Risk of Central Bank Policy Error Rising

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Adam Ditkofsky, CFA

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Adam Ditkofsky, portfolio manager of fixed income, CIBC Asset Management.

In terms of implications on volatility and inflation from the war in Ukraine, 2022 has been a very challenging year for the markets. Inflation has been front and center on every investor’s mind and the war has only exacerbated the situation, particularly as it relates to commodities, specifically energy, prices and food. So far this year, we’ve already seen drastic increases in prices, and since the war broke out, it’s only gotten worse. And it’s no surprise as Russian oil accounts for 30% of the European Union’s total imports and Russian gas accounts for 40%. So concerns about further sanctions will likely put upward pressure on prices.

Food is another major issue, with close to 20% of the world’s barley supply and 14% of wheat coming from Ukraine and Russia. Russia’s also responsible for a major part of the world’s fertilizers, so it’s not surprising that the food and agriculture organization of the UN or the FAO is saying there is risk of food and feed prices to be up 8% to 22% above their current already elevated levels, for 2022 and for 2023.

Couple this with easing of Covid restrictions in the West, with the continued supply chain disruptions globally, and it’s clear that elevated inflation is not going away anytime soon. A far stretch from the transitory implications of Central Banks and the markets we were expecting last summer. In fact, with Canada and the U.S. being almost at full employment, there are real risks that inflation could remain above the 2% Fed and Bank of Canada targets for several years.

In terms of implications for the Fed and the Bank of Canada on bond rates, we’ve already seen bond yields move sharply higher in recent months, thanks to already elevated inflation, which in the U.S. is close to 8%. But also related to expectations that both the Fed and the Bank of Canada will raise rates quickly and reduce the stimulus they provided the market during the pandemic to get inflation under control. In March, we saw both the Fed and the Bank of Canada raise rates by a quarter of a percent. But just as importantly, they provided some guidance on future rate hikes and the shrinking of their balance sheets. Overall, the underlying message from both central banks is that they will do what it takes to get inflation under control.

Now, this could include hiking rates at a faster rate, for example, they can raise rates by half a percent, as opposed to a quarter percent, or they can shrink their balance sheet quicker than the market’s expecting, and that’s referred to as quantitative tapering or QT. Now, in addition to hiking rates in March for the first time since 2018, the Fed revised their projections, being far more hawkish than their previous guidance from December. The Fed is now projecting six additional quarter percent rate hikes this year, compared to the three projected last September for this year. Now they expect inflation to exceed 4% of this in 2022, compared to their previous forecast of 2.7%.

Now just as important are market expectations, which for both Canada and the U.S. is seven quarter rate hikes over the next 12 months. That means there are a lot of hikes already priced into the market, so the question we should be asking now is, have we already seen the bulk of the move higher in interest rates? If history is a guide, generally rates see the bulk of their moves higher before central banks start to hike.

In terms of risk of a policy error, which means central banks either hike rates too fast or reduce their balance sheet too quickly and cause a recession, well, there’s no better guide than the yield curve. The yield curve has called eight of the last eight recessions over the last 50 years when the 10-year treasury falls below the three month treasury rate, while that hasn’t happened yet, another important indicator is the two year 10 year treasury yield curve, or the difference between the two year rate and the 10 year rate for treasury yields. And that curve has fallen below 50 basis points. This generally puts the bond market and economists on recession watch. And that’s definitely the case that we’re in right now. We’ve already seen parts of the yield curve invert. The three year five year yield curve in the U.S. has already inverted. And so has the five year 10 year yield curve. Both have already inverted signaling a potential policy error by the Fed. So expectations are that the Fed will continue to hike rates as they try to ease inflation, but they’re also going to attempt to orchestrate a soft landing. Hopefully not causing something in the financial system to break and/or trigger a recession. Now, so far this year, we are already seeing implications on risk markets with equity markets being down and credit spreads being wider. So the hope is that the Fed pauses their rate hikes after several meetings to assess the implications of their action and to avoid any unintended consequences. Now, again, the curve hasn’t inverted yet, but the Fed and the Bank of Canada definitely appear to be late to the game with hiking rates. And there are definitely real risks of a policy error.

In terms of implications to GDP, inflation has already had negative consequences. Especially in today’s context because it’s been outpacing wage growth, causing real wages to shrink. So the last data release was for February of 2022, and we’ve already seen that average hourly earnings are down in February 2.6% year over year. So what does that mean? Consumer buying power is falling despite U.S. unemployment being almost at full unemployment as 3.8%. Now it may not feel like that, especially if you try to make a dinner reservation in a major metropolitan city, and that’s because consumers have pent up savings from the pandemic, which in some cases have been offsetting higher prices, but government transfers have ended, which is creating a major fiscal drag for the economy.

So couple this with a higher Fed funds rate and implications are for a quicker pullback in GDP. Now in March, the Fed reduced their 2022 GDP forecast from 4.1% to 2.8%. Previously in December, we were projecting GDP growth of sub 3% for the whole year for both Canada and the U.S. But our outlook now is expected to be much lower and probably closer to 2%.