Keeping up with the Canadians

The Remarkable Role of Rates 

Policy rates have driven the direction of markets this year, sparked by the rapid application of out-sized rate hikes delivered by central bankers around the world. Given the impact these factors have on valuing the largest global markets in Real Estate, Debt, and Equities, while rising rates have created opportunities in Fixed Income, we have seen divergence and asymmetrical risk across various economies. For those interested in a refresher: 

When we perceive the role of interest rates on the economy, we can visualize this relationship as a seesaw with the slope reflecting the inverse of the rate sensitivity of the country. Countries with significant imbalances can benefit significantly from even moderate rate cuts, while they can simultaneously only digest so many hikes before the economy begins to contract.  

Countries with elevated rate sensitivity can be found by looking at the amount of debt outstanding (household debt), the choice of mortgages (mix fixed, variable, average duration), and how much employment and overall economic activity is tied to housing/real estate. Countries with high national and/or household debt levels are naturally burdened with principal repayments in addition to amplifying the absolute magnitude of relative rate changes. 

When we look at countries with particularly rate-sensitive economies, we do not have to look far... 

Checking in on Canada 

When we considered the outlook for Canada earlier this year, highlighted in our piece Canada: The North Remembers, we expanded upon three key themes; Housing, Labour, and Inflation.  

This view reflected that Canada’s enhanced rate sensitivity paired with observed economic weakening offered insight into a global economic outlook, largely the speed and severity of a looming recession.  

The Canadian economy is extremely highly geared toward the real estate sector; given that this is one of the most interest-rate sensitive areas of any economy, one will likely observe a more meaningful impact. When revisiting Canadian housing, we have seen continued stress across the market, with sales data having notably declined in major hubs, with Toronto and Vancouver seeing YoY decreases in October sales by close to 50%. Further, with prices on the decline, and inventories rising across the country, the Canadian housing market appears vulnerable, with continued weakness on the horizon.  

When looking at the labour markets, while the unemployment rate has broadly remained flat following an initial August jump. However, this resilience has been driven largely by growth in “lower-paying” service employment, which faced extraordinary lay-offs at the onset of the COVID 19 pandemic and have steadily sought to normalize in the wake of broad re-opening and market de-frothing. While labour market resilience could be perceived as inflationary, concentration in low-paying roles will reduce reliance upon waning government support and normalize consumption trends in-line with long-term expectations. 

In this regard, as recessionary risks appear front of mind in Canada despite recent resilience, we expect to see continued weakening across the majority of sectors; likely led by the aptly nicknamed “FIRE” sectors (Financial, Insurance, Real Estate) as leading indicators. 

While inflation remains elevated, both Canada and the US have seemingly turned a corner after steadily rising data in the past year has begun to normalize. In the most recent print, we have seen goods inflation turn negative, following also a broad decline in commodity prices. However, services such as rent and owner-equivalent rent present lagging stressors; recent data from Zillow and RedFin illustrate that this stress may not be here to stay. Given the time-lags in data collection and transmission of monetary policy, the coming 1-2 quarters will be pivotal in determining the path and stickiness of inflation.  

Reflecting upon the above chart, we can see that the inflationary narrative roared to new heights in Q1/Q2 2022, and this will create a much higher baseline from which 2023 CPI is calculated. Given the moderation in month-over-month inflation readings, the embedded inflation which caused stress in 2022 may prove to be an asset in 2023’s readings. The next two CPI releases might see some elevated pressure in the critical YoY readings as two low numbers are falling out. Starting 2023 – the heavy prints of early 2022 will start falling out of the 12 months window. The pace of inflation has clearly decelerated – yet it will take some time for it to fully show in the YoY metric.  

However, not all has played out entirely as expected, namely the speed and severity of the economic downturn within the Canadian Economy. This is perhaps best reflected by the Citi Economic Surprise Index (economists expectations of economic data vs. the actual outcome), which at the time of our initial post in September, settled at ~ -70 and was falling drastically. While many of the dominant challenges continue to reflect systemic strain, the index has reverted to a marginal positive value. This likely suggests that economist were expecting less resilience from the Canadian economy.  Oil/gasoline can play a role here too – the price at the pump has fallen steadily over the past few months – that provides a mini-stimuli for a significant part of the population.

Potentially Pressing the Pause Button 

Exiting a year defined initially by being oblivious to inflationary threats and then turning around to “hike first, ask questions later”, the question has arisen of exactly what is to come, and when a policy “pivot” may be expected. While the idea of a “Powell Pivot” has recently driven equity market optimism, we are reminded that the loosening of monetary policy is generally associated with economic weakness, often dragging equity markets in process. We can see this clearly when contrasting the Fed Funds Rate with the S&P 500. However, bond markets, with higher seniority, lower risk and inverse pricing to interest rates, have historically outperformed. 

When we look north of the border, we seek to understand the notion of a pause; no longer hiking, but not yet cutting, as the BoC optimistically aims to dually observe the delayed effects of prior hikes on inflation, while ideally avoiding a looming recession. While the playbook may not be as clear as past months, the Bank’s decision to watch and wait appears justified at this point, taking a precedented approach to unprecedented times. 

Since 2000, Canada has seen 6 complete hiking cycles, broken into 8 components, with 2003 and 2007 each including a quickly reversed “top-up” after a pause. From this, we can derive a collection of considerations regarding the post-pause policy projections. 

From the initial post-hike pause (removing the outlier of 2010-2014 extended pause), the next policy decision typically occurs ~6 months out, with rate cuts (5.8 months) often occurring faster than rate hikes (6.7 months). However, this is aided by the fact that when supplementary hikes are applied, rate cuts are often imminent, as shown in 2003 and 2007 (albeit in vastly different economies). This period further aligns roughly with our expectation for Canada’s “lead” on most developed nations, pre-emptively recognizing the potential length and severity of a recession and the BoC again leading the way in response. 

Revisiting the Risks of Reversal 

When evaluating any proposal, the significance of the risks often outweighs the value of the potential rewards, and this case is no different. Any sizeable shift in economic data, monetary policy, or fiscal policy could de-rail the efforts made to date, even if made with the best intentions in mind. From a monetary perspective, the risk of a premature pivot whether under political pressure or unjustified dovishness. However, today’s release highlighting the consideration of future hikes has kept markets in check to ensure that the messaging is clear; even if we may pause, rate cuts are not on the menu until inflation is controlled and/or the economy/labour market is not experiencing acute stresses. As core inflation remains in excess of 5% and labour markets hold tight, risks of structural inflation remain elevated.  

While the risk of over-tightening exists, Macklem, Powell and other central bankers have been vocal in their preference for over vs under-tightening given the significance of returning long-term inflation to the 2% target. Additionally, with a recession currently the base-case for most markets, minor to moderate over-tightening would create a lesser deviation from the baseline. However, should a recession not be around the corner, a high-growth high-inflation environment would be detrimental to fixed-income, however these odds appear to be slim and declining in Canada. 

From a fiscal perspective, the principal risk appears to be that of over-assistance, with government intervention moderating essential demand destruction to re-support balancing fundamentals. As above, Canadian homeowners are excessively strained, as borrowers on fixed-rate mortgages refinance at shockingly higher rates and half of variable-rate mortgages reach trigger rates increasing payments. Balancing the short-duration mortgage component of the country’s high household debt levels, the idea of fiscal intervention has come to light. Potentially taking the form of targeted mortgage subsidies, supplementing the existing top-up to the Canadian Housing Benefit for renters. As highlighted in our last piece I’m Sorry...  such intervention would likely continue the trend towards short-term intervention, acting for the sake of acting with less regard for long-run consequence. 

However, as governments around the world continue to recoil from the whiplash seen in the UK resulting from Liz Truss’ short tenure as prime minister; it appears unlikely that such action would be taken in the near future and without extensive consultation. 

Now, the million-dollar question; How do we act on this information? 

Positioning for Potential 

In general being long fixed income has played out well recently - in Canada most certainly, but also in many other jurisdictions. When examining the collective state of Canada, inclusive of monetary policy, economic data, and fiscal governance, we continue to believe that Canadian Fixed Income is well positioned for resilience amid a variety of economic conditions. The Bank of Canada’s willingness to lead from the front, facing the fastest hiking cycle in decades has provided perceived stability to the government and lenders alike. While Canada’s rate sensitivity remains a source of risk for the country, the rate-driven return from BoC cuts should outweigh any superficial spread widening.  

In this environment, I continue to find value in Canadian Fixed Income, including Short-Term Investment Grade Bonds and Real-Return Bonds (RRBs: Canada’s Inflation Linked Bonds). With RRBs producing positive real returns across the curve, investors can lock in positive returns without concerning themselves with inflation, while 5-5.25% yields on short-term Canadian corporate bonds continue to offer a good chance on solid absolute returns. Longer-term bonds had a epic run in the past few weeks and are now trading at around 100bps below the peak. That is a lot in a short period of time - with the curve being at exceptionally inverted levels.

As we revisit our athletic analogy, Canada looks to have assembled a strong team of fixed income contributors to deliver in many conditions, even against opponents tougher than my (prematurely eliminated) German soccer team... 

Congratulations on making it to the end - I hope that you found this piece enticing and educational... As monetary policy and macroeconomic conditions continue to evolve, we examine the role of policy on the economy, markets, and populations. As conditions continue to challenge investors, clients, and citizens alike, I hope that this piece provides yourselves and your clients with insight and confidence towards the direction of fixed income markets. 

If you have any thoughts, comments, or questions - please reach out.  

All the best,  

Konstantin