November Outlook
November 17, 2022 | By Hank Cunningham
Inflation remains a global issue, despite the recent improvement in North America. In Europe, consumer prices have accelerated above 11% with no sign of relief. There has also been extra turbulence caused by extraordinary developments in the UK. The U.S. Federal Reserve has quashed near-term enthusiasm that its interest rate hikes are near an end. Chair Powell has stated repeatedly that he would like to see several consecutive months of improved inflation numbers before considering a pause. Thus, the Fed Funds Rate is likely to rise 50 basis points on December 14. The Canadian bank rate will likely move up a similar amount on December 7.
As to market yields, the U.S. two-year yield, currently at 4.4%, could reach 5% with further tightening and the 10-year appears to be headed to 4.25% to 4.5%. There have been few signs of strain in credit markets, but vigilance is required. Given the extent of the bond market sell off, rallies from time to time are likely. It is possible we will see 3.5% on the 10-year Treasury.
The Bank of Canada has little choice but to follow the Fed as the Canadian economy has also proved to be resilient. In addition, the Canadian dollar has suffered at the hands of a strong U.S. dollar, although it has bounced from recent lows. The weaker loonie will nevertheless exacerbate inflation trends in Canada as import prices add to domestic cost pressures.
In summary, global credit markets are discounting the next rounds of interest rate hikes. This removes the surprise factor and should result in few knee-jerk reactions. There remains the possibility that several central banks may reduce their bloated balance sheets via bond sales.
The big question is: when will we see inflation turn? One month does not make a trend. While the cost of goods has shown weakness in recent months, the biggest component of the CPI is service costs, and they show little sign of slowing and may actually increase. There are signals of a recession on the horizon, but economic growth remains positives. Odds of such an outcome have grown, but a recession is by no means a certainty. Those who believe in the inevitability of a recession point to the lagged effect of monetary tightening and suggest it has yet to be felt, other than in the interest rate-sensitive housing market. It is important to watch the corporate bond market for signals that tightening is beginning to affect credit quality.
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