Are we there yet?

By: Patrick O’Toole, Adam Ditkofsky and Pablo Martinez

Economic data

Now that both the Bank of Canada and the Fed are on pause, the question market participants are asking is “How soon before central banks start cutting rates?”’ Futures markets are currently pricing in rate cuts within the next 6 months, but given inflation remains well above the Fed’s 2% target, these expectations seem optimistic. Of course, if something in the market were to break, causing significant instability, then anything is possible. However, barring such a circumstance, this type of action seems unlikely. Both the Fed and the Bank of Canada are trying to re-establish their credibility as inflation fighting entities, so they will want to see stronger evidence that price levels are moving back to target before starting to ease policy. The good news is that we have seen inflation come down significantly from last summer’s peak levels, but while it continues to move in the right direction, there is still uncertainty for the second half of this year. So just like how my kids ask me “Are we there yet?” in the car on a long road trip, the answer here is the same: “Not just yet.”

Canadian economic data was fairly light this week, seeing only building permits, which blew past expectations of -2.2% with a +11.3% month over month increase in March. However, the headline number was somewhat deceiving, as the entire increase was driven by non-residential permits, which rose 32%, while residential permits fell by -0.9% month over month, or -18.1% on a year over year basis. Not a great data point to support an affordable housing market, especially as Canada looks to absorb 500,000 new immigrants per year. In the US, we saw a lot of key inflation data this week, with the April consumer price index (CPI) meeting consensus expectations at 0.4% month over month, or 5.0% year over year. Core inflation data (excluding food and energy) was also in line with consensus at 0.4% month over month and 5.5% year over year, with the bulk of the increase being driven by shelter. However, while still elevated, shelter is also showing signs of cooling, but likely not enough to support rate cuts this year. We also saw producer price index (PPI) data for April, which was below expectations at 0.2% month over month and 2.3% year over year, and continues to suggest that producer price pressures are easing. This is also consistent with other data we’ve been seeing this month, including the New York Fed Supply Chain Pressure Index, which has also been easing and suggests that supply chains are finally normalizing. Wholesale trade data was also below expectations, with the inventory/sales ratio sitting at 1.4x, representing its highest level since June 2020 and well above pre-pandemic levels. This suggests that wholesale inventories are bloated and should also be a positive catalyst for further inflation easing. Lastly, we saw weekly jobless claims jump to 264,000, the highest print since October 2021, providing us with further evidence of slowing economic data.

Bond market reaction

Bond yields were lower on the week, consistent with most data coming in softer than expected. However, Canadian rates continue to be range bound, with 10-year bond yields fluctuating between 2.70%-3.10% since the collapse of Silicon Valley Bank. So, it wouldn’t be a surprise to see rates move modestly higher in the near term, especially since futures markets are currently pricing in aggressive rate cuts over the next 6 months. Credit spreads were modestly tighter on the week, as most corporate earnings continued to meet or exceed expectations. We also saw several corporate issuers bring deals to the Canadian market, most of which were well oversubscribed and saw decent performance. The US market also saw strong activity. However, several deals were challenged by economic weakness and market timing. High yield spreads were also modestly tighter, with the index yield being stable at approximately 8.5%.

Stock market reaction

Equity markets were mixed this week, apart from technology companies which drove up the Nasdaq. Alphabet, Google’s parent, gave a comprehensive update on new developments internally. In the last few months, Google has been under tremendous pressure to keep up with AI developments, and recent attempts to impress investors had disappointed until this week. Google unveiled new features regarding chat bots, maps, and search. The implications and use cases of AI are still being figured out, but the arms race to the finish line has many excited. We also saw Air Canada’s earnings this week, which exceeded expectations. Canadians continue to travel despite inflation concerns and declining consumer confidence. Flights are running full and the company expects momentum to continue, thus taking up their financial guidance for the year.

What to watch next week

Next week in Canada, we’ll see CPI, housing data, wholesale trade, manufacturing and retails sales. In the US, we’ll get retail sales, industrial production, business inventories, housing data and the leading indicator index for April.

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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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