#MacroMemo: July 17 – 21, 2017

Bank of Canada raises rates:

• The Bank of Canada raised rates as expected, delivering the first increase in seven years. The overnight rate now sits at 0.75%. In so doing, this action provides yet another signal that the era of extreme monetary stimulus is coming to a close.
• The overall tenor of the accompanying statements were rather more hawkish than expected. Not only was the growth forecast tweaked higher and the size of the output gap ratcheted lower, but the Bank now expects the economy to return to its full potential by the end of this year. Previously it has expected this convergence to occur sometime in the first half of 2018.
• The global growth forecast was adjusted higher, inflation weakness was dismissed as the temporary result of a few industry-specific distortions and the Bank included a rare bit of forward guidance about future decisions. Although this statement technically only spoke of data dependency in making further decisions, the inclusion of any anticipatory statement at all strongly smacks of plans for more tightening.
• Going into the meeting, the debate was whether the Bank viewed this tightening as merely an unwinding of the oil shock stimulus from early 2015, or instead as the beginning of a grander adventure in higher Canadian rates. Either interpretation is still reasonable – the language in speeches leading up to the decision clearly tilted toward the former interpretation. But the breadth of optimism in this decision inclines us to give serious odds to the Bank viewing this action as the start of a tightening cycle set to last considerably longer than a paltry two rate increases.
• Of course, there could yet be economic developments that interfere with the best laid plans. We remain concerned about the state of Canada’s housing market and a potentially growing competitive disadvantages versus the U.S. (tax/tariff/environment/labour laws).

Market complacency:

• Financial markets continue to anticipate very little market volatility in the immediate future, as measured by the VIX, MOVE and CVIX indices (for stocks, bonds and currencies, respectively).
• There are quite a number of competing interpretations for this situation, with implications ranging all the way from slightly positive to quite negative:
• Slightly positive: markets may be prescient in anticipating an unusually stable period ahead. This would be good from an economic standpoint, if less perfect for an active investment manager.
• Mixed interpretation 1: volatility expectations are set in significant part on an adaptive expectations basis. This is to say, recent months have been fairly stable and so the market assumes more of the same. This isn’t a bad forecasting strategy.
• Mixed interpretation 2: in a low return world, a disproportionate number of investors are juicing their returns by selling volatility (selling options). This practice is depressing the level of the VIX and related measures. It is a classic “picking up nickels in front of the steamroller” trade – sellers of options enjoy a small win most of the time, but suffer large losses occasionally.
• Mixed interpretation 3: the global environment has been fraught with uncertainty for a decade, yet investors have survived and markets have gone up more often than down. Like a soldier on their third tour of duty, perhaps investors just don’t worry about volatility any more.
• Negative interpretation: When the VIX is low, market returns have historically been inferior over the subsequent year, often as the market is forced to adjust its risk assessment higher. Related to this, low expected market volatility tends to be associated with a fairly late stage of the economic cycle. The last time expected volatility was this low was in 2007 – an inauspicious year.
• In contrast to the calm market attitude, uncertainty is arguably still fairly high when measured via the global policy uncertainty index or more qualitatively via observations about unclear American fiscal policy, the advanced state of the business cycle, geopolitical risks, the beginning of global monetary tightening and the unusually long period since an equity bear market.

U.S. deregulation hopes:

• We have made a habit of regularly revisiting the U.S. regulatory environment, recognizing that actions on that front hold the potential for a material short-run economic boost.
• Although the Trump Administration has managed very few legislative victories, there has actually been more deregulatory progress than commonly imagined.
• It is important to recognize that there are three different ways that federal regulations can be reduced. The first and indisputably most potent approach is to pass legislation. But this hasn’t happened in any significant way.
• However, two other important steps have been taken. One is via executive orders, which can alter the interpretation of previously passed legislation and assign or retract the resources necessary to enforce laws. President Trump has been quite active on this front.
• The other way an administration can influence the regulatory environment is by changing the overall regulatory climate. This arguably happened the day Trump was elected. Businesses feel more free to push the regulatory envelope without fear of an aggressive enforcement response. This is already visible in the NFIB’s small business survey, which shows that small businesses are significantly scaling back their concern about the level of red tape in the U.S.
• At a more granular level, several deregulation developments of note have occurred recently:
• The U.S. opted out of the Paris Agreement on the environment
• Policymakers have succeeded in unwinding many of the final pieces of legislation passed by the Obama Administration thanks to a little-used “Congressional Review Act” that permits any legislation passed in the previous several months to be annulled via a simple Congressional majority.
• President Trump’s latest appointment to the U.S. Federal Reserve – Randal Quarles – will act as the Fed’s point person on bank regulation, and is anti-Dodd-Frank.
• All of this deregulation is arguably one reason for faster U.S. growth in 2017, though one must be cognizant that there are sometimes longer term consequences to deregulation when environmental, financial or human safety are compromised.

Trump impeachment risk:

• Another frequent hobbyhorse of ours is the risk of an early exit for U.S. President Trump before his four-year term is up.
• This risk seemed to be declining handily in June given the fairly meek testimony from ex-FBI director Comey and stonewalling by NSA head Sessions.
• However, this risk has since surged in July, for a few reasons:
• Some relates to Trump’s cascading unpopularity – with public support now down in the 36% to 38% range.
• Some relates to repeatedly delayed efforts to modify Obamacare, which is now seriously impeding tax cut plans.
• The CBO recently delivered its assessment of the proposed Trump budget, finding it to be nowhere near self-funding.
• Crucially, Trump has now suggested via a tweet that he is being formally investigated by the FBI. This was not the case when Comey was in charge, suggesting an intensifying investigation.
• Recent revelations that President Trump’s son, Donald Trump Jr., met with Russian operatives to gain an advantage in the presidential campaign add credence to many previous allegations.
• Intelligence community alumni continue to be proven correct in their predictions and point to further adverse developments.
• British bookies now assign a 45% to 50% chance of an early Trump exit. We respond to recent events by revising our own view up from a 35% to a 40% chance. We are content to remain somewhat below 50% given that Trump seems unlikely to resign and he enjoys the theoretical support of Republican majorities in both the House and Senate.

China data dump:

• Much as several developed-world leading economic indicators generally perked up over the past month after a springtime swoon, China’s latest data dump was fairly positive. Quarterly annualized GDP growth managed a strong 7.0% advance in the second quarter. The annual gain was a similar 6.9%.
• The ongoing Chinese shift from manufacturing toward consumption remains visible in the relative growth rate of retail sales and industrial production, but both managed to best expectations in June.
• Despite all this, we still flag the potential for slower growth given prior policymaker tightening and a declining economic speed limit for the country.

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Published July 17, 2017