7th inning stretch

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 11/04/2022

Economic Data

We’re increasingly confident that the rate hike game is in its late innings, particularly in Canada.?And that may be true in the U.S. as well after this week’s FOMC meeting.?The Fed did hike by another 75 bps, taking its target range to 3.75%-4.00%, but the following statement can be taken to read that the magnitude of rate increases may ease at its December 14 meeting, "In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments." ?The futures market still sees the Fed’s rate peaking at 5%-5.25%, and the Bank of Canada’s peaking at 4.5% (3.75% now).?So, grab a beer and a hot dog as there are ?likely another 1 or 2 innings left in this rate hike cycle, with hope that we don’t see the central banks go into extra innings to get inflation closer to target.?But uncertainty remains as to the pace and end point.?Fed Chair Powell did say that “It is very premature to be thinking about pausing … The risks are asymmetric. If the Fed does too much, it can cut. If it doesn’t tighten enough, then you’re in real trouble. If we do not tighten enough, inflation may become entrenched.”?And remember, the Fed usually isn’t finished hiking until the Funds rate is above its favoured inflation measure.?

There was some good news on the inflation front with the ISM survey of purchasing managers prices paid component moving sharply lower. ??Unit labor costs also moved lower, but remain high on a year/year basis and are notoriously volatile. ?Unfortunately, the Fed is also focused on the stubbornly strong employment market.?The JOLTS report showed a rising number of job openings and today’s report of a gain of 261,000 jobs will not change Chair Powell’s concern that more work is to be done.?After the report, the odds for another 0.75% increase in the Fed Funds rate in December rose.

In Canada, the employment report has not been as strong of late, but today’s sure was, with a blowout gain of 110,000 jobs in October.?Over the last 6 months, we’ve seen gains of 56,000 jobs.?That’s about 9,000 per month which is not great, but still positive. ?Hourly earnings are rising, and that will worry the Bank of Canada a bit. ?Higher interest rates are biting as seen by building permits plunging 17.% in September, with all categories taking a hit.

Bond Market Reaction

Although several Fed governors were expressing dovish views, and stoking expectations for a pivot in Fed policy this week, Fed Chair Powell asserted his authority by leading us to expect a higher terminal rate, with no pivot imminent.?Yes, the Fed plans on interest rates moving higher and remaining there for some time.?But, history shows that, since the late 1980’s, the Fed has generally CUT rates after 6-7 months of its last hike.?Lower rates in H2’23? ?Maybe.?After all, Fed tightening cycles usually go too far, something breaks, and the pendulum swings back a bit.?But we have to hit the peak in Fed Funds first, and it’s not here yet.

Stock Market Reaction

Equity markets gave back almost all of last week’s gains following Chairman Powell’s press conference on Wednesday. ?The prospects for additional interest rate hikes leading to an expected economic contraction overwhelmed fairly decent earning releases. ?While many companies beat consensus estimates, the market punished stocks that gave dampened growth outlooks.?Gold stocks also weren’t too pleased with the “ultimate level” of interest rates settling out higher than previous thought. ?The real strength was found in the energy sector, with Suncor, Cenovus, Tourmaline and Ark all up between 5-10% this week. ?It is understandable why these companies are performing so well: they are not expensive; they’ve paid down most of their debt; they are managing to prudently grow while maintaining margins; and they are returning a tremendous amount of excess free cash back to shareholders in the form of dividends, buybacks and special distributions. Let’s just hope politicians don’t meddle too much in those windfalls. ?

What to Watch Next Week

U.S. mid-term elections could mean a swap of control of both the House and the Senate to the Republicans.?But it may take a while to know the full results.?The remaining two years of the Biden presidency could be mired in conflict that results in a hamstrung government.?The U.S. will also see the release of consumer credit, the October inflation report, hourly earnings, and consumer sentiment.?There is nothing in Canada.

Disclaimer

Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

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