A Publication of BMO Capital Markets Economic Research
By: Douglas Porter, CFA, Chief Economist, BMO Capital Markets, April 20, 2018
Here on January the 110th, the weather has been slow to heat up, but we may finally be seeing a thaw in inflation. The sustained and rather forceful strength in oil prices in recent weeks adds a bit of spice to the brewing inflation pot. WTI has galloped 12% since the start of the year to its highest level since late 2014, even as U.S. oil production continues to reach for the sky. You know it’s getting really serious when the President starts complaining about high oil prices in the latest tweet. The oil rise adds to the already interesting mix of drum-tight labour markets, a dash of fiscal stimulus in Canada (and a bucket in the U.S.), minimum wage hikes, and a teaspoon of tariffs.
As if on cue, Canada today delivered its highest reading on headline inflation in almost four years at 2.3% y/y for March. That’s just a sliver behind the U.S. result for the same month (2.4%), and two pence back of the U.K. (2.5%). While inflation of just slightly above 2% is going to scare no one, especially given that it’s being led by rising oil prices, it does mark a notable change from last spring. It also comes against an increasingly fertile landscape for inflation pressures to take hold a bit more seriously, with some measures of core inflation now grinding along at a 2% pace or higher. The old-school CPI excluding food and energy is now chugging along at a 2.1% y/y pace in the U.S. and 2.0% on the button in Canada. In fact, the latter has suddenly sprinted at a 2.9% annualized clip in the past six months, its fastest pace in 15 years.
This quiet upward drift in both headline and core inflation has been a factor behind the grinding rise in yields. U.S. Treasuries approached their highest in four years for 10s (at 2.95%), while shorter-dated issues are at the highest in almost a decade. For 10s, that marks a rise of more than 10 bps in a week and brings the year-to-date surge to more than 50 bps. It’s been a broadly similar story in Canada, albeit a bit more restrained, with 10s up 10 bps this week and roughly 30 bps so far this year.
To be clear, we’re not in the camp calling for a big bounce in inflation—the official call is for an average headline rise of just a bit above 2% in both Canada and the U.S. for 2018/19. But, the risks of such a bounce have clearly increased, with some new-found pressure added both from surprisingly sturdy oil prices and trade tariffs globally. Just as an example of the latter, note the 17% y/y flare-up in aluminum prices in the past year; or better, the 42% y/y surge in lumber.
By the same token, we’re not especially bearish on bonds, we just happen to believe that in this environment, the underlying upward trend will stick for some time yet. Circling back to 10-year Treasuries, we believe it is a matter of time before they finally pierce the 3% threshold in a meaningful way for the first time in seven years, and then mostly stay there in 2019. Canadian yields have been boosted a little less by the onslaught of a supply wave, but will likely be dragged along in tow— we’re looking for a return to 3% 10-year yields by late next year, especially if the NAFTA news continues to improve. On that point, the official words remain quite constructive of-late, although the details are (not surprisingly) turning out to be devilishly difficult to sort through in the tight time frame imposed on proceedings.
The short end of Canada’s market was under sustained, steady upward pressure this week, even as the Bank of Canada’s rate decision and Monetary Policy Report were blissfully light on surprises. The Bank upgraded its outlook for both this year’s inflation (gracefully bowing to reality) and next year’s growth (on mild fiscal stimulus), but also shaved this year’s GDP (to match our call at 2.0%) and bumped the outlook for potential growth (to 1.8% on average). Overall, that’s a wash, and we remain entirely comfortable with our call of two more rate hikes from the Bank later this year, with the next move likely arriving in July.
The Canadian dollar took a step back this week, despite positive noises on NAFTA and further net gains in crude. After nearly touching 80 cents Tuesday, the currency spent the rest of the week in mild retreat, faltering back to around 78.5 cents (just over $1.27/US$). For a change, it was far from an outlier as the U.S. dollar was broadly stronger. We continue to look for the Canadian dollar to end the year close to 80 cents, and then firm slightly further next year. But the latest action just reinforces the point that the loonie continues to fly its separate way from oil for now—since the middle of 2017, the correlation in daily moves between the loonie and oil has actually been minimal, compared with over +0.90 in the eight years prior. And we can’t blame the discount on Canadian oil for the latest move, as WCS has rebounded to more than $50. Perhaps even the loonie has been temporarily a bit dazed and confused in its flight plans by the absence of spring.
TalkingPoints - End of Endless Winter
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TalkingPoints - End of Endless WinterDownload PDF - 187 KB