot plot had a median expectation that rates will rise by a cumulative 175 bps through the second half of this year (coincidentally matching our call, precisely) and then another 50 bps in 2023 (we say zero). After initially pricing in even more than the Fed median call, markets have since moved back in the direction of our view, presumably in the belief that the economy just can’t handle much more than that degree of tightening.

One key indicator that reinforces the view that growth may soon buckle is the surprising sag in a wide variety of commodity prices. Oil prices dominate the airwaves on this front, and they did indeed recede slightly after a big stumble last week. Even with a firming on Friday, they are still close to the lowest levels since early May at around $107, backing away somewhat from an alarming trend earlier this month. North American natural gas prices have taken an even bigger step down, albeit for a variety of reasons beyond the growth outlook. Perhaps more telling is the sharp pullback in industrial metals—particularly Dr. Copper. The red metal has dropped almost 20% in the past three weeks and is now at its lowest ebb since early 2021, after hitting a record high in the immediate aftermath of the Ukraine invasion. In fact, many broad measures of ex-energy commodities—even agriculture—are now lower than pre-invasion levels amid global growth concerns.

The sudden pullback in commodities and weaker global growth outlook has thrown a serious shadow on Canada’s prospects. We have long asserted that Canada’s relative near-term outlook versus the U.S. had two big positives, and one big negative. The latter is the extreme dependence on housing, which is quite clearly staring into the teeth of a deep correction. But that drag was expected to be more than offset by a) greater room for a reopening bounce, and b) the boost from a greater reliance on commodities and a positive terms of trade lift. For instance, export price gains have outstripped the rise in import prices by more than 20% over the past two years. But with many resource prices now retreating, that boost is at risk of fading. On cue, the TSX has been hit hard in recent weeks, especially relative to U.S. averages. In the short space of three weeks, the TSX fell 11% by Thursday’s close, and has now shown next to no outperformance versus the S&P 500 since the Russian invasion began.

The retreat in commodity prices is also weighing on the Canadian dollar. While the currency was little changed this week, it has been slowly drifting lower for most of this year in the face of a robust U.S. dollar. At just under the $1.30/US$ level (or 77 cents) it is dancing close to the weakest level since late 2020. Even though the loonie saw precisely zero benefit from the surge in commodity prices—and specifically oil—in the first five months of the year, it is now being undercut by the reversal in resource prices, naturally. The clear takeaway from the price action is the old saw that a market which doesn’t respond bullishly to bullish news isn’t bullish.

The risks to the Canadian outlook were given no favours from this week’s highly anticipated CPI release. As per usual, inflation landed hotter than the hottest estimate at 7.7% y/y in May, the fastest pace in more than 39 years. With pump prices on course for another solid gain in the current month, and a few planned hikes in other goods on deck (natural gas, milk), we’re probably not quite at the peak level just yet for headline inflation—Canada is almost certainly going to join the U.S. and Europe in the 8%+ club in the summer. Perhaps even more concerning for the Bank of Canada is the pronounced upswing in core trends in recent months. To pick but one gruesome example, CPI ex food and energy has sprinted at an 8.3% annualized pace in seasonally adjusted terms over the past three months.

One reason core inflation is starting to bubble in Canada is that cost pressures are spreading amid a tight job market. One important domestic indicator that often flies under the market’s radar is the establishment survey of employment (or SEPH): April’s reading was released on Friday. It’s often ignored because it lags its flashier cousin, the Labour Force Survey, by roughly seven weeks and is thus typically seen as “old news”. But, besides an alternative jobs count, the SEPH also reports on job vacancies (a record 1 million in April) and wages. And, the latter was especially notable this time—the fixed-weight measure leapt to 6.2% y/y in the month, surging well above anything we’ve seen in other wage measures this year, and about 1 ppt higher than the prior high in the 30 years of history for this series. In other words, after a long stretch of surprising calm for Canadian wages, the payroll survey just fired a shot across the inflation bow.

The supersized inflation result alongside a drum-tight labour market will keep the pressure squarely on the Bank of Canada. Even prior to this week, we and others had called for a 75 bp response by the Bank at its coming July meeting. However, much like our outlook for the Fed, we expect that a cumulative additional rate hike of 175 bps through the second half of the year—bringing the overnight rate to 3.25% by year-end—will be sufficient to chill the economy, and ultimately cool inflation. Even as we remain adamant that inflation will prove stickier than the consensus expects, we also suspect that the economy will prove to be much more sensitive to rate hikes than many expect. Before the market gets too far ahead of itself in pricing in massive further rate hikes, it’s worth recalling that it can take anywhere from 12-18 months for rate hikes to fully work their way through the economy—we are now barely three months into this rate-hike cycle.

Speaking of secondary economic indicators, who knew that the University of Michigan’s consumer sentiment survey would leap into the mainstream? After Powell specifically cited its inflation expectations result as a key factor prompting the upgrade to a 75 bp hike last week, the survey has moved into the big leagues. And today’s revised figure showed that the five-year inflation estimate was, in fact, 3.1% versus the initial 3.3% result. That’s barely above the 3.0% average for the first half of this year, and just matches the January reading. Apparently, the initial uptick in five-year expectations was driven by just a handful of respondents, as many in the survey don’t even attempt to answer that (quite tricky) question. Far be it for us to question the wisdom of the quick change to last week’s 75 bp Fed rate hike, especially in light of the grotesque CPI result. But it does reinforce the age-old point that policy should not be driven by one or two single indicators, especially those that are subject to sudden revisions.

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.