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by  Eric Lascelles Mar 23, 2021

What's in this article:

Global Investment Outlook

Our quarterly Global Investment Outlook is now available. The full set of articles is here.

Or, read the economic article, including our latest economic forecasts.


Overall, the key positive and negative drivers remain fairly static and balanced. On the positive side, economic data remains strong and vaccination progress is impressive. On the negative side, the new virus variants continue to accelerate. We anticipate a third pandemic wave in many countries.

Virus figures

Globally, COVID-19 is accelerating again, though still well short of previous peaks (see next chart).

Global COVID-19 cases and deaths

Global COVID-19 cases and deaths

As of 03/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

The increase is disproportionately in emerging market nations, where the new variant is presumably taking hold. Brazil is struggling in particular, given that it is the source of one of the most concerning variants and its policy response to the virus has been poor (see next chart). It now has the most infections per day of any country in the world. India’s caseload is also rising markedly.

COVID-19 cases and deaths in Brazil

COVID-19 cases and deaths in Brazil

As of 03/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

In Europe, France, Germany and Poland are again experiencing a sharp increase in cases (see Germany in next chart). Italy’s numbers have also deteriorated. Curiously, Spain remains in excellent shape, continuing a pattern of contrarian behaviour (see subsequent chart).

COVID-19 cases and deaths in Germany

COVID-19 cases and deaths in Germany

As of 03/21/20201. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

COVID-19 cases and deaths in Spain

COVID-19 cases and deaths in Spain

As of 03/20/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Canadian cases are now definitely rising as well, though not aggressively (see next chart). Each of Ontario, British Columbia and Alberta have rising caseloads. Quebec holds onto its improving trend for now.

COVID-19 cases and deaths in Canada

COVID-19 cases and deaths in Canada

As of 03/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

The U.K. infection numbers continue to get better. This is logical given that the country has been combatting the new variants for many months, it is excelling at vaccinations, and it maintains a much more cautious social distancing stance.

The U.S. numbers are also improving, albeit only slightly. This is thanks to rapid inoculations that appear to be fighting the new variants to a stalemate (see next chart). However, we fear that the U.S. infection numbers could begin to rise again shortly given that the majority of U.S. states are now reporting a deteriorating trend (see subsequent chart).

COVID-19 cases and deaths in the U.S.

COVID-19 cases and deaths in the U.S.

As of 03/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Number of U.S. states with transmission rate above key threshold of one

Number of U.S. states with transmission rate above key threshold of one

As of 03/21/2021. Transmission rate calculated as 7-day change of underlying 5-day moving average of new daily cases, smoothed with 7-day moving average. Transmission rate above one suggests increasing new daily cases. Includes Washington, D.C.  Source: Haver Analytics, Macrobond, RBC GAM

Predicting a third wave

We continue to anticipate a third virus wave for several reasons (see accompanying table):

  • The infection trend has recently begun to deteriorate, as just discussed.
  • Virus variants continue to accelerate, as discussed in the next section.
  • Social distancing fatigue is gradually increasing.
  • Social distancing rules have been eased in many jurisdictions, as discussed later.
  • Seasonal factors may be partially to blame (though it not genuinely clear whether the virus is most pernicious in the winter or fall/spring).

The factors driving repeated virus waves

The factors driving repeated virus waves

As at 03/15/2021. Vertical height of category reflects its relative importance. Colour conveys its effect on pandemic. Source: RBC GAM

A third wave is far from certain everywhere. Countries like South Africa, Ireland and Denmark have seemingly done fine even as the variants have become the dominant strain in those countries. But most countries should expect additional challenges as the variants spread.

Fortunately, the economic damage should be limited. This is in part because the second wave didn’t do a great deal of damage, and in part because fatalities and hospitalizations should remain below prior peaks due to rising immunity levels – meaning that countries probably won’t lock down very aggressively.

Furthermore, we expect any third wave to be short-lived. The warmth of summer is not too far away, and the rate of vaccination progress is sufficiently quick that any third wave is unlikely to last beyond May.

Variant spread

Tracking variants with publicly available data remains as much art as science. We can say, for instance, that the total number of new variant cases reported in the U.S. and Canada last week increased by 83% and 23% relative to the week before, respectively (see next chart).

Week-over-week growth in total variant cases

Week over week growth in total variant cases

As of 03/21/2021. Source: CDC, Government of Canada

But do we really believe that the variants are accelerating nearly four times more quickly in the U.S. than in Canada -- even though Canada’s overall caseload is deteriorating, while the U.S. is not? Not really. In fact, Canada’s variant growth rate over the prior week was very similar to the U.S. All of these figures can be distorted quite badly when a country increases the number of variant tests it performs. We suspect the U.S. growth rate is exaggerated by this phenomenon, but it is unclear to what extent.

The data is often better at a sub-sovereign level. For instance, Ontario extrapolates from its testing to approximate the number and fraction of total cases that are probably the variant. This reveals a clearly rising number of variant cases, to the point that they now represent 54% – the majority – of new Ontario cases. The transmission rate for the new variants is estimated to be 1.38, while the transmission rate for the original virus is estimated at just 0.93. Thus, existing social distancing restrictions are sufficient to keep the original virus at bay, but not the new variants.

Re-opening trends

Our global stringency index below shows that countries are still opening their economies more than they are closing them. However, the rate of opening has clearly slowed and the degree of openness remains somewhat shy of the peak from last September.

Global Stringency Index

Global stringency index

As of 03/21/2021. Global Stringency Index measuring the strictness of lock-down policies that restrict mobility, calculated as stringency index of 50 largest economies. Source: University of Oxford, International Monetary Fund, RBC GAM

The Bank of Canada has put together a stringency metric of its own for Canada (see next chart). This is superior in two key ways:

  1. It allows comparisons across Canadian regions.
  2. The methodology appears to better align with what Canadian policy actually prescribes – a common criticism of the Oxford University methodology used in the global stringency index.

COVID restrictions eased in eastern Canada

COVID restrictions eased in eastern Canada

As of 03/10/2021. Atlantic region includes New Brunswick, Newfoundland and Labrador, Nova Scotia and Prince Edward Island. Prairies region includes Alberta, Saskatchewan and Manitoba. Source: Bank of Canada, RBC GAM

The chart confirms that Canadian rules have become less strict over the past few months, with the greatest easing in Ontario. But Ontario has merely caught up to the average level of restrictions elsewhere. Quebec now stands as the most stringent region. Unsurprisingly, Atlantic Canada has the easiest rules – a luxury made possible by the limited number of infections in the region.

The dominant global trend remains reopening rather than closing. But this may be about to reverse as the third wave arrives. Several European countries including Italy and France are now locking down again. There is a fair chance that other countries will do the same.

Vaccination efforts

Inoculation statistics

Nearly 450 million vaccines have now been administered globally, spanning 133 countries. Israel remains in the lead, with 112 shots per 100 people. Among large, wealthy nations, the U.K. and U.S. lead, with 44 and 36 doses respectively. Europe stands at around 12 per 100 people while Canada lags at just 10 (see next chart).

Cumulative doses administered by country

Cumulative doses administered by country

As of 03/21/2021. Cumulative total doses administered by country per 100 people. Source: Our World in Data, Macrobond, RBC GAM

Fortunately, in most cases, the pace of inoculations is picking up (see next chart).

Coronavirus vaccine daily doses administered

Coronavirus vaccine daily doses administered

As of 03/21/2021. 7-day moving average number of new daily coronavirus vaccine doses administered per million. Source: Our World in Data, Macrobond, RBC GAM

AstraZeneca concerns

The AstraZeneca vaccine has had a rockier path than most, in two main ways:

  1. There were concerns it might not be safe for those older than 65 years.
  2. There have been recent reports of blood clot complications.

In practice, both concerns appear to be overblown, meaning that the vaccine can continue to be used as a workhorse of the COVID-19 inoculation effort.

The age restriction was mainly because the vaccine had not been adequately tested on older people. It now has been and the results argue it is safe for this group to use. Indeed, countries like Canada have now lifted their earlier age-based restrictions.

Quite a number of European countries including Germany, France and Italy have stopped administering the AstraZeneca shot over concerns it may cause blood clots. However, AstraZeneca counters that the rate of blood clots and related incidents are no higher than in that of the general population. The European Medicines Agency has now declared the vaccine safe and effective. It seems likely that the vaccine will be re-approved in most countries.

Vaccinating children

A major hindrance in the effort to achieve herd immunity is that the 20% to 25% of each country’s population that are children are not currently eligible. This seems likely to change over the coming months. Pfizer’s CEO said children might be approved within a matter of weeks. Dr. Fauci of the U.S. sounded a more cautious note, indicating that children might start to be inoculated by the fall.

Vaccine nationalism and diplomacy

In the vaccine nationalism file, the European Union is considering granting its member countries more power to stop the export of COVID-19 vaccines, much as Italy already did to Australia’s order. It seems that much of this effort is focused on crimping the U.K., though other countries including Canada might also be affected. At present we do not expect the supply to be seriously restricted, but this is a risk.

At the other extreme, the U.S. is now joining China and Russia in vaccine diplomacy, creating friends by sharing its ample supply of vaccines. The U.S. will send each of Canada and Mexico several million doses of the AstraZeneca vaccine. This is certainly a win for the countries receiving the vaccines, but also a win for the U.S. Not only does it burnish its reputation, but the specific doses weren’t being used anyway since the U.S. has not yet approved the AstraZeneca vaccine. And because the two recipient countries must eventually repay the U.S. with a proportionate number of vaccine doses later, the U.S. may well be able to lend or give the same vaccines a second time to lagging developing nations, further currying favour.

Vaccine passports

Our confidence continues to mount that most countries will implement vaccine passports or at least have different rules depending on whether a person has been inoculated or not.

Examples abound:

  • Israel only allows vaccinated people into shopping malls and other social establishments.
  • The U.S. now permits people who have been inoculated to socialize indoors together.
  • Iceland now permits vaccinated travelers to visit the country.
  • China has launched a virus passport to permit international travel.
  • The European Commission has proposed that vaccinated people be allowed to travel freely between EU nations.

Economic developments

U.S. winter storm

Real-time data has already provided us with a sense for the economic damage done by the major winter storm in the U.S. in February. Now, traditional economic indicators have caught up and are confirming that damage. U.S. retail sales fell a sharp 3.0% in February (though they rose an unfathomable 7.6% the prior month as fiscal stimulus was delivered). Industrial production was down 2.2% in February.

Fortunately, the storm and its consequences are now mostly gone. The March data should reveal a proportionate rebound, with a bit of room for catch-up activity as well.

Real-time data remains strong

The real-time economic data for March appears to confirm that predicted rebound. Our real-time economic activity index for the U.S. has resumed its climb (see next chart).

U.S. economic activity accelerates in latest turn

U.S. economic activity accelerates in latest turn

As of 03/06/2021. Economic Activity Index is the average of nine high-frequency economic data series measuring the year-over-year percentage change. Source: Bank of America, Goldman Sachs, OpenTable, Macrobond, RBC GAM

Remarkably, U.S. hotel demand is now the highest it has been since the pandemic, above even the levels achieved late last summer (see next chart).

U.S. hotel occupancy continued to improve

U.S. hotel occupancy continued to improve

For the week ending 03/06/2021. Source: STR, Wall Street Journal, RBC GAM

U.S. commercial bank loans first soared as the Fed injected liquidity and businesses drew upon precautionary lines of credit before fading over the subsequent seven months. These loans have now begun to rebound again (see next chart).

U.S. credit demand sees slight trend reversal

U.S. credit demand sees slight trend reversal

Note: For the week ending 02/24/2021. Source: Federal Reserve, Macrobond, RBC GAM

Lastly, global flights are now rising again and are the highest they have been since the onset of the pandemic (see next chart). It would appear quite a lot of economic normalization is occurring.

Commercial flights tracked by Flightradar24

Commercial flights tracked by Flightradar24

As of 03/10/2021. Include commercial passenger flights, cargo flights, charter flights, and some business jet flights. Source: Flightradar24 AB, RBC GAM

Upgrading forecasts

As discussed in greater detail in our latest Global Investment Outlook, our economic forecasts over the past quarter have broadly risen and remain above the consensus. Indeed, given the rate at which the U.S. is vaccinating and the heroic size of the latest fiscal stimulus package, there is already some upside risk to our U.S. forecast (see next table).

U.S. forecast for 2021

U.S. forecast for 2021

RBC GAM vs. CE calculated as RBC GAM forecast minus Consensus Economics (CE) forecast. Source: CE, RBC GAM. As at 02/26-2021.

Inflation worries

Inflation is one of the market’s new, great worries. In evaluating the veracity of this risk, let us start with the observation that inflation has actually been quite low across most of the pandemic, as one would expect when millions lost their jobs and many businesses have struggled. It simply isn’t a time when people can demand big wage increases or businesses can ram through large price increases.

In more recent months, inflation has rebounded somewhat, though still remains below target. U.S. inflation is now up to 1.7% year-over-year (YoY), with core inflation still just 1.3%. Neither matches the long-run 2.0% target. It is a broadly similar story in Canada, with overall inflation at just 1.1% YoY and core inflation averaging 1.7%.

Inflation expectations up but normal

Inflation expectations have certainly risen. Worldwide Google searches for the word “inflation” have roughly doubled over the past few months. Market- and survey-based long-run inflation expectations in the U.S. have both increased somewhat (see next chart). However, it is notable that neither is especially high in an absolute sense – just higher than they were during the worst of the pandemic. Thus, forecasters aren’t expecting any serious problems over the long run.

U.S. inflation expectations rose, but only to normal levels

U.S. inflation expectations rose, but only to normal levels

Market-based inflation expectations as of 03/19/2021, survey-based inflation expectations as of Mar 2021. Source: Federal Reserve, University of Michigan Surveys of Consumers, Haver Analytics, RBC GAM

Short-term upside pressures

It is instead over the short run where inflationary forces are perceived to be most pernicious. The Atlanta Fed survey of inflation expectations one year out has increased to one of the higher readings over the past five years (though not beyond).

One of the unique characteristics of the pandemic has been that demand preferences changed significantly. During the early part of the outbreak in particular, people purchased more food and used less transportation. Because the Consumer Price Index (CPI) basket remains relatively static, spiking food prices and falling transportation costs were insufficiently captured by the official inflation reading. As a result, actual inflation was as much as 0.8 percentage points higher than what was officially registered. But that distortion has already shrunk to just 0.5 percentage points. Our calculation of spending patterns argues that food consumption is now back to an approximately normal level. Transportation demand is only modestly below normal (see next chart).

Impact of COVID-19 on consumer spending: food vs. transportation

Impact of COVID-19 on consumer spending: food vs. transportation

As of Jan 2021. Source: Macrobond, RBC GAM

As the pandemic fades from view, such distortions should gradually reverse. In other words, if anything, it seems reasonable to expect true inflation to run perhaps 0.5 percentage points below the official inflation reading over the next few years. Inflation won’t be quite as high as it looks.

Other temporary idiosyncratic shocks also abound.

The U.S. winter storm in February sent oil and plastics prices soaring as production was temporarily halted. But the storm is now over and those forces should now abate.

On the subject of oil prices more generally, annual inflation readings are set to spike over the next few months as plummeting oil prices from last year fall out of the equation while rebounding oil prices this year remain in the equation. But, fundamentally, oil prices were around $60 before the pandemic and are now again around $60. Once might argue that this rebound has been too enthusiastic given that fuel demand will likely remain below pre-pandemic levels for some time and given credible forecasts that demand for fossil fuels may peak structurally in the 2030s. But the main message is that oil has delivered a net 0% of inflation since the start of 2020, albeit in a volatile way.

So U.S. headline CPI is likely to briefly touch 3.5% YoY over the next few months as this oil see-saw plays out. However, it isn’t really a reflection of underlying inflationary heat so much as the recovery of earlier temporary weakness.

The global residential housing boom represents a murky combination of inflation and asset price appreciation. CPI indexes capture housing costs in remarkably different ways and to varying degrees. The residential construction boom, in turn, has sent wood, brick and copper prices significantly higher. These don’t figure very directly into CPI, but certainly affect businesses. There is some evidence that the U.S. housing boom in particular may be starting to slow, as evidenced by (slightly) less ebullient builder surveys and rising mortgage rates. More on that in a later week.

Pushing in the other direction, serious congestion at Los Angeles ports is now reportedly easing, which should reduce some of the supply pressures contributing to rising prices for a range of sectors.

Multi-year but not permanent inflation pressures

What about upward inflation pressures that might last a few years rather than just a few months?

First, economies are reviving. That should increase inflation. But most countries are at least a year or two from eliminating their output gap. In turn, it is hard to argue for outright high inflation from a cyclical perspective.

Perhaps outsized U.S. fiscal stimulus could induce a spurt of additional inflation there, but much of the money will likely be saved. There is little precedent for policy support creating an outright economic mountain where there was once an economic hole. It usually just makes a hole somewhat less deep. The stimulus will also eventually fade, removing any inflation pressure.

Furthermore, it has been credibly argued that there is more economic slack in the world right now than commonly estimated. For instance, broad measures of unemployment remain extremely elevated and significantly higher than official metrics.

On the other hand, it is fair to concede that many sectors of the economy are already operating at their full capacity. In turn, such sectors might credibly have pricing power or experience wage pressures. But this is less unique than it sounds. While the pandemic has created a more extreme sector skew than usual, it is completely normal for some sectors to outperform others during recessions. Furthermore, one would presume that the weak sectors should have unusually poor pricing power and weak wage pressures that provide a counterbalance in the other direction.

The new U.S. inflation mandate – a tolerance for a bit more than 2% inflation after a period of below-target inflation – is entirely relevant, but needs to be put in the right context. One prominent voice at the Fed argues this will only be to the point of tolerating additional inflation to make up for the prior year’s undershoot, not the prior decade’s. Over the long run, the new policy should actually reduce the chance that inflation drifts chronically above target since bygones will no longer be bygones.

The inflationary effect of additional onshoring efforts should be quite small to the extent they primarily focus on the medical supply chain. They will likely add less than 0.1% per year to inflation.

Fears that countries may intentionally pursue higher inflation to erode their public debt loads are unconvincing. This tactic inevitably backfires once the bond market figures it out, and the targeted rate of inflation isn’t presently under the direct control of politicians.

U.S. dollar weakness may be moderately inflationary for the U.S, but by definition must therefore be deflationary for other countries.

Some countries – Canada, prominently – are in the midst of increasing carbon taxes. This does add modestly to inflation – perhaps 0.2ppt to 0.3ppt per year – but ends as soon as the country stops increasing the tax rate.

The main point is that, as this discussion has hopefully elucidated, the net upward pressure from these cyclical inflation factors should be fairly limited and – in most cases – temporary.

The big risk

To the extent there is a big risk that could send inflation sharply higher, it is arguably the amount of money being printed by central banks. Should all of that money gain traction with the economy, it could be explosive.

However, this risk is smaller than it appears. Although such measures of money supply as M2 have undeniably surged (see next chart), this is only partly because of money printing. It is also significantly because households and businesses have had a preference for liquidity during the pandemic and because fiscal stimulus has caused savings rates to soar. Those secondary factors are not inflation – in fact, they help to repress inflation.

U.S. money supply growth surged during pandemic

U.S. money supply growth surged during pandemic

As of Dec 2020. Shaded areas represent U.S. recessions. Source: Haver Analytics, RBC GAM

As central bankers discovered in the 1970s, there is actually only a small and tenuous connection between the rate at which the monetary base grows and the rate of inflation. Indeed, the great bulk of the money printed by the U.S. Federal Reserve this cycle has been effectively returned to the central bank in the form of additional reserves (see next chart). It never made its way into the real economy.

Most of Fed’s money printing didn’t reach the economy

Most of Fed’s money printing didn’t reach the economy

As of Jan 2021. Source: Federal Reserve Board, Haver Analytics, RBC GAM

It was a similar experience with the earlier global financial crisis – plenty of money printed, but little inflation. You might argue that bank deleveraging provided a potent offset to the money printing at that time – one that doesn’t exist today. But Japan’s experience with money printing over the past two decades has uncovered very little inflation even when banks were actively leveraging.

In a worst-case scenario in which money printing did prove extremely inflationary, let us not forget that the very goal of central banks is to achieve a normal amount of inflation. They have every ability to course-correct, albeit at the cost of higher interest rates.

Downward structural forces

For all of the upward idiosyncratic and cyclical forces, there are profoundly deflationary structural forces as well.

The Phillips Curve is flatter than it once was, perhaps due to the rise of a globalized labour force and the decline of unionization. In turn, even if the economy returns to its potential, there is no guarantee of sustainably normal inflation, let alone high inflation. The past decade was marked by policymakers trying to elevate inflation to 2%, but usually failing. It has been a long time since there was a serious wage-price spiral.

The demographics of the 21st century are profoundly deflationary. The combination of slower population growth and an aging population appears to exert a real downward pressure on prices. While this is counterintuitive in that old populations usually dis-save – spending more than they earn – other considerations dominate, such that Japan and now much of the Eurozone experience notably lower inflation than elsewhere. To a lesser extent, these same forces apply to North America.

We believe there is a real chance that the rate of technological progress will increase relative to the relatively subdued norm of the past two decades, with higher productivity growth likely proving deflationary.

Finally, as emerging market nations get wealthier, this normally goes hand-in-hand with lower inflation rates in those countries. This phenomenon is already visible in some of the world’s most notoriously high-inflation countries such as Brazil and India.

Inflation models

For all of this, consumers are undeniably facing rising inflation right now. Real-time inflation measures are going up and now point to 2% to 3% inflation readings in the near term. Our own inflation model can explain three-quarters of what is happening to prices via such inputs as the output gap, import prices, inflation expectations and the recent inflation trend. It indicates that inflation should approach 3% in the near term (see next chart). But many of these pressures are only temporary.

Model argues U.S. inflation is already above 2%

Model argues U.S. inflation is already above 2%

As of Feb 2021. Shaded area represents recession. Source: Haver Analytics, Macrobond, RBC GAM

For the most part, central bankers don’t appear to be overly worried by the prospect of too much inflation. This is reassuring because they are the world’s experts on the subject. The most recent Federal Reserve meeting yielded forecasts for 2022 headline and core inflation that ranged from 1.8% to 2.3%. This is to say that even the most worried District Fed President only expects inflation to be a few tenths above normal next year.

For the moment, businesses appear to be facing steeper price pressures than individuals. The Institute for Supply Management (ISM) Manufacturing Index’s prices paid component recently rose to an elevated reading of 86 – nearly at the level of its June 2008 (commodity boom-induced) high. The producer price index is now rising at a warm 2.4% per year – much higher than last spring, but still below the 3% to 4% range that prevailed in 2017 and 2018. Perhaps the question is the extent to which businesses will be able to pass along their higher raw material costs. We suspect this will be limited given the incomplete state of the economic recovery.

Inflation bottom line

For the moment, more inflation is actually a good thing. It represents inflation becoming less low, rather than too high. And it allows real yields constrained by the nominal zero bound to fall, adding support to the economy. Furthermore, if normal-to-slightly high inflation were sustained beyond the next year or two, this might actually mean the world has broken out of secular stagnation – arguably a good thing.

Most of the upward inflation forces people are worried about are idiosyncratic or cyclical upward pressures. That is to say, they are mostly temporary. Of these, only money printing could have a big effect, and there is little evidence of that happening. While inflation may touch 3.5% over the next few months, it is likely to run only moderately above 2% over the next few years. This is a bit higher than we are accustomed to, but not truly high. And then, over the long run, there remain more downward pressures than up. This argues that sustaining 2% inflation could be a challenge.

Sharply higher yields

The U.S. 10-year yield has leapt from just 0.51% last August to 1.69% today. It goes without saying that this is quite a large move over such a short period of time.

It makes sense that yields have been rising, for several reasons:

  • They are rising off an extremely low base and as extraordinary risk aversion fades.
  • The economy has strengthened significantly.
  • The economy is expected to continue strengthening.
  • Inflation is expected to rise (see bottom-right quadrant of next chart).
  • There are mounting expectations that central banks may tighten monetary policy sooner than planned. This shows up in standard measures of central bank expectations, though not, curiously, in the bottom-left corner of the next chart; instead the increase in yields is attributed to a rising term premium in the top-right corner.

Disaggregating bond market movements

Disaggregating bond market movements

As of 03/19/2021. Source: Federal Reserve Bank of New York, Bloomberg, Haver Analytics, RBC GAM

Central bank expectations

Some emerging market central banks are already in motion: both Russia and Brazil have raised rates already. However, it should be noted that when U.S. yields go up, many emerging market central banks have to tighten their monetary policy. This is to stem the capital outflow and currency depreciation that results as investors flock to the U.S. bond market in search of juicier coupons. It is not purely a function of economic expectations in Russia and Brazil.

While the U.S. Federal Reserve maintained its prior course of stimulus at its latest meeting, the accompanying economic and inflation forecasts were undeniably more optimistic about the future. Additionally, while the median Federal Open Market Committee (FOMC) projection for the fed funds rate was unchanged – predicting no rate hikes until 2024 – four participants now expect tightening to begin in 2022 and another 3 expect the starting gun to be fired in 2023. Still, this remains well short of current market expectations and argues that the bond market may have gotten somewhat ahead of itself.

In Canada, the latest Bank of Canada decision followed a similar template, maintaining the existing level of policy support and highlighting upside risks to growth. Thus, the central bank is likely to tighten earlier than once envisioned, but not necessarily quite as soon as the market presently imagines.

Premature expectations

Historically, the last 16 times the U.S. 10-year yield rose by a percentage point or more in short order, the fixed income return over the subsequent year was positive. This is to say that yields stopped rising, and in many cases even fell back somewhat.

Similarly, the experience of the past decade demonstrates that the bond market was far too quick to price in rate hikes, repeatedly being premature relative to the actual tightening date (see next chart).

Rate hike expectations tend to be premature

Rate hike expectations tend to be premature

Note: As of Feb 2021. Source: Federal Reserve Board, Bloomberg, Haver Analytics, RBC GAM

Reflecting back on specific taper tantrums from that period, in 2013 then Fed Chairman Bernanke mused that the Fed might start scaling back its monetary support over the subsequent few meetings. This sent yields a big 140 basis points higher over the span of five months. Crucially, yields then spent the next year and a half retreating back to where they had started as the Fed opted to continue with its monetary support. The stock market proved resilient throughout the episode.

Later, in 2015, bond yields rose into the Fed’s first actual rate hike at the end of that year, but then spent much of 2016 falling as the pace of tightening proved less forceful than imagined. The stock market was able to record new highs before the year was out.

Further considerations

The Fed has a new mandate that should allow it to retain monetary stimulus for longer than in the past. Thus, the coming tightening cycle should prove somewhat more dovish than past cycles.

In the seven months before the pandemic, the U.S. 10-year yield ranged from 1.5% to 1.95%. It has now returned to that same range, despite a much higher unemployment rate and a far lower policy rate. That argues yields are somewhat too high at their current levels.

U.S. fiscal update

The U.S. has finalized its enormous fiscal package worth $1.9 trillion – the full amount that President Biden had envisioned. That represents 9% of GDP, and comes on the heels of a package worth 4% of GDP that was delivered just a few months earlier. The U.S. is now in the unique international position of delivering more fiscal stimulus in 2021 than it did in 2020.

In turn, it would appear that the U.S. has oversized its fiscal stimulus relative to the economic need. It will undoubtedly help in the race back to economic normality (adding as much as 3 percentage points to 2021 growth), but at a considerable cost given that the additional public debt will likely prove permanent.

On an unrelated note, there remains the real possibility of an infrastructure and investment package on top of this. This would be paired with tax increases. The former might deliver $2 trillion of spending over a period of years, partially paid for with perhaps $1 trillion of tax increases, disproportionately affixed to corporations and the wealthy.

While pundits believe such a package has a real chance of being passed, we would warn that it would require 10 Republican votes in the Senate – far from a sure proposition when tax increases are included and given the history of rancor in Congress.

On a related note, some U.S. states are also beginning to raise taxes to meet their balanced budget requirements. This includes New York State, which is targeting higher income groups – likely a recurring theme with politicians over the next few years.

-With contributions from Vivien Lee and Sean Swift

Interested in more insights from Eric Lascelles and other RBC GAM thought leaders? Read more insights now.


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