The Bulls Capitulate

The current debate about the strength of the global economic recovery is pretty much over, at least for now.

In the opening months of 2012, beauty was in the eye of the beholder. Those with a bullish view pointed to some positive short-term momentum in specific economic data (like job growth) while those with a more bearish outlook focused instead on longer-term imbalances (like debt-to-GDP ratios) to justify their caution.

But last week much of the encouraging short-term economic data that the bulls had been relying on swung negative and this triggered an investor stampede into AAA-rated government bonds, driving the bond yields in a select few countries to their lowest levels since the start of the Great Recession.

Here is a summary of the factors that led to this capitulation:

• U.S. GDP growth came in at 1.9% for the first quarter of 2012, slowing sharply from the 3% GDP growth rate in the fourth quarter of 2011.
• The latest U.S. employment report was a big disappointment. It showed that the U.S. economy generated only 69,000 new jobs last month, which is less than half of the 150,000 new jobs that the U.S. needs just to keep pace with its monthly population growth. The details were no better: full-time jobs were replaced by part-time jobs, incomes rose more slowly than the rate of inflation, and 50,000 jobs were backed out of the revised versions of the March and April job reports.

The disappointing U.S. GDP and employment numbers put to rest any argument that the U.S. economy will soon reach “escape velocity”, a three-stage process where fiscal and monetary stimulus spurs business investment which leads to employment and income growth, which fuels increased consumer demand. Instead, stimulus budgets are running dry, business investment is slowing as inventories are now over-stocked, and the modest increase in U.S. consumer spending is being driven by reduced savings rates, not rising incomes. Given the political situation, would it be more appropriate to suggest that the U.S. economy has instead achieved “escapism velocity”?

• Spanish ten-year bond yields rose to 6.53% last week, continuing what now seems to be its inexorable march towards the 7% level where Greece, Ireland and Portugal all had to seek bailouts. (Spain has more outstanding debt than the other three countries combined, which is why the country is classified as both too big to fail and too big to save.)
• Spain’s prospects have continued to deteriorate as its government struggles to find a bailout solution for its fourth largest bank, Bankia. The first proposed solution was to infuse the bank with Spanish government bonds, which Bankia would then use as collateral for more European Central Bank (ECB) loans. Bankia would presumably then use that new money to buy more Spanish sovereign debt, and so on. I thought John Mauldin summarized this proposed solution perfectly: “This is somewhat like a destitute bar patron guaranteeing his friend’s tab so his friend will buy him more drinks. The ECB is the bartender. European taxpayers are the bar owners.”
• Spanish savers aren’t waiting to find out how this story will end. They are now pulling their money out of Spanish banks faster than at any point since 1990, when these bank transactions were first tracked (and that is accelerating Spain’s unfolding banking crisis).
• Chinese manufacturing activity slowed in May after showing some strength in April and Indian GDP growth slowed sharply from 6.1% in the fourth quarter of 2011 to 5.3% in the first quarter of 2012. These pieces of economic data are especially concerning for commodity-based economies (like ours).
• On the home front, Canada’s first-quarter GDP growth came in at disappointing 1.9%, down from 2.5% in the fourth quarter of 2011. While fears of a debt bubble have been allayed by a significant slowdown in our borrowing growth rates (which slowed to a near two-decade low of 1.8% in April), the flip side of this encouraging development is that consumer spending, a key driver of our GDP growth, has slowed markedly. It grew by only .2% in the first quarter and that worrying piece of data indicates that the most effective domestic counter-balance to the strong external headwinds that have been buffeting our economic momentum is now waning.
• While there is no statistic to quantify a change in market psychology, I think investors are now discounting the future economic impact of more bailouts. Previous rounds have proven largely ineffective over anything other than the short term and such measures are most effective when they are pre-emptive and come as a surprise to markets, as opposed to when they are enacted as defensive responses. When further action is expected, as it is now, the need for more bailout and stimulus programs can actually exacerbate the crisis because these emergency measures can reinforce investor fears.

How timely then that we will hear from Governor Carney and the Bank of Canada (BoC) tomorrow with the next scheduled Policy Announcement. While no move in the BoC’s overnight rate is expected, I will be very interested to read Governor Carney’s commentary on how recent events have affected his prediction that our interest rates would rise more quickly than most were expecting (a view I outlined in detail and disagreed with here and again here). I expect Governor Carney to reiterate his concerns about the dangers of rising household debt levels, but I also think he’ll invoke his previous caveat about weighing interest-rate policy decisions against heightened risks and will soften his call on the timing of rate increases.

Five-year GoC bond yields plunged last week by 25 basis points, closing at 1.07% on Friday. While a decrease in five-year fixed rates is long overdue (gross spreads are now above 2% vs. their long-term average of about 1.65%), the current situation is more complicated. Federal finance minister Jim Flaherty recently indicated that he is uncomfortable with five-year fixed rates below 3%, so larger lenders may use his words as a justification to bank the extra spread (grudgingly, I’m sure).

Variable-rate mortgage borrowers will be interested to know that the bond market has moved from betting on a rate hike before the end of the year to now pricing in the 75% probability of a rate cut. Futures traders remain a fickle bunch and I think a rate cut is still unlikely, but variable-rate borrowers can take comfort in knowing that recent developments have pushed the timing of the next rate increase farther off into the future.

The bottom line: Keep your eye on this Friday’s employment report from Statistics Canada. We’ve had some strong job numbers lately but that trend hasn’t been supported by other economic data. We’ll see which side of that divergence blinks first.