Volume 25, Issue 3 January 18, 2021.

  Source: Globe & Mail


Yielding to Reality
Douglas Porter
BMO Chief Economist

After blasting out of the gates to start the year, bond yields took a bit of a breather this week; 10-year Treasuries slipped a touch following a 20-bp leap last week. A variety of factors weighed in—some constructive, some less so. Risk sentiment broadly paused after a rip-roaring start to 2021, and the S&P 500 is now little-changed in the first two weeks of the year. A pair of weak U.S. economic releases played a big role in this sober re-assessment, specifically a jump in weekly jobless claims to 965,000 and a second hefty drop in retail sales in December, both much weaker than consensus.
 
The main message is that the U.S. economy may be struggling much more heavily with renewed restrictions than widely expected. No doubt, the uncertainty surrounding fiscal support—right up until the end of the year—may have also caused some short-term havoc with the economy. Note, too, that small business sentiment took a big step back in December, with the political backdrop likely playing an important role there as well. After what we expect will be a surprisingly perky Q4, with GDP growth north of 4%, the economy will likely struggle to post any growth in Q1.  And, that’s even with the big helping hand of the $900 billion stimulus package. We suspect that the extra dose of stimulus spending proposed by President-elect Biden will be watered down and will ultimately have more impact on Q2 than the opening three months of the year.
 
The more constructive factor restraining yields this week was a run of dovish commentary from the Fed, first from Governor Brainard (low forever?), and then from Chair Powell. The key, and simple, message was that it simply was far too early to be even discussing tapering QE—although apparently not too early for some regional Presidents. While we expect a lively debate at the FOMC later this year on the pace of QE, actual tapering is expected to be a story for 2022. And, as Powell suggested on Thursday, the Fed will provide plenty of advance warning for the markets before they make the first cut in what has been an exceptionally aggressive and supportive bond buying spree.
 
Notably, even with the modest pullback in Treasury yields this week, underlying inflation expectations imbedded in the market continued to grind higher. The so called breakeven rate for 10s has climbed to 2.09%, up 10 bps just since the start of the year and well above the pre-pandemic level of around 1.8%. Rising oil prices have played a role; even with a late-week pullback, WTI is still above $52, up 25% from just two months ago and not far from a year ago. But there are plenty of factors gradually lifting inflation expectations (which Sal details below). Perhaps most importantly is the Fed itself, which has clearly committed to letting inflation run a bit above their 2% target for a spell before tightening policy. On that front, there is still work to do, as core CPI was flat at 1.6% y/y in December, while the core PCE deflator (and the Fed’s
target metric) remains a few ticks lower.
 
Our overall view is that yields will continue to grind higher this year, with the ultimate destination highly dependent on the ongoing race between the virus and the vaccine, as well as just how much of Biden’s proposed $1.9 trillion stimulus ever sees the light of day. The official forecast of a 1.25% level for 10-year Treasuries by end-2021 is clearly on the cautious side, and has yet to factor in additional stimulus measures above those already signed into law. At the same time though, we believe that ongoing heavy support from the Fed, and opportunistic foreign buying of Treasuries, will keep the rise in yields in check. Simply, the markets have largely priced in a solid and sustained economic recovery—while that largely aligns with our view, there is little doubt that there is still plenty of room for at least some modest disappointment to that sunny outlook.

 

Have a great week.

Frank & Mark.




Source: Globe & Mail, BMO Capital Markets, Bank of Canada

Canada:

The TSX slipped 0.7% this week, with an even split between gaining and declining sectors. Recall that the index pushed above pre-COVID levels for the first time last week, and continues to trade just shy of record territory near the 18,000 level. Note that it took Canadian stocks almost 11 months to reclaim late-February 2020 levels, or roughly twice as long as the S&P 500. As we’ve discussed previously, part of this reflects the fact that Canada doesn’t carry a lot of weight in sectors that were really working early in the pandemic—big technology and consumer discretionary. The current gap in performance since the February high is 11.4 ppts in favour of the S&P 500. But, if we were to weight all sectors equally, the gap would shrink to just 1.1 ppts. This pretty clearly highlights the weighting issues with Canadian equities.

That said, TSX performance over the past three months has been very nearly in-line with the S&P 500. This reflects better momentum in two heavyweight (for Canada) sectors. Banks have benefited from vaccine optimism and a steeper yield curve. At the same time, a rally in oil prices has lifted energy stocks again. The reality is that the TSX really can’t sustain any kind of momentum unless these two sectors are working—and they are doing so right now.

YTD, the TSX is up 2.73% and the benchmark 10-year yield ended the week to yield 0.80%.

 
U.S.:
Equity markets struggled this week as the prospect of a more aggressive U.S. stimulus plan was countered by some soggy economic data. The S&P fell 1.5%, with telecom, technology and consumer discretionary lagging. Declines in those sectors were too much to be offset by a pop in energy stocks.

President-elect Biden outlined a stimulus package that totals $1.9 trillion, or a hefty 9% of GDP, though the ultimate amount that gets passed remains to be determined. Among the measures proposed are additional cheques of $1,400 for most people, expanded leave and child care, higher and extended UI benefits, higher transfers to state and local governments and an increase in the federal minimum wage to $15. The potential boost to growth, as well as the budget deficit, nudged long-term Treasury yields higher again before backing off late in the week.

On the data front, retail sales slumped 0.7% in December, which disappointed expectations heading into the end of Q4. Small business sentiment also fell in the month, while consumer confidence pulled back in January. On the flip side, industrial production finished the year firmly, while inflation continues to perk up.


YTD, the S&P 500 is up 0.3%, the Dow Jones Industrials are up 0.7%, and the Nasdaq is up 0.8%. The yield on the 10 year Treasury closed at 1.11%.




Source: BMO Capital Markets 

The Good:  Existing Home Sales +47.2% y/y (Dec.); MLS Home Prices +13.0% y/y (Dec.); BOS Indicator +3.47 pts to 1.29 (Q4);
Industrial Product Prices +1.4% (Dec. P).
 

The Bad:  New Motor Vehicle Sales -9.9% y/y (Nov.).