Yesterday, the Bank of Canada (BOC) shocked markets by hiking its benchmark policy rate by a full 1% (100 basis points) to 2.5%, which is the first time the nation’s central bank has hiked 1% since 1998.
Prior to the meeting, markets had priced in a 75-basis point hike for yesterday’s BOC meeting followed by roughly 50%/50% probability of a 50 basis point or 75 basis point increase in September.
After today’s 1% hike, the market is now pricing in 100% probability of a 75-basis point hike at the BOC’s next meeting on September 7th and a whopping 88.8% chance Canada opts for a second 1% hike at its next scheduled meeting.
That’s a HUGE shift indicative of the shocking nature of the move.
BOC Governor Tiff Macklem noted the central bank wanted to “front-load” rate increases to help guard against runaway inflation and the statement accompanying the hike noted: “The Bank of Canada is keenly aware of the possibility of a wage-price spiral and is firmly committed to ensuring that this dynamic does not set in.”
Macklem was asked twice during the press conference – once in English and then again in French – whether a soft landing is possible. While he said that such a scenario is still possible, he added that the path to a soft landing is now narrower.
Whether you care to say it in French or in English that means one thing:
Recession in Canada is the most likely outcome because rates will have to rise by a lot – and quickly – if there’s any hope of bringing down the generational surge in inflation.
Let’s move back south to the US outlook:
Yesterday morning at 8:30 AM eastern time (ET), the US Bureau of Labor Statistics announced headline inflation jumped 9.1% in June, the fastest pace since November 1981.
That’s well above May’s rate of +8.6% and the +8.8% rate economists had expected before the release.
Listen, some will tell you that inflation is peaking this summer while others will tell you that inflation is all about war in Ukraine.
However, the reality is that even if we exclude food and energy prices, the core CPI index was +5.9% year-over-year, still almost 3 times the Fed’s target and significantly higher than economists’ consensus outlook for a gain of +5.7% year-over-year.
And, while oil and food prices are coming down and goods price inflation may be peaking, what really has me worried isn’t so much the headline and core numbers but just how broad-based US inflation is right now.
Indeed, a whopping 80.4% of all Consumer Price Index (CPI) sub-indexes surged by +4% year-over-year in the most recent release, up from about 27.3% a year ago, 48.7% in January 2022 and 76.0% in March after the start of the war in Ukraine.
When you add the much hotter-than-forecast CPI number this morning to Canada’s July surprise, the market has started to price in an even bigger move from the Fed later this month.
Specifically, as of the end of June the Fed Funds futures market was pricing in 100% probability that the Fed hiked at least 50 basis points at its July 27th meeting and a 72.7% the central bank hiked 75 basis points. For September, the most likely outcome priced in Fed Funds futures was for a 50-basis point hike.
As of Tuesday’s close, the market was looking for a 75-basis point hike on July 27th and 50-basis points in September – about 1.25% in total hikes by the time of its September 21, 2022 meeting.
However, right now, the market is pricing in a 54.2% chance the Fed follows Canada’s lead and hikes 100 basis points later this month – futures are now pricing in 160 basis points of total hikes by the time of the Fed’s September 21, 2022 meeting.
And here’s what’s even worse: The market now seems to be telling us that a US recession is likely to start by the end of this year, forcing the Fed to begin cutting rates by the time of its February 1, 2023 meeting – in fact, by late 2023 or early 2024, the Fed is expected to cut rates by about 75 basis points from a projected peak Fed funds rate of 3.60% by the end of this year.
So, why aren’t rate cuts good news?
The simple fact is that the Fed usually only starts cutting rates when the economy sinks into recession.
If you don’t believe me, then just ask Fed Chair Jerome Powell who had this to say during the Q&A session following a speech to the National Association for Business Economics on March 21, 2022:
“Frankly, there’s good research by staff in the Federal Reserve system that really says to look at the short -- the first 18 months -- of the yield curve. That’s really what has 100% of the explanatory power of the yield curve. It makes sense. Because it’s inverted that means the Fed’s going to cut, which means the economy is weak.”
-Source: Bloomberg “Powell Says Look at Short-Term Treasury Yield Curve for Recession Risk” emphasis added is my own.
Undoubtedly, Powell was referring to a 2018 research paper from the Fed titled “(Don’t Fear) The Yield Curve.”
In it, Eric Engstrom and Steven Sharpe argue that the near-term forward spread – a measure of the expected 3-month T-bill rate in 18 months less the current rate – has more predictive power than the classic 10-year/2-Year or 10-Year/3-month yield curve metrics.
Specifically, when expectations for the 3-month T-bill rate in 18 months’ time are lower than the current 3-month T-bill rate – an inversion at the front of the yield curve – it’s a strong signal the market is looking for the Fed to embark on a serious rate cut campaign.
Well, take a look:
Source: Bloomberg
Conveniently, in late March when Powell spoke for the NABE, this spread was actually steepening even as many popular versions of the yield curve were flattening prompting some concerns about the health of the global economy.
On March 21, less than 4 months ago, this near-term forward spread stood at around 2.44% and it reached a peak on April 1st at just under 2.7%.
Yesterday, this measure of the yield curve stood at 0.6685%.
Granted, that’s not yet inverted, but it’s down nearly 30 basis points (0.30%) yesterday alone.
And over the past 73 trading days since April 1, 2022 it’s flattened more than 200 basis points (2%), the fastest pace since at least 1996 when this data series begins.
In short, the probability of a US recession – and recessions for Canada, Europe and most major economies – has moved from “growing risk” to “probable” within 12 months.
The consensus on Wall Street remains at only a 1-in-3 shot of recession; however, based on the economic data I follow, I believe the probability is much higher than that, somewhere north of 80%.
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DISCLAIMER: This article is not investment advice and represents the opinions of its author, Elliott Gue. The Free Market Speculator is NOT a securities broker/dealer or an investment advisor. You are responsible for your own investment decisions. All information contained in our newsletters and posts should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.