Highlights. Forecast dated December 18, January United States. Canada

Transcription

1 Highlights January Our economic forecasts align with those of the dovish FOMC participants. Not surprisingly we share their view of the appropriate fed funds rates one and two years hence. a range of.7 to. by year end and.7 to. a year later. Translating our base case scenario for growth, inflation and the fed funds rate into a -year yield leaves us seeing Treasuries at close to. in December. Many are wondering whether the Bank of Canada will ease again in. We do not think so. However, if more easing was required, we believe forward guidance to the financial markets that the policy rate will stay low for a long time despite the FOMC launch of monetary normalization would do more good than any other conventional or unconventional policy initiative. With the overnight rate stable at., with some fiscal stimulus from Ottawa and with Treasuries trading near. in December, we see -year Canadas at about. a year from now. Paul-André Pinsonnault Forecast dated December, United States Quarters Fed Fund Mth Bill YR YR YR YR // Q/ Q Q Q Q/ Q Q Q Canada Quarters Overnight Mth Bill YR YR YR YR // Q/ Q Q Q Q/ Q Q Q

2 Is the ECB finished for a year? Market reaction to the ECB stimulus package, announced December, was unequivocal: market participants had expected more aggressive action. The yield to maturity of short-term Bunds jumped bps as Mario Draghi explained the decision and -year Bunds lost of their value on the day. Negative market reaction to the ECB`s easing package Yield to maturity of German -year bonds m m7 m m9 m m m NBF Economics and Strategy (data via Bloomberg) --7 Defending the Governing Council s decisions, the ECB president argued the next day in New York City that the package was not meant to address market expectations, it was meant to address our inflation objective. He added that in his view the market had failed to appreciate the importance of the decision to reinvest principal payments on the securities purchased under the APP as they mature. However, Mr. Draghi s acknowledgment that there had been dissension among members of the Governing Council about the extent to which its monetary policy stance should be recalibrated was interpreted by many market participants as an indication they should expect no more from the ECB in. Our own view is that with the Fed started on normalization and with some evidence that credit growth is picking up in the Eurozone, the bar for the ECB to take new measures will be high. The ECB is turning more accommodative than the Fed, a comparison important to the foreign exchange market. But we think the Eurozone economy will grow. in rather than the.7 projected by Mr. Draghi. On the inflation front, a base effect will result in some acceleration of -month inflation early in, though the ECB has projected average inflation of only. in. That projection was done when Brent was trading near US$. Since then it has fallen below $7. So given our outlook of a somewhat less robust economy and of possible disappointment on inflation, we cannot completely exclude further action from the ECB. On the other hand, although lower oil prices do not help the ECB with its inflation target, they support Eurozone economic growth. It is the latter effect that is likely to dominate ECB thinking at this point. If the Governing Council does decide more action is needed, we think it will be limited to extending the mix of assets eligible for the European QE. Yellen s balance message well-received by financial markets Now that the FOMC has ended seven years of a near-zero fed funds rate, what path for normalization? Addressing such concerns, Fed chair Janet Yellen said the FOMC would like to be able to move in a prudent and gradual manner, but the pace would be data-dependent and the end point of the nominal policy rate would be dictated by inflation and the real neutral rate (the rate that would be neither expansionary nor restrictive if the economy were operating near potential). Fed staff analysis currently pegs that rate close to zero. A variety of persistent economic headwinds has helped push down the neutral rate, and structural factors such as demography are likely to keep it lower than in the past. Under these conditions, the dot plot of FOMC participants suggests that they see the neutral real rate edging up gradually to. to.. In the long run, all participants see inflation at and most see the nominal fed funds rate at. or. FOMC: Participant projections at December - meeting Midpoint of target ranges for the fed funds rate at year end Median =.7 Median =.7 NBF Economics and Strategy (data from FOMC dot plot) --7 According to Ms. Yellen, moving early on a first rate hike even though inflation is still low will limit the risk of having to tighten abruptly at some point to avoid overshooting the FOMC inflation target.

3 In her press conference following the December rate announcement, she noted that when central banks have waited too long to tighten they have ended up having to act abruptly and very sharply later on, triggering economic downturn. The FOMC wants to avoid that mistake. Ms. Yellen said she would like to see a very long-running and sustainable expansion. This was music to the ears of the stock market. The S&P jumped from shortly before the FOMC announcement to an intraday high of 77 (+.) after her press conference. So an unexpected shock to the economy or a wrong move by the central bank could kill the recovery in the view of the Fed chair. Unfortunately a prolonged low real neutral rate is not good news for the central bank. It constrains the central bank s ability to offset negative shocks. Since there is a limit to how far the nominal rate can go below zero, low inflation and a low real neutral rate might make it impossible to push the nominal policy rate low enough to return the economy to a sustainable growth path. Even quantitative easing could be of limited effect in such an environment. One channel through which QE stimulates growth is the term premium and its implications for portfolio rebalancing. But if Treasury yields have been low for a long time, this channel has less room to operate because portfolios would already be overexposed to other asset classes. These arguments have important implications for monetary policy. The FOMC will have to proceed cautiously as it normalizes. It will also remain quite sensitive to economic developments that threaten the strength of the current expansion. These considerations are already affecting how the FOMC intends to manage the size of its balance sheet. It plans to keep that size unchanged until normalization of the fed funds rate is well under way. Ms. Yellen said one factor in the rate hike was the desirability of having some scope to respond to an adverse shock to the economy by lowering the fed funds rate. And so it would be nice to have a buffer in terms of having raised the fed funds rate to a certain extent to give us some meaningful scope to respond. In our view, this suggests that the FOMC will maintain its current policy of reinvesting portfolio maturities until the fed funds rate is close to or slightly above. The December dot plot suggests that this may not occur before the second half of 7 the median projection for the target fed funds rate at year end 7 is.7. U.S. Treasuries: Term premium and yield to maturity Fisher equation: R = E (real rate) + E (inflation) + premium Historical perspective Term premium during the Great Moderation. Percentage points.. Mean.9.7 Std. dev..9. U.S. -year yield Term premium NBF Economics and Strategy (data via Bloomberg and New York Fed) --7 In holding on to its large portfolio of Treasuries the FOMC will also help keep a lid on the term premium of long-term Treasuries. Thus in the early stage of monetary policy normalization the slope of the yield curve is likely to flatten. On the other hand, the fed funds rate will increase much more slowly than in previous tightening phases. So the flattening of the yield curve, as measured by the difference between the fed funds rate and -year Treasuries, is likely to be gradual. Normalization starts with a flatter curve than in 99 and 9 7 U.S. -year yield minus fed funds rate Fed funds rate U.S. -year yield NBF Economics and Strategy (data via Bloomberg) --7 Our economic forecast is for Q/Q U.S. GDP growth of. in and.9 in 7. The Q/Q projections of FOMC participants range from. to.7 in and from. to. in 7. Our own projections are thus toward the lower end of these ranges. As for the quarterly growth rate, we continue to see it peaking in the second quarter and cooling in the second half. We expect - month total CPI inflation of.9 at year end and. at year end 7. This scenario is consistent with PCE inflation of. in and. in 7. This puts - -

4 us in line with the median inflation forecast of FOMC participants for and one tick below it for 7. In other words, our economic forecasts align with those of the dovish FOMC participants. Not surprisingly we share their view of the appropriate fed funds rates one and two years hence a range of.7 to. by year end and.7 to. a year later. Translating our base case scenario for growth, inflation and the fed funds rate into a -year yield leaves us seeing Treasuries at close to. in December and. a year later. The median economic projection of FOMC participants would suggest. and. respectively if the economy unfolds according to the views of the hawkish participants. U.S. Treasuries: What if investors believe the dot plot? Yield to maturity of -year Treasuries U.S. -year yield Simulation assuming FOMC s dot-plot median becomes the consensus NBF Economics and Strategy (data via Bloomberg) In the first three weeks of December the price of WTI crude fell almost US$7 to as low as US$.7. In late July it was trading at $7.. Not surprisingly, the optionadjusted spread (OAS) to Treasuries of high-yield energysector corporates exploded from bps in May to bps in the third week of December. That s pretty close to the 9-bps spike of. Spreads of other sectors or even of investment-grade oil companies have of course not widened to that extent. Year to date, high-yield energy-company bonds have returned.97, compared to +. for A-rated U.S. corporates. Still, the Financial Times reports record redemptions from U.S. investmentgrade bond funds lately. NBF U.S.: High-yield Energy index under significant stress BofA Merrill Lynch OAS of U.S. high-yield and investment-grade Energy indexes 9 7 Percentage points 99 NBF Economics and Strategy (data via Bloomberg) and in Canada High-yield Investment-grade Given what is happening to energy-sector financing costs south of the border, it is clear that energy producers in general will remain in cost-cutting mode. This will be no help to Canadian GDP growth in. Further, we expect housing and consumption to soften in, and fiscal stimulus from Ottawa to come only late in the year. Given this outlook, many are wondering whether the Bank of Canada will ease again in. The OIS market is giving odds of roughly on a rate cut or cuts between now and the Bank s July rate-announcement date. The loonie: Riding the commodity-price/ cycle A floating exchange rate helps absorb the effect of falling commodity prices USD/CAD NBF Economics and Strategy (data via Bloomberg) -- The warm weather that El Niño has brought so far this winter does nothing to support oil prices, making investors nervous. But the effect of loonie depreciation on the monetary policy outlook should not be overlooked. In the Eurozone, fear that inflation expectations could come unmoored on the downside played a role in prompting the

5 ECB to cut its deposit rate from. in to a negative. at this writing. Eurozone core inflation has been undershooting the ECB inflation target since September. In Canada, currency depreciation has helped keep core inflation above since the fall of. Thus the Bank of Canada does not face a landscape of persistently low inflation fuelling anxiety about how strongly Canadian inflation expectations are anchored. Absent another major shock to the domestic economy, we do not see the BoC having to reach so far down in its toolbox as to push the overnight rate into negative territory. The Bank has other unconventional tools that would be better suited to the Canadian situation. For one, a forward guidance to the financial markets that the policy rate will stay low for a long time despite the FOMC launch of monetary normalization would in our view do more good than any other conventional or unconventional policy initiative. Further, given the vulnerabilities related to high household debt and the housing-market imbalance, would a lower overnight rate require more macro-prudential policies? If so, the question becomes: to what extent would such policies offset the stimulus of a policy rate cut? That said, we note the recent trend to moderation of price pressures, with core CPI inflation running at a mild. annualized over the last three months. We see -month core inflation slipping below in in our base case scenario, to.. in the first half of the year. We also see the economy growing. in. In this scenario, a mix of some fiscal stimulus and forward monetary policy guidance would be the most likely to help the Canadian economy adjust to declining terms of trade. Fiscal stimulus and a rising Treasury yield will pull the -year Canada yield higher in 9 7 Basis points Canada -year yield Yield spread of Canadas to Treasuries U.S. -year yield Latest: bps, but likely to narrow to bps in NBF Economics and Strategy (data via Bloomberg) The bottom line is that we do not see further rate cuts in Canada out to our forecast horizon. With the overnight rate stable at., with some fiscal stimulus from Ottawa and with Treasuries trading near. in December, we see -year Canadas at about. a year from now. In December, S&P downgraded Alberta s long-term rating from 'AAA' to 'AA+'. The outlook on the new rating is stable. This is one of those rare instances where a province was downgraded from a stable outlook, and speaks to the speed with which Alberta s fortunes have turned. Note, however, that the bond market had previously moved to discount a lot of economic and fiscal bad news into Alberta s credit spread, with the province s growing borrowing program having added to the spread pressure. Year-to-date, long term Alberta s spread to Canada have widened by bps compared to bps and bps respectively for Ontario and Quebec. As Warren Lovely points out Canada s oil-levered provinces are feeling acute economic and fiscal pain while Quebec and Ontario spreads to Canada are benefiting from their superior levels of secondary market liquidity. Given the current outlook, his recommendation is to remain defensive as far as oil-levered provinces are concerned. Still, in general, current valuations look attractive, with shorterdated provincials offering compelling carry/roll-down returns and longer-dated provincial credit appearing cheap to his valuation model Provincial dashboard Provincial spread // // Y-T-D Long Issuer Yield Yield Change Can //.. -. Provincial Spreads (bps) Spreads (bps) Change B.C Alberta Mid Saskat Manitoba ONT Que.7.. Short N.B..... N.S N.F PEI q q q q q q q q Weekly excess returns - Maturity -year and longer q q q q q NBF Economics and Strategy (data via Bloomberg)--

6 Canadian bond market total returns Total Returns // Since Since Since Since // 9// /9/ /9/ Cash.... Canada Short...7. Mid.... Long....7 Universe Provincial.7... Municipal Corporate AA..9.. A BBB.... Universe Total....7 S&P/TSX NBF Economics and Strategy (data via Datastream) Canadian interest rates Weekly, last observation December, 7 Long corporate A Long provincial BoC overnight target Canada -year Canada -year 7 9 NBF Economics and Strategy (data via Bloomberg) Bond Market - Canada Close-on // // 9// /9/ /9/ Interest Rates 9-day (B/A's) years years years years..... Spreads 9 d - years years - years 9 - years Currencies CAD / USD EUR / CAD Source: NBF Economy and Strategy (data via Bloomberg)

7 ECONOMICS AND STRATEGY Montreal Office Toronto Office Stéfane Marion Marc Pinsonneault Warren Lovely Chief Economist & Strategist Senior Economist MD, Public Sector Research and Strategy Paul-André Pinsonnault Matthieu Arseneau Senior Fixed Income Economist Senior Economist Krishen Rangasamy Senior Economist Angelo Katsoras Geopolitical Associate Analyst General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. ( NBF ), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada. This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges. The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. 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