#MacroMemo: September 11 – September 15, 2017

Monthly economic webcast:

• Our September monthly economic webcast has been published, entitled “Geopolitics to the fore.”

Bank of Canada raises rates:

• The Bank of Canada raised its overnight rate by 25bps to 1.00%, surprising markets that had only priced in 40% probability of a move. For our part, we had believed an increase was marginally more likely than the market imagined, but lacked conviction on the subject. The fact is that no economic model in the world will claim that a quarter point here and a month there makes much of a difference. That level of granularity is largely an exercise in tea-leaf reading, and alas the Bank has been fairly tight-lipped of late.
• The market response – a soaring loonie and substantially higher yields – looks to be exaggerated to us. There are several reasons why.
• First, this decision hardly comes out of the blue. The Bank was already on a tightening path, with the market mostly priced for a near-term hike, albeit in October rather than September. Although the increase came a month early, the difference is hardly game-changing. True, the market continues to price in a chance of a further October hike, but with less than a 50% probability.
• Second, the Bank of Canada has emphasized that the decision to raise rates was largely backwards-looking in motivation. Recent growth has been stronger than expected, highlighted by Canada’s truly remarkable 4.5% annualized GDP gain in the second quarter that was literally triple the country’s theoretical speed limit. It is not that the Bank has suddenly upgraded its expectations for the future.
• Third, and further to the previous point, whereas the July decision was dripping in hawkish phrasing, the new statement makes quite a show of emphasizing caution about the future. Prominent among them, the Bank expects a deceleration of growth over the second half of the year, it continues to acknowledge low inflation and slow wage growth, and it dwelled on downside risks emanating from such sources as geopolitics (North Korea, U.S. foreign policy), potential trade tariffs and the strong Canadian dollar. Finally, whereas the July statement talked explicitly of “further adjustments” to the policy rate – about as strong a forward-looking statement as the Bank of Canada makes under its current management – the September statement says more elliptically that “future monetary policy decisions are not predetermined.”
• We assume a further rate increase from the Bank, likely in December or January. But further action beyond that is in no way assured, particularly given the stronger currency, diminishing fiscal stimulus, prior reductions in monetary support, a wobbling housing market and a myriad of competitiveness challenges on the horizon.
• Supporting this below-consensus view, Canadian economic data since the decision have been no better than mixed. Trade and employment data both had softer underbellies than the headlines conveyed (real exports are now below start-of-2016 levels; full-time hiring fell by a nearly unprecedented 88K positions).

Understanding Canada’s stock-GDP disconnect:

• Normally, national economies and stock markets at least rhyme with one another. Economic strength begets financial market gains.
• Unusually, this couldn’t be further from the truth for Canada across most of 2017: the country has managed the ignominious feat (from an investor’s perspective, at least) of leading the G7 in economic growth while trailing home dead last in stock market return.
• While a rare occurrence, there is no mystery as to why this gap has opened up.
• First, a big chunk of the Canadian stock market is housed in the resource sector. Resource prices and demand are determined globally, with Canadian economic conditions almost irrelevant to the proceedings. At the risk of being cheeky, one could even go so far as to argue that Canadian economic strength – all else equal – could even slightly impede the sector as this translates into higher labour and corporate borrowing costs. Commodity prices have declined since February, hobbling this part of Canada’s stock index.
• Second, another large chunk of Canada’s stock market is the financial sector. Starting from a position of very low rates, one could argue that financial institutions should relish rising interest rates as a means of plumping their net interest margins after years of skeletal spreads. However, rising interest rates happen to elevate a second less savoury issue in the case of Canadian banks: the possibility of a housing bust.
• Third, other markets – the U.S., most prominently – have soared across 2017 in significant part on higher tech stocks. Canada’s tech sector is comparatively puny.
• The bottom line is that Canada’s stock market underperformance is less mysterious than it first seems. Looking forward, some gains seem likely, though our forecast of a U.S. dollar rebound argues that in currency-adjusted terms Canadian equities could continue to lag their U.S. counterparts for the time being.

Bitcoin as currency:

• Bitcoin and several of its more prominent cryptocurrency brethren have staged quite an impressive rally over the summer, more than doubling in value.
• Our judgement on the viability of Bitcoins depends entirely on the precise question being asked.
• If the question is whether Bitcoins are a serious threat to traditional currencies over the near or medium run, the answer is a definitive “no.” A viable currency must serve as a reasonably stable store of value and be highly fungible. Bitcoins are neither.
• Store of value: Cryptocurrency valuations halve and double with disturbing regularity. Furthermore, it is possible to be robbed of all one’s cryptocurrency if hackers can figure out your key (a password or sorts). You wouldn’t even know until long after the fact. Furthermore, there is no legal recourse: because cryptocurrency ownership is anonymous, there is no one for the police to pursue.
• Fungibility: Similarly, Bitcoins are not very liquid. The vast, vast majority of conventional retailers do not accept them, and are unlikely to start anytime soon so long as more conventional currencies are still around.
• If the question is whether Bitcoins are a serious threat to traditional currencies over the long run, the answer grows a bit hazier, but is also likely a “no.” The fundamental allure of Bitcoin and its ilk is the anonymity and cheap transaction costs they afford.
• Anonymity: But governments are unlikely to allow the anonymity to persist. China, for instance, has just made it illegal to convert between its currency and cryptocurrencies, recognizing that people have been using it as a means to elude capital controls and transfer funds out of the country. Even for developed countries without capital controls to worry about, it is crucial for governments to be able to “follow the money” from the perspectives of taxation and criminal activities. Because cryptocurrencies do not allow this, governments are likely to regulate them ever more tightly if their popularity grows, potentially to the point of completely eliminating the charm of their anonymity.
• Transfers: The other long-term allure of cryptocurrencies is the cheapness of transferring funds between people. This could genuinely put downward cost pressures on financial institutions. However, let us also recognize that the cost is artificially low. This is in part because eventually governments will oblige cryptocurrencies to leave a paper trail for such transactions. It is also because – at least in the case of Bitcoin – transaction costs are being subsidized by the payment of newly created Bitcoins to those processing the transactions. However, the supply of Bitcoins is set to slow asymptotically, with the result that a proper fee will eventually have to be charged. Furthermore, the current Bitcoin infrastructure permits surprisingly few transactions per second and is difficult to scale up.
• But what about the blockchain accounting technology that underlies cryptocurrencies – the distributed ledger system that eliminates the need to trust other parties when engaging in transactions? This does appear to have considerable promise, though note three things. First, it is vanishingly rare for funds to be misplaced within the existing system, despite the need for trust. Second, the Bitcoin approach is actually inferior to several other similar cryptocurrency systems. Third, the adoption of distributed ledgers by society will have no bearing whatsoever on whether Bitcoin prices rise to the moon or crash to zero – one doesn’t need a Bitcoin to use a blockchain.
• Could Bitcoins serve as a (potentially rather large) niche product, filling holes in the global transfer system, enabling people to bypass capital controls, enabling black and grey market transactions and serving as a vehicle for speculators? Absolutely! Bitcoin prices could well run significantly higher. But this is a very different question from whether Bitcoins are about to do away with the current system of fiat money, or disrupt commercial and/or central banks out of existence.

Hurricane(s) update:

• Although there are as yet no locusts reported, every other calamity is seemingly imposing itself upon the Caribbean and Gulf Coast region. In the wake of Hurricane Harvey, which imparted biblical flooding on the Texas city of Houston, three additional Hurricanes are now swirling in the Caribbean, with the largest – Irma – having already devastated several Caribbean islands and set to make landfall in Florida over the weekend (this note was penned on Friday). To top it off, Mexico has just suffered its most intense earthquake in over a century.
• With so many ongoing developments, it is still premature to talk about the economic implications with any authority. However, we can speak generally about the normal course of events, and use a few placeholder figures.
• First, the short-term effect of natural disasters is usually to diminish GDP since economic output and demand are both impeded. Financial markets also sometimes suffer from a bit of risk aversion (lower stocks, lower yields). At present we are budgeting for something in the range of a 1ppt or slightly worse hit to Q3 annualized GDP in the U.S. Similarly, the disruption of oil refining in the Gulf region may send U.S. CPI as much as 0.75% higher than normal in September.
• However, very quickly, these moves are usually reversed. U.S. Q4 annualized GDP should manage an outsized gain nearly proportional to the original loss (or if not the fourth quarter, the first quarter of 2018). Inflation should revert to normal as refinery production rises again. Aggregate level financial market losses also usually unwind, though their effect can be more lasting at the sector level since publicly traded insurers will have to eat a significant fraction of the losses associated with the destruction of property, an economy-wide figure arguably on track for something in the range of $100B to $200B once all of the weather events are accounted for.
• Over the next five years, one might expect a bit more economic activity as rebuilding occurs, though the true long-term story is simply that natural disasters rarely alter the economy’s underlying momentum.
• Because the economic effects tend to be temporary, central bankers should not react too forcefully to these disasters. They might conceivably slow the Fed down a hair in its tightening plans, but more because the economic data becomes blurry for a few quarters rather than because there is a genuine fear of permanent consequences. 

Miscellaneous medley:

• The U.S. debt ceiling threat appears to have been deferred until year end by an improbable alliance between President Trump and Congressional Democrats. Whether this is a) cause for celebration – across the aisle cooperation could signal progress on other important fiscal files; b) cause for concern – Congressional Republicans are said to be outraged and could kill tax cut plans; or c) merely a special situation enabled by the desire to quickly secure funding for disaster victims; is open for interpretation.
• The U.S. Beige Book looked fairly strong, signaling a continuation of solid U.S. growth and some mounting capacity pressures beneath the surface. This is consistent with our diagnosis that the U.S. is at a fairly late stage of its business cycle.
• The ECB seemed not to be too fussed about the strong euro, instead attributing it mostly to the improving health of the Eurozone economy. It appears that October will be the date when additional details about QE tapering will be revealed, with the tapering itself perhaps beginning in January.

Week ahead:

• A raft of Canadian housing data beckons for the week ahead. Thematically, we expect further weakness in Toronto versus strength ex-Toronto.
• U.S. CPI data could perk up a little thanks to an increase in oil prices in August. However, the annual figures should remain roughly steady at just below the 2.0% target. Of course, the real fireworks will be the September data when the effect of Hurricane Harvey on gas prices becomes visible. Through it all, core inflation should remain fairly stable.

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 Published September 8, 2017