A Publication of BMO Capital Markets Economic Research
By: Douglas Porter, CFA, Chief Economist, BMO Capital Markets
You know that it would be untrue, you know that I would be a liar, if I was to say to you, yields they couldn’t get much higher. We often remind that the punchline of Aesop’s fable “The Boy Who Cried Wolf” is that the wolf actually does show up one day (and eats said boy, after polishing off the local sheep). And, after forecasters seemingly cried wolf for years about the threat of rising interest rates, the wolf has finally shown up… and it’s hangry.
This week saw yet another upward lurch in long-term North American yields, with the 10-year Treasury at one point reaching the highest level since 2011 at above 3.10%. That also just happened to be our year-end target, prompting a reset in the forecast, with the new call 3.25% (but next year’s steady at 3.50%). Not to be outdone, Canadian 10-year yields also continued their long march higher, pushing above 2.50%, also close to our previous end-18 target (now 2.7%). While yields on both sides of the border took a small step back on Friday, the technical damage has been done, and both are still up a meaty 10 bps from a week ago.
Given that economic growth, inflation and wage gains haven’t done anything particularly surprising this year, the X-factor behind the yield surge has been the powerful rise in oil prices. Brent pushed above US$80 at one point this week, WTI touched $72, and even the previously lacklustre WCS popped above $55. Put in perspective, these are all upwards of $15 above the Bank of Canada’s assumptions employed in the latest MPR, which was released precisely one month ago. That is a very big change in a fundamental variable in a very short period of time.
As we discussed in greater detail in last week’s Focus Feature, there are normally at least three economic and financial light switches that get thrown by such a pronounced move in oil prices: 1) the Canadian dollar, 2) the TSX, and 3) relative Canadian GDP growth. So far, those switches look like they are moving through cold molasses.
The loonie has actually weakened this year and even over the past month against the rapidly rising U.S. dollar amid no resolution on the NAFTA file (the May 17 “deadline” came and went with nary a whimper). The loonie has in fact made a strong run against other currencies, and is actually one of the firmer units in the past two months. But, the key point is that it is still down against the big dollar even with the remarkable recovery in Canadian oil prices. It even softened further on Friday to 77.5 cents despite reasonably firm March retail sales (+0.6%) and another small upward grind in core inflation (to just above 2.0% in April).
There was much fanfare over the 10-day winning streak by the TSX (which looked in small danger on Friday), as it received a nice lift from the comeback in energy. Over the past three months, the beleaguered index has managed to rise 4.5%, handily outperforming the S&P 500 (down 0.6% over that time frame), largely thanks to an 11.4% pop in the energy component. Yes, outperforming. But, alas, the index is still slightly underwater so far in 2018 after a tough start to the year, and the fact that much of the energy surge represents a rebound from the extremely depressed conditions during the winter. Still, the sustained strength in oil prices provides very real hope that the long-standing relative underperformance of the TSX may finally be coming to an end.
However, the combination of the upswing in oil, the better tone to the TSX, and the still-competitive level of the loonie has not moved the needle much on the relative Canadian economic growth outlook. The latest consensus forecast, compiled just this week, shows a tiny uptick in this year’s call to 2.1% GDP growth, but no change to 2019 at 1.9% (both are one tick above our call, while the BoC is at 2.0% and 2.1%, respectively). That still leaves Canada trailing far behind the expected U.S. average growth rate of 2.8% this year and 2.5% in 2019, even with the big added assist from rapidly rising oil prices. We would be remiss to not point out the helpful and huge move in lumber—a one-time stalwart of Canadian exports. Softwood prices have essentially doubled over the past year, soaring well above US$600 this week, easily smashing prior records.
For the Bank of Canada, this coincidence of events likely leaves it on the sidelines at the May 30 decision. While the strength in oil is a positive for the growth and inflation outlook, it seems highly unlikely to deliver the capital spending lift that would normally flow from such a move in crude. The latest pipeline headlines just served to remind all of the constraints on that front. Meantime, we have no clarity on NAFTA, and the housing sector may be living down to fears about the sensitivity of the economy to higher rates—April home sales fell almost 14% y/y and MLS prices are now barely positive on a yearly basis. Arguably, the rapid backup in bond yields—and the pressure that could put on mortgage rates—will make the Bank even more cautious on further moves, given their well-advertised concerns about households’ sensitivity to rising rates.
The title of this piece is a painfully obvious ode to American writer Tom Wolfe, who passed away this week. His “The Bonfire of the Vanities” was a seminal 1980s work, and it seems somehow very appropriate to focus on that novel this week (rather than, say, “The Right Stuff”). After all, recall that key player, Sherman McCoy, was a Wall Street bond trader. It’s really too bad that Mr. Wolfe never had a chance to follow up with how Sherman fared during the 2007-09 financial crisis.
Download PDF - 199 KB
TalkingPoints-LightMyBondFireDownload PDF - 199 KB