Making sense of the markets this week: April 16, 2023

BoC pauses rate hikes and its crystal ball predicts 3% inflation this year

On Wednesday, the Bank of Canada (BoC) continued its best to try and balance competing monetary goals of disinflation, while not crashing the entire economy.

By holding the key interest rate at 4.5%, while emphasizing no plans to lower that rate any time soon, the BoC continues to attempt to calm consumer behaviour while not causing a banking panic. The interest rate pause was widely expected after February’s inflation rate came in at 5.2% and was reflective of a strong downwards trend.

Perhaps the most interesting bit of news is that the BoC foresees the official inflation rate to come down to 3% by the middle of 2023. It says the timing for going from 3% to 2% will be more difficult to predict. If Canada can hang on to its full employment and meagre gross domestic product (GDP) growth, then that rate of 3% inflation isn’t a worst-case scenario.

As part of his balancing act, BoC Governor Tiff Macklem made sure to temper good news with strong notes of caution, saying: 

“Let me assure Canadians that we know our job is not done until we restore price stability. That’s the destination—we are on our way and we will stay the course.”

This more or less confirms those thoughts of the “higher for longer” interest rates camp.

Here’s an interesting graphic, put together by CBC News, comparing Canada’s inflation rates to that of other countries:

One area of monetary policy not getting nearly as many headlines as the key interest rate decisions is that of quantitative easing. In other words, how many bonds the BoC is selling into the bond market each month. 

By selling bonds in the open market, the BoC takes money out of circulation by removing cash from banks and replacing it with previously-purchased bonds. With the BoC no longer artificially stimulating demand for bonds, bond rates are free to climb as high as they need to in order to entice investors to buy them.

The BoC increased its balance sheet from $120 billion in March 2020, to more than $575 billion at its peak during the pandemic (March 2021). It’s actively been reducing its balance sheet since April 2022 by letting its bonds mature, as well as selling bonds back to financial institutions. As of February, the balance stood at $393 billion.

Clearly there’s substantial “dry powder” for the monetary policy wonks to deploy, should they want to continue to reduce the amount of money in circulation without raising the interest rate.

News that the 4.5% key interest rate might be hanging around for a while is a boon to cautious savers who rarely have loans to pay off (think retirees who own their own homes). However, this will clearly be tough to take for those with mortgages coming due in the near future.

TINA, meet TIAA

In the years leading up to (and most definitely during) the pandemic, it became fashionable to say “There Is No Alternative” (TINA) when discussing the prospects for equities versus fixed income or other assets.

Sure, valuations were high on stocks, and dividend yield levels weren’t blowing anyone away. But, what were you going to do? Earn 1% per year in bonds? Throw your money at meme stocks or bitcoin? Hence, in many ways, there was no alternative to investing in stocks.

It turns out, investing in stocks, especially if you tilted your portfolio towards profitable companies—as opposed to debt-fuelled growth stocks—was actually a pretty good idea. But, past results aren’t always indicative of future returns.

Given how high interest rates have been for the past year or so, combined with inflation pressures to keep those rates higher for longer, you have a recipe for a very viable alternative to stocks, indeed. It may have taken investors a while to break up with TINA, but suddenly interest in TIAA—There Is An Alternative—is way up. 

Not much of a surprise but ⁦@Google⁩ search volume for terms like “yield,” “Treasury Bill,” and “Certificates of Deposit” has surged to record high (since data started in 2004) … search activity for “money market” at highest since 2008
⁦@DataArbor⁩ pic.twitter.com/4D29PmgjeR

— Liz Ann Sonders (@LizAnnSonders) April 6, 2023

Liz Ann Sonders, chief investment strategist at Charles Schwab & Co, points out that the number of investors looking to snag a very low-risk 5% worry-free return is at all-time highs. 

When Google’s search terms, like “treasury bill,” “yield,” “certificate of deposit” and “money market,” are spiking, I’d say that’s a pretty solid indicator of a de-risking trend. (American CDs, certificates of deposit, are the equivalent of Canada’s GICs guaranteed investment certificates.)

There is no question that, as investors shift their interest down the risk spectrum, some money is going to move out of blue chip dividend stocks and into GICs and bonds. I’m interested to see if the inflows from riskier investments such as growth stocks or cryptocurrencies, into dividend stocks, will be enough to offset the outflows. For more of my thoughts on fixed-income investing you can read my article on the best low-risk investments in Canada on MillionDollarJourney.com.

U.S. inflation down as monetary screws tighten

The U.S. Labor Department announced on Wednesday that the consumer price index (CPI) was up only 0.1% during March, and up 5% on a year-over-year basis.

This is obviously a substantial cool-down from the inflation rates we saw last summer. It also marks the first time in over a year that core inflation outpaced overall CPI inflation.

Some of the main takeaways from the U.S. Labor Department announcement were:

• Shelter costs were up 8.2% year-over-year.
• Food costs fell by 0.3% in March—the first drop since September 2020, but are still up 8.4% from a year ago.
• Used vehicle prices declined 0.9% in March and are down 11.2% year over year.

As a result of the news, stocks were up on Thursday and treasury yields fell, as the markets priced in a reduced chance of future interest rate increases from the U.S. federal bank.

Interestingly, economists point to inflation rates with a strong trend downward. And the Consumer Expectations Survey released Monday by the U.S. Federal Reserve stated that near-term inflation expectations (one-year estimates) were actually up 0.52% to 4.7%. It appears that just as central bankers are succeeding at getting inflation under control, the public fears that inflation will continue to skyrocket. Managing these expectations might be the key to knocking inflation down to the 2% target.

When U.S. banks cough, can Canadian banks catch a cold?

As it becomes more and more likely that the U.S. Fed will not need to continue aggressively hiking interest rates to control inflation, the risk to commercial banks’ balance sheets should also recede.

Nonetheless, the below graphic from Visual Capitalist is a really interesting look at which banks are at the most risk due to uninsured deposits.

Clearly, the less diversified regional banks are in a more precarious position than their too-big-to-fail big brothers.

While these U.S. banking arms of Canadian banks are relatively small pieces of their overall corporate puzzle, it’s comforting to know that the U.S. financial situation stablizing is also good news for our beloved bank stocks here in Canada.

Kyle Prevost is a financial educator, author and speaker. When he’s not on a basketball court or in a boxing ring trying to recapture his youth, you can find him helping Canadians with their finances over at MillionDollarJourney.com and the Canadian Financial Summit.

About Kyle Prevost

Kyle Prevost is a financial educator, author and speaker. He is also the creator of 4 Steps to a Worry-Free Retirement, Canada’s DIY retirement planning course.

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