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by  Eric Lascelles Mar 29, 2022

What's in this article:

Global Investment Outlook

Our Spring Global Investment Outlook has now been published. The economic article, summarizing our main views for the future, is entitled “Fragile recovery ahead”.

Overview

Several key economic matters continue to brew. The war in Ukraine remains highly consequential for commodity prices and economic growth. The pandemic is on a knife’s edge – having improved substantially but with the possibility of another wave in the near term. China has had to lock down further, though its government promises more policy support. Globally, recent economic data has been fairly strong, but there are some signs that growth may be fraying. We also address a number of key inflation themes, central bank plans for aggressive tightening, and what the yield curve is saying about the risk of recession.

War in Ukraine

The Russian bombardment of Ukrainian cities continue, with Russia advancing further into the key port city of Mariupol. Intelligence reports flag the risk of a major Russian cyberattack.

Certainly the largest recent development is that Russia is now reportedly narrowing its military focus toward eastern Ukraine. This is a big deal. It is a recognition that all of Ukraine is proving difficult for Russia to swallow, that Russia’s ambitions are significantly reduced, and that the risk for many Ukrainian cities and much of the country’s civilian population has just been significantly reduced. Presumably, the flow of refugees from Ukraine will slow (though it is already massive – see next chart – and that doesn’t include internal displacement). The risk that Russia expands the battlefield to include other Eastern European countries was already quite low, but is now even smaller. Russia’s hands are already quite full.

Ukrainian refugee migration by neighbouring country

Ukrainian refugee migration by neighbouring country

As of 03/25/2022. Source: United Nations High Commissioner for Refugees (UNHCR), Macrobond, RBC GAM

Russia could enjoy greater success as it focuses its military efforts. Supply lines will be shorter and the country already had a significant foothold in eastern Ukraine before the war began. Ukrainian troops in Eastern Ukraine will now have to fight on two fronts as Russian troops now approach from the west.

Ceasefire?

Hopes aren’t quite as high as a few weeks ago when both sides were talking optimistically about an imminent deal. However, there is still the real possibility of a cease-fire in the near term. Both sides continue to meet in Turkey. Turkey’s foreign minister recently opined that the two countries “have almost reached agreement” on four key aspects of a peace deal. Progress was reported on:

  1. Kyiv agreeing to declare neutrality and give up its quest for NATO membership.
  2. The demilitarization of Ukraine in exchange for security guarantees from the West.
  3. The “denazification” of Ukraine (Russia’s odious term for regime change in Ukraine).
  4. The removal of restrictions on using the Russian language in Ukraine.

In exchange, Russia would potentially agree to a ceasefire and withdraw its troops to where they had been before the February 24 invasion.

But it would be a surprise if Ukraine accepted a forced change of government given the popularity of the current administration. A pro-Russian replacement is almost unfathomable.

Meanwhile, Ukrainian President Zelensky has insisted that Russia cannot slice Ukraine into pieces. It is unclear if that statement applies to Russia’s pre-war hold over Crimea and its tentative hold on parts of Eastern Ukraine (which Russia is very unlikely to cede), or if he instead simply refers to a refusal to accept further territorial losses. U.S. President Biden recently said “Putin cannot remain in power,” which is unlikely to be viewed favourably by Russia, nor a demand to which Russia will accede.

Ukraine must also have grave concerns as to whether Russia will abide by any pact that is reached. Furthermore, the ceasefires Russia reached in earlier conflicts with Georgia and Moldova were both ultimately to its advantage to the extent that the ceasefires shielded the Russian proxies who had gained control of the territories from attack.

It is clearly a complicated picture. We assign a one-in-three chance to a deal over the next few months. This is actually a little higher than that assigned by Good Judgement Open1. It estimates a 27% chance of an agreement before June 1 and a 73% chance before December 1.

Commodity prices

Elevated commodity prices remain the main channel by which the war in Ukraine maps onto the global economy. A wide range of commodity prices remain quite high since the Russian invasion, though the recent trend has been mixed.

Food prices have soared and have mostly held onto their initial gains. This, in turn, is beginning to create the prophesied instability in the world’s poorest countries. Ukraine’s agricultural output alone feeds an astonishing 400 million people, many of whom will now go hungry. Food price protests have been reported in Iraq, Sri Lanka, Sudan and Albania, with additional turmoil expected. Congo has warned that rising bread and oil prices could be “major sources of instability”.

Metal prices have retreated significantly from their highs, but remain elevated (refer to the price of nickel in the next chart).

Nickel spot prices

Nickel spot prices

As of 03/25/2022. Source: London Metal Exchange (LME), Macrobond, RBC GAM

Oil prices have similarly retreated from their highs, though it has been a choppy path. Since late February, the price of a barrel of West Texas Intermediate oil first rose from $92 to $124, then fell to $95, then rose to $115 and has now fallen back to $103 on March 28.

Some of the volatility has related to questions about supply. OPEC has so far not come to the rescue and a Russian pipeline was briefly damaged by adverse weather. Yet a surprising amount of volatility has related to questions of Chinese demand. As China has locked down more cities, energy analysts have marked down China’s expected demand, and in turn, the price of oil.

We continue to anticipate a 2 million barrel per day mismatch between global oil supply and demand. This theoretically justifies an oil price that could approach $143 per barrel. But there isn’t much precision to that estimate. Third-party estimates broadly range between a 1 million and 3 million barrel per day mismatch. Estimates of the elasticity of the price of oil in response to changes in supply is even greater.

As expected, some governments are opting to absorb part of the cost of energy price increases on behalf of their citizens. Germany has unveiled fuel subsidies and reduced the cost of public transit. Austria has reduced its natural gas and electricity tariffs and increased commuting subsidies. Three U.S. states have approved gas tax holidays, as has the province of Alberta in Canada. In British Columbia, drivers are set to receive a one-time tax rebate. In the Caribbean, Jamaica introduced a mix of subsidies and gas vouchers, while Barbados has capped the tax on gasoline and diesel fuels. These are just a handful of examples.

When might sanctions be lifted?

Russian sanctions are the primary source of high commodity prices and thus economic damage. It is thus critical to have a sense not just for the damage inflicted by those sanctions, but for how long the sanctions might last.

On this subject, a wide range of scenarios exist. It is conceivable that sanctions could be lifted quite soon. If a ceasefire or peace treaty were signed within the next few months, it is possible that sanctions could be lifted at the same time. The British Foreign Minister recently affirmed this possibility, indicating that sanctions on Russian individuals and companies might be lifted at that time.

However, the war could continue for quite some time.

Furthermore, it is far from certain that Russian sanctions will be lifted whenever the war comes to an end, for several reasons:

  • Countries may be unwilling to lift sanctions unless Russia fully vacates Ukraine, including Crimea – a tall order.
  • Russia would get the wrong message if its economy were allowed to fully rebound as soon as military activities cease: a more enduring lesson is arguably advisable.
  • Even if Russian sanctions were lifted, western companies will likely remain reluctant to again embrace Russia. They have just lost gobs of money in the country. They now recognize how vulnerable any Russian operations are. They’ve also seen Russia’s efforts to invalidate their right to intellectual property over the past month.

As such, short of a new Russian government, the bulk of existing sanctions seem most likely be maintained for a period of several years whether the war lasts that long or not.

Economic implications

Let us briefly revisit some of the economic implications of the war. For Ukraine, the best guess is that the economy has shrunk by around half. Due to the intricacies of calculating annual average GDP growth plus the possibility of some revival later in the year, the savviest forecasts embedded within the consensus assume a 2022 GDP impact of around -35% for Ukraine.

For Russia, the consensus economic forecast continues to fall, now landing in the middle of the range we laid out for it over a month ago. The Bloomberg consensus in March calls for a 10% decline in Russian GDP in 2022.

Meanwhile, in the Eurozone the growth consensus for 2022 remains relatively resilient, having fallen from +4.0% in February to +3.3% in March. Our own penciled-in forecast has fallen by around twice as much, to +2.5%. This represents a serious downgrade and a stark deceleration from approximately +5.2% growth in 2021. However, it is still consistent with a moderate economic recovery. Recession risks for the continent are elevated by virtue of the commodity connection with Russia, but still short of 50%.

In Germany, the Bundesbank’s weekly economic activity index confirms a palpable deceleration, though nothing on the scale of the spring of 2020 (see next chart).

Deutsche Bundesbank Weekly Activity Index

Deutsche Bundesbank Weekly Activity Index

As of the week ending 03/20/2022. Weekly Activity Index estimates the trend-adjusted growth rate of economic activity by comparing the average over the past 13 weeks to the average of the preceding 13 weeks. Source: Deutsche Bundesbank, Macrobond, RBC GAM

There isn’t much evidence of serious economic damage so far to other developed nations, but the commodity shock is still young, and theory suggests a palpable effect.

Pandemic inflection point

The pandemic is now at a possible inflection point. The trend had been mostly good for the past few months as the Omicron wave faded. A tick higher in developed-world cases has lately been partially reversed (see next chart). It is quite possible that enough people have been vaccinated and infected in most countries to greatly limit future waves.

COVID-19 emerging market versus developed market infections

COVID-19 emerging market versus developed market infections

As of 03/25/2022. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM

However, we are inclined to think that a smallish BA.2 wave is on the way for most developed countries over the next fewer months. The BA.2 sub-variant appears to be 30—40% more contagious than the Omicron variant, and roughly equally likely to cause hospitalization or death. Booster shots are beginning to wane in efficacy as the months pass. And, as restrictions ease, the capacity for spread increases. Cases are again rising in a number of European countries (see next chart).

Transmission rate below one means COVID-19 decelerating

Transmission rate below one means COVID-19 decelerating

As of 03/25/2022. Transmission rate calculated as a 7-day change of underlying 7-day moving average smoothened by a 14-day moving average of new daily cases. Source: WHO, Macrobond, RBC GAM

COVID-19 infections may be starting to creep higher in Canada. Although the nationwide infection count is officially still in slight decline, the rising test positivity rate hints of under-testing (see next chart). And some of the country’s larger provinces are definitely beginning to deteriorate, including Quebec and Ontario (see subsequent chart).

COVID-19 cases and positivity rates in Canada

COVID-19 cases and positivity rates in Canada

As of 03/25/2022. 7-day moving average of daily new cases and test positivity rates. Source: Our World in Data, WHO, Macrobond, RBC GAM

Spread of COVID-19 in Ontario

Spread of COVID-19 in Ontario

As of 03/27/2022. 7-day moving average of daily cases and deaths. Source: Government of Canada, Macrobond, RBC GAM

U.S. infections are still technically in decline at the national level. However, it is notable that the number of states reporting a rising infection load is increasing. That group includes behemoths California, Texas, Florida and New York (see next chart).

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 03/25/2022. 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

We have saved China for last. It is experiencing, by far, its largest wave of infections since the winter of 2020 (see next chart). We suspect further increases are yet to come. More on that in the next section.

COVID-19 cases and deaths in China

COVID-19 cases and deaths in China

As of 03/24/2022. 7-day moving average of daily new cases and new deaths for mainland China. Source: John Hopkins University, Haver Analytics, RBC GAM

China’s yin and yang

The China story is becoming quite complicated, with powerful opposing forces simultaneously attempting to impose their will.

Bad news

On the negative side, the COVID-19 situation is getting significantly worse. The country’s zero tolerance policy is struggling against the hyper-contagious BA.2 sub-variant. Hong Kong is already far into an out-of-control outbreak. On the mainland, the city of Shenzhen (population 17 million) only recently emerged from lockdown. Now Shanghai (population 26 million) – which had been teetering on edge for the past several weeks – is being locked down. More cities are likely to follow. This obviously does economic damage, both to China domestically and to the provision of goods globally. That said, the country has recently enjoyed some success with “closed loop” systems, whereby factory workers live at the factory and so are still able to produce manufactured goods even when a city is in lockdown.

China is thought unlikely to abandon its zero-tolerance policy in the near term. The policy is popular with the public, the government has crowed about how China’s approach has been superior to that of the rest of the world, and it would look bad to have a massive outbreak before President Xi is appointed to an unprecedented third term this fall.

China is nevertheless quite vulnerable to a major outbreak for a few reasons. In addition to the sheer contagiousness of the latest variant, most of China’s population was inoculated with a vaccine that appears to be significantly less effective against recent variants. The lack of earlier waves means very few people have acquired powerful natural immunity, and just 51% of the country’s population aged 80-plus is vaccinated (though the vaccination rate is quite good for younger age groups).

A top scientist recently admitted the country cannot maintain the stance forever. That would require remaining walled off from the rest of the world indefinitely. But re-opening isn’t much easier. Because of so little immunity within the population, China would likely suffer a much larger wave than that experienced elsewhere.

Good news

Conversely, on the positive side, China’s government continues to emphasize its economic stability goals for 2022. The country is nearly alone in delivering monetary stimulus at a time when most others are fretting about high inflation and raising interest rates vigorously. Banks have recently been instructed to increase loans for homebuyers and developers, and the credit impulse is already turning higher (see next chart).

Chinese credit impulse turned higher

Chinese credit impulse turned higher

As of Dec 2021. Measured as year-over-year change of 3-month rolling average of sum of total social financing excluding equities and local government bond issuance as % of GDP. Source: Haver Analytics, RBC GAM

China’s top economic advisor recently demanded that regulators develop market-friendly policies designed to “invigorate the economy.” A range of supportive policies is expected to include tax cuts, pro-employment measures, infrastructure investment (especially energy), and support for small businesses and manufacturing. Perhaps most telling, the country surprised pundits with its target of +5.5% real GDP growth for 2022, higher than the anticipated +5.0% number. President Xi is thought to want strong growth in the year leading up to his reappointment. We still maintain a below-5% forecast largely due to the expected damage from COVID-19 lockdowns and a global pivot from Chinese-produced goods to services.

Over the medium run, Chinese people are said to face “three great mountains” before they can achieve prosperity: improving the state of education, health care and housing. Government initiatives are likely to have an eye toward improving these areas. The country’s earlier crackdown on for-profit education providers (one estimate had a third of Chinese households spending an incredible 30—50% of their income on education spending in 2019) and on certain housing excesses both fit into this overarching plan. In 2021, the country also published a five-year plan to upgrade its healthcare sector.

Economic developments

An eclectic mix of economic developments merit examination.

COVID-19 restrictions

We begin in Canada. COVID-19 restrictions here are now the lightest they have been since the beginning of the pandemic, surpassing even the summer/early fall of 2021 (see next chart). This provides an important economic tailwind for Canada. There had briefly been concern that a rail strike would impede activity, but this was resolved in under a week, leaving little damage.

COVID-19 restrictions in Canada

COVID-19 restrictions in Canada

As of 03/09/2022. Atlantic region includes New Brunswick, Newfoundland and Labrador, Nova Scotia and Prince Edward Island. Prairies region includes Alberta, Manitoba and Saskatchewan. Source: Bank of Canada, RBC GAM.

Globally, Goldman Sachs estimates that global economic output is now undermined by just 2% due to the restrictions that remain. This is an improvement from the 3—4% impingement estimated during the worst of the Omicron wave. The 2% figure represents economic output that has been in purgatory for the past two years and can yet be unleashed as conditions normalize over time.

Jobless claims strong

Quite remarkably, U.S. weekly initial jobless claims are now not just lower than they were before the pandemic, but the lowest they have been since 1969 (see next chart). This reflects the economic progress made in the U.S. economy, and highlights that the argument for monetary tightening is not just premised on high inflation but also on a tight labour market.

U.S. jobless claims now below pre-pandemic level

U.S. jobless claims now below pre-pandemic level

As of the week ending Mar 12, 2022. Shaded area represents recession. Source: Department of Labor, Haver Analytics, RBC GAM

U.S. first-quarter GDP is now tracking just +1.3% annualized – a far cry from the +7% annualized gain in the final quarter of 2021. However, it should be emphasized that much of the quarter’s anticipated weakness is a consequence of the prior quarter’s outsized strength, with some give-back necessary in inventories and exports. To be sure, the Omicron wave and now higher commodity prices also do some damage. But the expected weakness has more to do with technical factors.

Economic news turns more negative

Although the recent trend in global economic data has been good, many indicators do not yet reflect the full effect of recent negative shocks. These include the start of vigorous monetary tightening and the onset of the war in Ukraine. The San Francisco Fed’s Daily News Sentiment Index provides a sense for this. Headlines have been grim in recent weeks, potentially reflecting a coming economic deceleration (see next chart).

Daily News Sentiment Index in the time of COVID-19

Daily News Sentiment Index in the time of COVID-19

As of 03/13/2022. Source: Federal Reserve Bank of San Francisco, Macrobond, RBC GAM

Financial conditions tightening

Approaching the prospect of an economic deceleration from a different vantage point, we can say that global financial conditions – a key determinant of economic growth – have deteriorated in recent weeks (see next chart). This is largely due to rising bond yields, widening credit spreads and a lower stock market. But it should be noted that the magnitude of the deterioration is not nearly as large as that experienced in 2020 or 2008. So far, the move has a greater resemblance to a mid-cycle correction like that experienced in 2015—2016.

Global financial conditions tightening quickly

Global financial conditions tightening quickly

As of 03/11/2022. Source: Goldman Sachs, Bloomberg, RBC GAM

Questionable consumers

A year ago, the economic outlook was quite strong thanks to enthusiastic consumers and businesses. Today, businesses still seem inclined to invest and add to their inventories, but the consumer outlook isn’t quite as remarkable as a year ago. In particular, the appetite to purchase large durable household goods like cars and appliances is not just waning but has declined to its lowest level in more than 40 years (see next chart).

Buying conditions for large durable household goods

Buying conditions for large durable household goods

As of 01/01/2022. Source: University of Michigan, Macrobond, RBC GAM

There are some benign explanations. These include the idea that consumers are now pivoting from buying goods to purchasing services, or that they would still like to buy big-ticket items but temporarily cannot get them due to supply chain issues. Seven in 10 Americans reported having to wait for or being unable to procure an item in a Gallup poll conducted last July. Meanwhile, recent corporate announcements reveal that the likes of Disney theme parks, Marriott, Expedia, MGM and Wynn Resorts are raving about the return of consumers to their high-touch service offerings.

But the assessment that buying conditions are poor is probably also in part a response to unaffordable prices, consumer fatigue after a long buying spree, and likely a degree of trepidation as interest rates rise and inflation remains very high.

Indeed, consumer confidence has tumbled (see next chart). By how much is a matter of vigorous debate. The Conference Board confidence survey argues the drop has been slight, whereas the University of Michigan survey claims the decline is among the steepest in history, and to a level of concern that has not been plumbed in a decade.

U.S. consumer confidence plummeted on inflation and Russian invasion of Ukraine

U.S. consumer confidence plummeted on inflation and Russian invasion of Ukraine

The Conference Board Consumer Confidence as of Feb 2022, University of Michigan Consumer Sentiment as of Mar 2022. Shaded area represents recession. Source: The Conference Board, University of Michigan, Macrobond, RBC GAM

The disagreement between the two surveys isn’t entirely random. The Conference Board survey puts a greater emphasis on employment conditions, which remain extremely strong. In contrast, the University of Michigan survey puts a greater weight on inflation, which has been problematic. The University of Michigan survey is also the source of the buying conditions question discussed earlier. Perhaps the best way to put it is that certain aspects of the U.S. economy are extremely strong right now, like the rate of hiring. Others are extremely poor, like high inflation.

So far, consumers have continued to spend to a reasonable degree despite their evident trepidation. Further, household balance sheets remain in good condition and we anticipate robust wage gains over the coming year, providing further support. We suspect consumers will spend to a reasonable degree, if to an increasing extent on services rather than goods. But the performance probably won’t be as spectacular as in 2021.

European economic damage

All eyes are naturally on European economic indicators given the connection to Russia. Some mild damage is clearly visible, as per the economic sentiment index in the ZEW survey (see next chart). The European composite Purchasing Managers’ Index also fell in March, but only slightly. It is still early, but the economic damage so far seems manageable, and well shy of a recessionary impulse.

Euro Area Economic Conditions Sentiment

Euro Area Economic Conditions Sentiment

As of Mar 2022. Source: ZEW (Centre for European Economic Research), Macrobond, RBC GAM

Inflation musings

Inflation remains very high. The U.S. CPI reading is at a four-decade peak +7.9%, while Canada reports a lofty +5.7% rate. Real-time inflation proxies are again rising, as one would expect given the recent leap in commodity prices. We continue to assume U.S. CPI crests within the next few months at approximately +9.5%. This is close enough to double digits to merit some concern that breaching the double-digit threshold could elicit a negative psychological reaction.

Let us address a few inflation subjects that have thus far been only tangentially addressed at best.

The economic damage from high inflation

Elevated inflation is generally described as being bad for the economy because it forces central banks to raise interest rates, slowing growth. This is true. But it bears mentioning that high inflation is also corrosive to economic growth all by itself. This is via the sorts of channels that one finds in an Economics 101 textbook. Examples include:

  • the “menu cost” of having to change prices frequently (though this is theoretically diminished in a digital age)
  • “shoe leather costs” as people feel compelled to buy things as soon as they earn money to avoid a higher price later
  • distortions that arise in the tax system.

One study from the International Monetary Fund (IMF) puts the damage of persistently operating in a 5% inflation environment (versus a norm of 1—3%) at -0.5% from economic growth per year. This is a significant sum and certainly worth avoiding if possible.

It’s not primarily about central banks

Today’s high inflation is not primarily the doing of central banks. Central banks have certainly helped to revive economic activity. That revival, in turn, means inflation is higher than otherwise. But one would struggle to argue that inflation should be much more than around +2.5% on the basis of present economic tightness alone, and even that could be an exaggeration.

Approached from a different angle, if high inflation were the product of far too much money sloshing around, one would expect inflation to accelerate roughly proportionately across all products. While the breadth of inflation has increased in recent months, it is still disproportionately a story of a few supercharged goods including energy, food, computer chips and cars.

Instead, high inflation is mainly the result of unusually strong demand for goods, now paired with a supply-side commodity shock. While it is technically possible that central banks could fix a problem that they didn’t make, it would require such an extraordinary amount of monetary tightening that the result would be quite unpleasant for all involved. Central banks can and are helping, but demand is also going to have to shift from goods to services and commodity prices have to stop rising before inflation can realistically be vanquished.

Don’t kill the price signal?

High inflation is generally undesirable. However, one line of thought argues that high inflation shouldn’t be quieted too forcefully. Prices, after all, are how information flows through the economic system. A high price is an inducement to make more. If people want more computer chips and cars, higher prices are what will motivate manufacturers to increase their production. When that extra production arrives, the price of those products can then settle back down. This argument is weakened somewhat by the fact that auto makers would absolutely love to produce more cars right now, but are impeded by a lack of availability of certain inputs. But, of course, the makers of those inputs are now being incented by carmakers who are surely happy to pay more for that one missing piece necessary for a new car.

Hawkish central banks

North American central banks have already begun their tightening cycle, with both the U.S. and Canada delivering 25 basis point (bps) rate increases in March. Further tightening is anticipated. Indeed, the latest projections from the Federal Open Market Committee (FOMC) now anticipate a Fed funds rate that rises from the current 0.25—0.50% to 1.9% by the end of this year, and all the way to 2.8% by the end of next year.

Further, it increasingly appears that those central banks may front-load the tightening by even more than previously expected, with big 50bps rate hikes at the next opportunity. In the U.S., Fed Chair Powell recently testified that the Fed is prepared to move more aggressively. In Canada, Deputy Governor Kozicki said the Bank of Canada is “prepared to act forcefully.”

We continue to think that, over the span of the next year or two, central banks may not have to raise interest rates by quite as much as they are currently projecting. If central banks are credible in promising a great deal of monetary tightening, this would reduce inflation expectations. In turn, it would reduce the amount of monetary tightening that actually proves necessary. By the second half of 2022 it is fairly likely that inflation will have peaked and that economic growth will have decelerated. The tightening clip may be able to slow markedly at that point.

On the other hand, if inflation sticks around and central banks are obliged to deliver all of the tightening that they are predicting, it is worth keeping in mind just how negative inflation-adjusted interest rates currently are (see next chart – the nominal yield is deflated by the current annual rate of inflation, not inflation expectations). Yes, the nominal policy rate has risen by 0.25 percentage points and the nominal 10-year yield has risen by a large 2 percentage points from its low in 2020. But the inflation-adjusted 10-year yield is still around 5 percentage points below where it was before the pandemic. This is still extremely stimulative from a monetary policy perspective, and still extremely cheap for borrowers.

Real yields have been falling since the onset of the pandemic

Real yields have been falling since the onset of the pandemic

As of 03/21/2022. Measured as nominal 10-year Treasury yield minus year-over-year percent change in CPI. Shaded area represents recession. Source: Macrobond, RBC GAM

For the moment, borrowers are indeed largely happy. The rate of bank loan growth in the U.S. actually accelerated over the past six months (see next chart).

U.S. credit growth picking up steam

U.S. credit growth picking up steam

As of the week ending 03/02/2022. Source: Federal Reserve, Macrobond, RBC GAM

Recession risk

A great deal of attention has been placed on the rapidly narrowing spread between the U.S. 10-year and 2-year bond yields. This flattening of the curve is viewed with trepidation, as there is a long history of recessions happening after the spread inverts, which it is not far from doing. The recession risk is undeniably real as post-pandemic buoyancy diminishes, central banks raise rates and commodity prices have surged.

However, the risk probably isn’t quite as high as the so-called 2-10 spread is seemingly arguing. There are several reasons why:

  • A different part of the yield curve – the spread between the 3-month T-bill and the 10-year yield –is thought to be even better at predicting recessions (if with less history to base that claim off of). This spread has actually remained materially positive and fairly steady recently. The New York Fed has a recession model that leverages this relationship, and it predicts that the recession risk for the year ahead is less than 10%.
  • Additionally, Federal Reserve research conducted before the pandemic found that another part of the yield curve – focused at the shorter end – was even better at anticipating recessions. That part of the curve has actually steepened sharply recently, suggesting the risk of recession is plummeting (see all three yield curve metrics on the following chart).

Mixed message on business cycle from yield curve indicators

Mixed message on business cycle from yield curve indicators

As of 03/24/2022. Near-term forward spread measured as forward rate of 3-month Treasury bill six quarters from now minus spot 3-month Treasury yield. Shaded area represents recession. Source: Engstrom and Sharpe (2018), FEDS Notes. Washington: Board of Governors of the Federal Reserve System, Bloomberg, Haver Analytics, RBC GAM

  • Alternately, one can look at the slope of the 2-10 yield curve after adjusting for inflation expectations. This is unorthodox, but sets aside inflation distortions and gets to the heart of the question of whether economic growth is expected to decelerate. To the contrary, the real 2-10 slope remains quite positive and has increased somewhat recently.

Real yield spreads are rising, now at multi-year high

Real yield spreads are rising, now at multi-year high

As of 03/28/2022. Source: Bloomberg, RBC GAM

  • As was the case over the decade prior to the pandemic, huge central bank bond holdings have depressed the long end of the yield curve. This means that the curve is artificially flatter and so the risk of recession may not be as high as it looks.
  • It is some consolation that the recent flattening of the 2-10 curve has been a bear flattener (meaning that yields are rising) rather than a bull flattener (when yields are falling). This is the more optimistic of the two outcomes.
  • One might even go so far as to argue that, in a world of quite high inflation, it would be more concerning if longer-dated yields were rising faster than short-dated ones, rather than the reverse situation we have today. It would suggest the market was pricing in structurally high inflation and/or structurally tight monetary policy. We should be relieved this is not the case.
  • Interestingly, the stock market rallied in response to the U.S. Fed’s first rate increase. This means the market views higher interest rates as a means of extending the rally by extinguishing inflation, rather than as a direct threat itself.

Again, the risk of recession is higher than usual right now. We peg the risk of recession in North America at a bit higher than 25%, with the risk in Europe a bit less than 50%. These are material risks and consistent with the view that now is not the time for extreme risk-taking. But, that said, the flattening 2-10 yield curve may not be quite as sinister as it first looks.

-With contributions from Vivien Lee, Andrew Maleki and Aaron Ma

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

1. Good Judgement Open, "Will Russia and Ukraine sign or announce an agreement to end the current conflict in Ukraine?" Data as of 3/28/2022.

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This document is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed. RBC GAM reserves the right at any time and without notice to change, amend or cease publication of the information.

Any investment and economic outlook information contained in this document has been compiled by RBC GAM from various sources. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its affiliates or any other person as to its accuracy, completeness or correctness. RBC GAM and its affiliates assume no responsibility for any errors or omissions.

Past performance is not indicative of future results. With all investments there is a risk of loss of all or a portion of the amount invested. Where return estimates are shown, these are provided for illustrative purposes only and should not be construed as a prediction of returns; actual returns may be higher or lower than those shown and may vary substantially, especially over shorter time periods. It is not possible to invest directly in an index.

Some of the statements contained in this document may be considered forward-looking statements which provide current expectations or forecasts of future results or events. Forward-looking statements are not guarantees of future performance or events and involve risks and uncertainties. Do not place undue reliance on these statements because actual results or events may differ materially from those described in such forward-looking statements as a result of various factors. Before making any investment decisions, we encourage you to consider all relevant factors carefully.

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© RBC Global Asset Management Inc., 2021