Economic data

This week was dominated once again by central banks, with the Federal Reserve deciding to keep rates unchanged at 5.25% while the European Central Bank moved interest rates higher by 0.25%. The unchanged rate from the Fed was expected by the market, but a notable development was the communicated higher expected level of interest rates for 2023/2024. The Fed communicated that they saw interest rates needing to move an additional 0.50% higher over the remainder of this year, which raised the question: “Is the central bank pausing in the cycle or just skipping a meeting?” It’s a valid question, as they see two additional hikes required with only four meetings left. The statement from the Fed was viewed as being hawkish, however, the press conference from Chairman Powell leaned towards a more balanced to dovish tone. All these factors left the market confused (and for good reason), with interest rate expectations not aligning with the Fed’s short term projections.

The perceived mixed messaging from the Fed is reflective of where we are in the cycle. Central banks are keenly aware that their actions have material time delays between implementation and producing the desired economic outcome. Further complicating their analysis of the economic landscape is that both the consumer price index (CPI) and employment are considered more lagged than other measurements of economic output. For example, during the 2008/2009 financial crisis, unemployment did not peak until 14 months after Lehman Brothers failed and almost 24 months after the US technically entered a recession. Today, understanding this lagged effect, and after 500 basis points (bps) of hikes at a historic pace, central banks most likely know they are near the 5-yard line. But as a sign of caution, historically, the last few hikes by central banks are almost always remembered as being policy errors. Taking this into account, policy makers are highly data dependent now, and it’s likely they’re also unsure as to whether they are currently pausing or skipping a meeting. What is highly likely is that interest volatility will be elevated between now and the next meeting, with economic data swinging the pendulum between one or two more hikes by the Fed before the year is over. In contrast to the Fed, the Bank of Canada assessed, after a six-month pause, that the economy was not moving sufficiently enough to counter inflation. But following the theme of lagged indicators, one could make the argument that the Bank only entered restrictive interest rate territory in the summer or fall of 2022, so our pause period may not have been fully reflective of the impact of higher interest rates as well. Supporting this argument has also been the fact that Canadian borrowers have been able to defer paying higher servicing costs on their mortgages, thus delaying any impact to their monthly cash flow. Ultimately, the Bank wants to see more progress on slowing the economy and like the Fed, will be hypersensitive to upcoming data.

This week we saw US CPI for May, which rose by 0.1% on the month (4.0% y/y), meeting expectations. However, core inflation remained elevated at 5.3% y/y, largely due to elevated used vehicle prices and shelter. US retail sales also came in slightly stronger than expected, with a monthly increase of 0.3%, while the market was expecting a 0.2% contraction.

Bond market reaction

Interest rates pulled a complete 360 on the week, with rates initially selling off by over 10 bps, after the US CPI release, to then completely reversing to end the week close to unchanged. The one theme that held was a further inversion of the yield curve (defined as the difference in yield between 10-year and 2-year government bonds). The slope of the curve inverted close to -1.15%, a new low in the cycle, as the market continues to anticipate higher short-term rates against an eventual easing of monetary policy. Despite these elevated economic concerns, both investment grade and high yield corporate bonds performed well this week, with credit spreads moving tighter.

Stock market reaction

North American equities defied expectations, defied the Fed, defied most prognosticators, and climbed that proverbial wall of worry to yet another weekly gain. In fact, the S&P 500 rose to a 52-week high, up about 3% for the week, and up nearly 24% from its October lows. Additionally, we are finally starting to see a broadening out of market leaders, as opposed to just the big seven US technology stocks that drove much of the earlier gains. As for the TSX, it really hasn’t participated in this year’s rally to the same extent as US equities, despite much cheaper valuations. The S&P/TSX is up about 5% year-to-date, and 12% from its October low, and is likely being held back by its more cyclical composition in financials, energy and materials.

What to watch next week

Next week in Canada, we get retail sales for the month of April, while in the US the major releases will be S&P Purchasing Manager Index (PMI), housing starts, and again jobless claims.

 Authors: Adam Ditkofsky, Pablo Martinez, Sandor Polgar, Steven Lampert, Craig Jerusalim and Rahul Bhambhani

Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; Pablo Martinez is Portfolio Manager, Global Fixed Income; Sandor Polgar, Portfolio Manager, Global Fixed Income; Steven Lampert is Senior Research Analyst, Investment Research; Craig Jerusalim is Executive Director and Portfolio Manager, Equities; and Rahul Bhambhani is Portfolio Manager, Global Equities.

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