At its latest policy meeting, the Bank of Canada opted to leave rates unchanged at 0.50%, as was widely anticipated. The accompanying statement was marginally less dovish than expectations at best. All in all, nothing really earth shattering. For me, it’s the undertones within the outlook for the Canadian economy that are of most interest.
Canada has had its share of macro concerns so far this year – both domestic and external. On the external side, the importance of the US to the Canadian economy means that it is particularly sensitive to any changes in US fiscal and trade policies. Much of the focus on the potential renegotiation of NAFTA has been on the impact for Mexico, while little has been said about the implications for Canada. One would assume that given the zero-sum-game nature of global trade, that anything that is positive for the US will, in turn, be negative for Canada. Throw in the uncertainty over any potential Border Tax and you start to see the headwinds that Canada may face in trading with its most important trading partner.
On the domestic side, the housing market has attracted some concern. House prices in both Vancouver and Toronto have been rampant, raising fears of a collapse. These fears have been heightened by the plight of Home Capital Group, a mortgage lender that required a capital injection to stave off a run on deposits following accusations that it had previously misled investors. Funding problems at a “specialised” lender understandably grabbed headlines and prompted caution.
All of these factors weighed on sentiment and pushed the currency and bond yields lower – as such, a lot of downside is now “in the price”. Is it all bad news for Canada? Not necessarily. We may yet see the benefits from a rebound in US growth from both its traditional Q1 lull and via any increase in fiscal spending that (eventually) comes through. History has shown that a strong US economy is ultimately beneficial to Canada, although often with a lag. The optimism around a fiscal splurge in the US has receded somewhat, but if the White House can manage to get a deal done, this can only be good news for the Canadian economy in the future.
Given these cross-winds, the Bank of Canada has been forced to walk a careful path with the bias thus far being towards the downside risk. With pessimism being so negative for much of this year, the chance of an upside surprise in the months ahead is growing – this is something the market isn’t priced for.
History has a habit of repeating itself. We often hear “it’s different this time” only to find that events at least rhyme if not repeat the past. A good example is US GDP data: Q1 GDP data has been weaker than expected in the US in each of the last few years and it proved to be so again this year. The latest GDP report showed only 0.7% growth on an annualised basis – which was below the consensus forecast of 1%, even after downward revisions to those expectations in recent weeks. This was the latest in a series of data “misses” in the US so far this year.
Interestingly these disappointments have occurred as economic data elsewhere has remained robust. The chart below shows the difference between the economic surprises in the US compared to Europe (how many data releases come in either above or below the “official” consensus).
Source: Bloomberg as at 2 May 2017
So what’s going on? Is the US now lagging Europe? The answer is “not necessarily” – it has a lot to do with the level of expectations. The optimism that followed the US election pushed both consumer and business confidence surveys to multi-period highs and left expectations overblown. The inevitable normalisation in this “soft data”, along with some misses on the hard data side, has driven the surprise indices lower.
In Europe the opposite is true – expectations have been so depressed for so long that the recent uptick in data (from a low base) has been enough to beat the consensus. This feels like the start of the European economy entering into a new phase where investors will need to be focussed more on upside rather than downside risks.
For the US, it’s not all doom and gloom. The Fed commented last night that they see the weaker data in Q1 as “transitory” with their growth forecasts still in place. With expectations having been pared back in recent weeks, maybe the scene is set for the US economy to now surprise on the upside.
The shape of the German yield curve has seen a rollercoaster ride in the last 12 months. The ECB’s QE programme caused the curve to flatten as the national Central Banks bought their allotted amount of bonds across the curve, with the ECB’s rules excluding the buying of any bonds yielding less than the deposit rate. This “rolling flattening” caused 30yr and 5yr German yields to compress by around 70bps in the first 6 months of 2016. In Q4, though, the ECB decided to tweak their rules by reducing the allocation to long dated bonds while crucially allowing bonds to be bought below the -0.40% deposit rate. Data released last night shows that the Bundesbank has made the most of these changes by shortening the average maturity of its buying from 12 years to almost 4 years! This, along with buying by the SNB amongst others, helped push 2yr yields to -0.95% – a new low – and the curve to its steepest level since 2015.
Is this an opportunity to oppose the move and position for a flattener? I’m not so sure. The Bundesbank buying plans are unlikely to change and with political uncertainty on the rise, the demand for “safe” German bonds i.e 2 and 5yr bonds, can continue. The short end will ultimately be vulnerable to a re-pricing once improved economic data encourages the ECB to taper further but, for now, the momentum and flow of buying favours a steepening bias. The flattener may have to wait on the side-lines for a few months before it gets its turn to ride the rollercoaster.