Volume 22, Issue 47 November 26, 2018.

  Source: Globe & Mail


Fed Policy: A More Cautious Rate-Hike Cadence Coming
Michael Gregory, CFA
BMO Deputy Chief Economist

This week’s comments by Fed Chair Powell were a catalyst for the market to rein-in rate hike expectations for next year (the OIS segment is currently pricing in just 1.3 moves now). Powell said policy rates “remain just below the broad range of estimates of the level that would be neutral for the economy”, which the market interpreted as being decidedly more dovish than his October 3rd comments (“We may go past neutral. But we’re a long way from neutral at this point, probably”.) Interestingly, both remarks appear consistent with the latest Summary of Economic Projections, with the median forecast achieving the 3% neutral rate by the end of 2019 (which is a long way away in today’s world), and surpassing it slightly in
2020. Meanwhile, the range of neutral rate projections ran from 2.5% to 3.5%, which is just above the current 2.125% target midpoint. So, it’s debatable whether these two sets of remarks reflect an interim fundamental shift in view, but the decision to
change our Fed call was not based on these comments.

Instead, this week’s reports on new and pending home sales along with the core PCE price index served as our catalyst. They confirmed two unexpected economic trends—ebbing core PCE inflation and a much weaker housing sector.

Core PCE inflation slipped to 1.8% y/y in October, and is now down from July’s recent high of 2.0%. And, if the shorter-term trends are any guide, it could slow further. Core PCE inflation was 1.5% annualized over the past six months and 1.1% over the past three. At this late stage of the business cycle, with real GDP growth running above potential and the economy running at full employment, this ebbing trend suggests that there is still some disinflationary slack lingering in the economy and/or the secular forces of disinflation (e.g., an aging population, technology-enabled disruption) are exerting more pressure than the cyclical forces of inflation. We judge these developments are going to make the Fed more cautious moving forward.

Inflation is simply headed in the wrong direction, and the Fed is not only aiming for the 2% target but would prefer to see it running a little bit above. Moreover, the down-drift in inflation is causing an up-lift in real policy rates. Taking everything to
two decimal places, the 2.13% target midpoint for the fed funds rate was 11 bps in real terms when core PCE inflation peaked at 2.02% y/y in July (the fastest in more than six years). It now sits at 35 bps, as inflation has fallen to 1.78%. This is nearly
equivalent to a quarter-point rate hike in real terms.

Meanwhile, the housing sector is weakening more than expected. Rising mortgage rates were anticipated to be a drag on activity, but they appear to be acting more like a brake. Combined new and existing home sales have fallen in six of the past seven months (and October was close to making it seven out of seven as the increase in existing sales just barely beat the decrease in new sales). Recent weakness has been regionally dispersed (not only due to hurricanes) and has occurred amid an increase in homes available for sale (not only due to lack of inventory). Pointedly, the drop in November’s NAHB Housing Market Index was the second largest in its 34-year history.

Thirty-year mortgage rates have recently been hovering in the 4.80%-to-4.95% range (pushing an annual change of about 100 bps), but with household debt-to-disposableincome ratios stable at multiyear lows and debt-service ratios probing record lows,
it’s hard to see why housing has weakened as much as it has in the wake of deteriorating affordability (which is still more attractive than its long-run average). Apart from the lingering psychological and emotional scars from the Great Recession, the hyper-sensitive response could also reflect a larger than anticipated impact of recent tax changes regarding limitations on mortgage interest and property tax deductibility (see Robert Kavcic’s Thought on page 7). Again, we judge these developments are going to make the Fed more cautious moving forward… rate hikes are turning out to be more potent for the housing sector.
Bottom Line: Our new Fed call trims next year’s rate hikes from three to two, and expands the intervals between moves. After December 19th, we see rate hikes on May 1st and September 18th (compared to a March-June-December configuration before), with still one hike in 2020. This implies a peak of 3.125% vs. 3.375% before.


Have a great week.

Frank & Mark




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

Canada:
The S&P/TSX Composite Index was lifted by the global equity rally, but Canada’s benchmark significantly lagged its U.S. counterparts. The announcement that General Motors plans to close its Oshawa operations dealt a blow to the Canadian economic outlook, while the dramatic plunge in oil prices since early October continued to weigh on the energy sector. Technology shares, among the worst hit in last month’s sell-off, led last week’s recovery. The materials and utilities sectors declined. Year-to-date, the TSX is down 6.2% and the benchmark 10-year yield was slightly lower ending the week to yield 2.26%.

U.S.:
Stocks in the U.S. started last week higher, after early reports of strong Black Friday and Cyber Monday shopping numbers pointed to a robust holiday shopping season. Adding to the optimism were higher corporate profits in the third quarter GDP report, and better-than-forecast personal income and spending in October. Technology shares, and the consumer discretionary sector (which includes Amazon.com) led the move higher. Year-to-date, the S&P 500 is up 3.2%, the Dow Jones Industrials are up 3.3%, and the Nasdaq is up 6.2%.  The yield on the 10 year Treasury closed at 3.01%.



Source: BMO Capital Markets