Managing Director and Deputy Chief Economist
By mid-2019 the current economic expansion will turn to be the longest expansion ever. There is little doubt that we are in a late cycle environment. The yield curve (the gap between long and short-term interest rates) is almost flat. And history tells us that when that curve is inverted (when short-term rates are higher than long-term rates) a recession is likely to follow. So should we start talking about the R word?
Every economic recession was caused or helped by a monetary policy error in which central banks were chasing inflation only to overshoot and materially damage the economy. Are we starting to overshoot now? Clearly, rates in both the US and Canada have not risen fast enough to reach overshooting territory, but both the Fed and the Bank of Canada are telling us that they are not done yet.
The Fed will continue to hike into next year. And today’s employment and wage numbers clearly support that trajectory. The issue will be the real risk of a significant softening in economic activity come 2020 as fiscal stimulus turns into fiscal drag. Will the Fed see what’s coming and start softening its position by mid-2019 or will it repeat past mistakes and continue to hike until it’s too late?
The same goes for the Bank of Canada. The recent communication from the Bank has been relatively hawkish. It seems that the Bank is considering taking real rates into positive territory and viewing the neutral rate at around 3%. So in order to get to that rate the Bank will have to hike by an additional 125 basis points.
We think that both central banks will not repeat past mistakes. By 2019, the Fed will have 2020 vision and will slow down its hiking trajectory. In fact, we will not be surprised if come 2020, the Fed will actually be cutting rates.
As for the Bank of Canada, the situation is even more complex. It’s hardly a secret that the Canadian economy is facing significant headwind. Yes the agreement on the USMCA worked to remove some uncertainty from the market and at the margin should help to lift business investment, but there are still many hurdles. Exports performance of late has been disappointing while consumer spending is showing a clear softening trend. Oil prices are now below the level seen when the Bank of Canada actually cut interest rates in 2015 to assist Alberta. The tax cut introduced south of the border is already working to redirect investment from Canada to the US. The recent move by the federal government to match the US Administration policy and introduce an accelerated depreciation schedule (in which businesses are allowed to write off investment in the first year) is a positive development but not a game changer. Accordingly, we expect Canadian GDP growth to average around 1.8% in 2019 and to slow notably to 1.3% in 2020.
While the Bank is expecting wage pressures to rise in the coming quarter, there is no evidence that that would actually happen. Add to it, the slowing housing market and the fact that higher interest rates and the change in mortgage qualification rates have led to a situation in which household credit is now rising at the slowest pace in any non-recessionary period over the past 50 years, and you can see easily why we doubt that the Bank will be able to take rates as high as 3%.