What now?

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   By Guest Blogger Ryan Lewenza

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It’s been busy on the inflation front with some important economic releases in Canada and the US.

US inflation rose 0.3% m/m in January, coming in hotter than expected with economists calling for an increase of 0.2%. On a y/y basis headline inflation eased to 3.1% versus last month at 3.4%. This is good news and continues the trend of lower inflation ‘prints’, but markets didn’t like this as economists were calling for inflation to ease to 2.9%. The slightly hotter inflation was largely due to higher gasoline prices and owner equivalent rents, which measures shelter costs in the US.

US inflation eased in January but hotter than expected

Source: Bloomberg, Turner Investments

Following the report both the equity and bond markets sold off. When bond prices fall their yields rise and we saw the US Treasury 10-year yield jump 14 bps to 4.3%. The question now is, what will the Federal Reserve (Fed) do with this new inflation data, and will it derail the expected rate cuts for this year?

US bond yields surged following the inflation report

Source: Stockcharts.com, Turner Investments

From our perspective, this inflation report doesn’t change the outlook on expected rate cuts.

As predicted in our outlook report, the bond market was pricing in far too many cuts – six 25 bps drops throughout the year. We said this was way too much and more three cuts this year are more likely, beginning in the spring/summer period.

From the outlook report, “Currently, the US bond markets are pricing in six interest rate cuts in 2024, with the Fed Funds rate declining to roughly 4% by end of 2024. I think that’s a bit aggressive and am more in the Fed’s camp, which, as of their last Fed meeting, was forecasting three cuts in 2024. I see this as being more realistic for next year given the stickiness in some inflation measures.”

So, the bond market is now pricing in fewer cuts following the inflation report. A month ago, there was a 100% chance of a cut by June and now that sits at 60% odds. In the short-term bond yields could rise further but the Fed should then start cutting come the summer and yields should drop this year.

If this plays out as planned, then here’s some of the implications:

• First, bond prices should rally this year, resulting in a decent year for bond returns. Currently bonds are yielding around 4-5%, but if interest rates come down as we expect then we could get some capital appreciation.
• Therefore, adding in the yields and the expected price appreciation, bonds could provide a total return this year in the 6-7% range. Not bad at all, and one reason why we’re bullish on balanced portfolios for this year
• Second, this could be positive for the equity markets. Historically, the S&P 500 has gained on average 12.6% in the 12 months following the first rate cut.
•  Third, lower interest rates in the US and Canada, could lower mortgage rates around the seasonally strong spring season so we could see a bounce coming in the Canadian housing market.
• Finally, these expected cuts are intended to provide relief/stimulus to consumers/economy. As interest rate changes impact the economy with a lag, these cuts will help reflate the US economy leading to higher economic growth in 2025 because of the cuts beginning in 2024.

Moving over to Canada, we received great news this week with overall inflation easing to 2.9% y/y in January from 3.4% in December. Core inflation also softened to 2.4% y/y. This is probably music to the ears of the Bank of Canada and Governor Tiff Macklem, who has indicated that they are prepared to cut rates provided they have confidence that inflation will trend down to their 2% inflation target.

This inflation report clears the deck for the first rate cut in years, which could come as early as the spring. Moreover, shelter costs, which include mortgage expenses and rents, accounts for 30% of the CPI measure, and if we strip out these elevated costs (partly due to the high interest rates), the overall inflation falls to 1.5% yoy. So, the Bank of Canada’s rate hikes have been a factor in our elevated inflation over the last few years. They can easily address this by easing policy and cutting rates.

All told, inflation has been the biggest headwind for the economy and markets over the last few years, and inflation pressures are now easing. Therefore, the BoC and Fed can begin cutting rates this year, which is an important factor in our bullish outlook on the equity markets and balanced portfolios for 2024.

Canadian inflation eased further in January

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

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About the picture: “I read your call for more dog pics. Bravo sir!: writes Ryan, C. in Calgary. “Attached you will find a pic of our Shih Tzu, Bella, enjoying a much needed “Power Nap” in my home office here in sunny and balmy Calgary, resting her head on a fully loaded power bar, despite a top of the line dog bed mere inches away out of frame. “