The Bank of Canada Warns … and WaitsMay 29, 2017
More Jobs Don’t Mean More Pay … for NowJune 12, 2017
The U.S. economy added 138,000 new jobs in May, well below the consensus forecast of 184,000. More importantly, the May headline number came in well under the average of 160,0000 new jobs that were created over the prior six months.
This result bolsters the view that the U.S. labour market is losing momentum and much of the detailed data further support that assessment. Despite this, the U.S. Federal Reserve continues to prepare financial markets for another policy-rate increase in June, and the futures market is currently assigning a 94% probability that this will occur.
At first glance, this timing seems counter-intuitive for a Fed that has until now focused its monetary-policy muscle on helping to improve the health of the U.S. labour market. But I think the Fed’s upcoming decision will mark a change in approach and in today’s post, I explain why.
Let’s start by taking a quick look at the key details in the most recent U.S. non-farm payroll report (for May):
- The U.S. economy generated only 138,000 new jobs in June, below the estimated 150,000 new jobs that are needed to keep it expanding. The initial estimates for March and April were also revised downwards by another 66,000 jobs.
- Average hourly earnings rose by 0.2% in May, and have now risen by 2.5% on a year-over-year basis. By comparison, U.S. inflation came in at 2.2% in April, so average wage growth is barely keeping up with average price increases. That means that a large number of U.S. consumers, who together account for about 70% of overall U.S. GDP, aren’t seeing any meaningful increase in their purchasing power.
- The official unemployment rate fell from 4.4% to 4.3% but only because more working-age Americans grew discouraged and stopped looking for work. The participation rate, which measures the percentage of working-age citizens who are either employed or who are actively looking for work, fell from 62.9% to 62.7% (and that number remains well below the average U.S. participation rate of about 66% in the years leading up to the start of the Great Recession).
Today’s tepid U.S. employment backdrop coincides with U.S. GDP growth rates of about 2%, and inflation hovering at around the same level. By any historical measure, this hardly seems like a time for the Fed to be tightening monetary policy. That is, unless it is willing to accept that its extended period of ultra-loose monetary policy has not fuelled a healthy labour-market recovery as was hoped.
While it’s true that the unemployment rate has now fallen to historically low levels, that is, in part, a function of a suppressed U.S. participation rate, and although new jobs are being created, they have tended to be the lower paying variety. Consider that in 2009, average U.S. wages were rising at the same annualized pace (2.5%) as today, even though the U.S. unemployment rate was more than double where it is now. That means that more jobs haven’t translated into more income growth for the average American worker over the past eight years.
While the Fed’s ultra-loose monetary policy has had only a minimal positive impact on the health of the U.S. labour market (and even that is debatable), the negative side effects of this policy have been easier to see and, more importantly, are no longer possible to ignore.
Here is a summary of the rising risks that I believe have caused the Fed to shift its focus from trying to stimulate employment growth to trying to preserve overall economic stability:
- Deteriorating Credit Quality – Ultra-low interest rates have forced financial institutions to take on more risk as lending spreads have fallen. Over time, credit quality has deteriorated and the risk of credit bubbles forming in areas like student loans and sub-prime auto lending has increased. To wit, there is now a record $1.4 trillion in U.S. student debt outstanding, and sub-prime auto lending now constitutes about 16% of the $1 trillion U.S. auto-loans market, which has expanded rapidly to record levels. At the same time, the delinquency rates for both have been steadily rising.
- Increasing Long-Term Liability Shortfalls – Ultra-low interest rates have also put insurance companies and pension funds in dire straits because they can’t earn the returns they need to cover their long-term liabilities. And because regulations tightly restrict the types of investments that these companies and funds can make, they are forced to buy AAA-rated debt at whatever price is offered, even in cases where yields are miniscule and insufficient. How exactly do they make that work?
- Elevated Levels of Investment Risk for Individuals – Ultra-low rates compel individual investors to take on more risk (and in many cases, undue levels of risk) in an effort to replace their diminished returns. This vulnerable segment of the population increases over time, making the overall U.S. financial system less stable and creating ripe conditions for the next crisis, for example, when equity markets correct and retired pensioners have no way to recover their losses – at the same time that their pension funds are also rife with shortfalls (see point above).
- Diminished Ammunition for Fighting the Next Recession – The Fed’s aggressive monetary-policy interventions since 2008 have used up most of its dry powder, leaving it with a diminished capacity to provide meaningful stimulus when the next recession hits. Meanwhile, like a drug addict who needs increasingly larger doses to produce the same effects, financial markets have now become accustomed to radical unconventional policy measures like quantitative easing, negative interest rates, outright asset buying and the like. So maintaining an ultra-low policy rate gives the Fed less ammunition to fight the next recession at the same time that financial markets will require more ammunition for its effects to have any simulative impact.
Ironically, the Fed’s decision to continue raising its policy rate in the face of relatively weak economic growth may hasten the arrival of the very recession that it worries it is so ill-equipped to fight. And the more the Fed tightens, the greater these odds become.
It will be interesting to see how the Canadian bond market reacts to the Fed’s next policy-rate increase. Our bond yields have been tightly correlated with their U.S. counterparts since the start of the Great Recession, but the Bank of Canada (BoC) has made it clear that it will lag the Fed’s tightening timetable and that it still thinks the Loonie’s value is too high relative to other non-U.S. currencies. Perhaps the Fed’s decision to continue tightening will also serve to weaken the correlation between GoC bond yields and U.S. treasury yields. For my money, it certainly should.
Five-year Government of Canada bond yields fell two basis points this week, closing at 0.93% on Friday. Five-year fixed-rate mortgages are available at rates as low as 2.19% for high-ratio buyers, and at rates as low as 2.24% for low-ratio buyers, depending on the size of their down payment and the purchase price of the property. Meanwhile, borrowers who are looking to refinance should be able to find five-year fixed rates in the 2.59% to 2.69% range.
Five-year variable-rate mortgages are available at rates as low as prime minus 0.80% (1.90% today) for high-ratio buyers, and at rates as low as prime minus 0.70% (2.00% today) for low-ratio buyers, again depending on the size of their down payment and the purchase price of the property. Borrowers who are looking to refinance should be able to find five-year variable rates around the prime minus 0.40% to 0.45% range, which works out to between 2.20% and 2.25% using today’s prime rate of 2.70%.
The Bottom Line: The Fed is all but certain to increase its policy rate when it meets next week. While that would normally lead to higher fixed rates for Canadians, the correlation between Canadian and U.S. bond yields should weaken now that the Fed and the BoC are proceeding on such divergent paths. Time will tell.