Policymakers have been telling the public that a soft landing is still possible. However, virtually no one believes it, according to BMO Capital Markets. BMO chief economist Douglas Porter recently explained that market expectations are eroding. Yields and commodity prices are cratering against a backdrop of higher inflation. This isn’t typical unless serious doubts have begun to materialize about future growth.
“It seems that almost no one now believes that the economy can achieve a soft landing in the face of the current inflation battle—not Chair Powell, the local Uber driver, Cardi B, nor the majority of Canadians,” explains Porter.
He gave a rundown on some of the eroding fundamentals sounding the alarm for a hard landing this week. Let’s run through them quickly.
Markets Have Begun To Reprice Assets Lower As Recession Fears Loom
Canadian and US markets have begun to reprice assets and not in the direction we want. Last week, yields and commodity prices began to reveal weaknesses. This follows equities entering a bear market the week before.
“One key indicator that reinforces the view that growth may soon buckle is the surprising sag in a wide variety of commodity prices,” says Porter, before rattling off a list of commodities that have seen prices erode over the past few months.
As high as oil prices are, with tight supplies, they still fell to the lowest level since early May. Porter made similar observations about the price of natural gas and copper. The latter has seen prices drop over 20% in a period of just 3 weeks. It’s technically enough to be considered a crash, but who wants to talk about copper?
“The sudden pullback in commodities and weaker global growth outlook has thrown a serious shadow on Canada’s prospects,” warns Porter.
Canada’s Inflation Is Expected To Climb Further
Weakening commodity prices are a big red flag in a high inflation environment. Annual growth of the CPI reached 7.7% in May, the highest level in nearly 40 years. BMO doesn’t see inflation peaking here either, with CPI yet to fully realize rising prices.
“We’re probably not quite at the peak level just yet for headline inflation—Canada is almost certainly going to join the U.S. and Europe in the 8%+ club in the summer,” he says.
Even With Inflation Rising, The Economy May Not Be Able To Handle Hikes
Rising inflation expectations are arriving with an unlikely guest — rate hike sensitivity. BMO sees the economy more sensitive to rate hikes than previously thought. Organizations like the IMF warned Canada that fostering high debt loads would restrict its ability to respond to shock. They ignored that advice and are in that exact scenario, and are now facing the exact crisis.
“Before the market gets too far ahead of itself in pricing massive further rate hikes, it’s worth recalling that it can take anywhere from 12-18 months for rate hikes to fully work their way through the economy—we are now barely three months into this rate-hike cycle,” he explained.
The Bank of Canada (BoC) has warned that monetary policy changes take 6 to 8 quarters to be fully priced in. That means the first rate hike in March won’t deliver its full blow until a year from now. Had the market hiked last year when inflation was at double the target rate, the climb wouldn’t need to be as steep. However, rates may not need to hike above the neutral rate — at least not as much as previously communicated.
Fixed income markets have begun to show expectations are tapering. “Amid mounting recession concerns, markets have had a serious rethink on central bank pricing and have moved off the most extreme levels from a little more than a week ago,” observed Porter.
According to his research, Treasury yields dipped in the US after surging over the past year. While a hike of 75 basis points (bps) is all but done for the next meeting, future hikes are becoming more uncertain.
“After initially pricing in even more than the Fed median call, markets have since moved back in the direction of our view, presumably in the belief that the economy just can’t handle much more than that degree of tightening.”
Rising inflation and a recession, also known as stagflation. This is something the Bank of International Settlements (BIS) also warned of this week. It’s been a long week.