Douglas Porter

October 7, 2022

In the wake of a dismal September, markets hosted their very own two-day Oktoberfest, with stocks and bonds rallying furiously to begin the week/month/quarter. However, the party was cut short by sober reminders from hawkish Fed speakers as well as oil spoiling the mood with its biggest weekly rise since March. It was passing strange that markets were surging to start the month, even as crude was marching higher as OPEC+ was busily prepping a hefty 2 million barrel per day slash in production. After all, the primary reason inflation has backed down even a smidge in North America is milder energy costs, so any significant threat on that front is a broader threat to the inflation outlook, and financial markets generally. We would thus regard the supply-induced jump in crude, from less than $80 a week ago to above $92 today, to be very bad news indeed—for inflation, for global growth, and for equities and bonds.

Piling on the pressure, the U.S. employment report landed slightly on the strong side of the ledger for September. The headline jobs gain was only a touch above consensus at 263,000, and wage gains were stable at +0.3% m/m and 5.0% y/y, but the unemployment rate re-tightened to a mere 3.5%. The set of data took Treasury yields up another leg, leaving them higher for the week even after diving deeply at the start. The 10-year bond was dancing not far from the 4% level, up a cannonading 240 bps from levels prevailing little more than a year ago. Meantime, the S&P 500 nearly erased all its early-week gains and is again down 24% from the peak at the start of the year. This ugly combination has savaged traditional 60/40 investors (or pretty much any mix of equities/bonds), in an environment where there has been nowhere to hide. Even cash has been pummelled in real terms amid 8% inflation. And, make no mistake, it is that persistence of hot inflation that has been the root cause of the broader market trauma.

Some are muttering that the Fed and other central banks are at risk of committing a policy error by over-tightening, both among market participants and others. For example, some in Canada are now openly questioning the ferocity of the BoC’s tightening campaign, especially since the Bank has no control over commodity prices or supply chains. (This was a common refrain even a year ago from certain quarters, who railed against any rate hikes by the BoC.) But the cold, hard fact is that the policy errors were made last year with overly easy conditions globally, and there is simply no pain-free path out of the high inflation predicament we are now squarely in. The only debate at this point is the extent of the pain.

The U.K. has provided us with a spectacular example of how not to deal with the current inflation backdrop. We have already noted extensively that the extremely sour market response to the tax cuts and fiscal largesse should serve as a warning for all policymakers. And that was before the mood turned truly ugly. Even with a partial backing down on the tax cut plan, 10-year U.K. Gilt yields remain in the penalty box, planted 30 bps above U.S. yields, and almost 100 bps north of like-dated GoCs. Note that U.K. 10s have doubled from barely 2% just two short months ago.

Even relatively good actors have not been spared. The Canadian dollar remains squarely on the defensive in the face of a steamrolling U.S. dollar. The loonie managed to firm slightly this week to 73 cents ($1.370/US$), but this followed a seven-week string of declines (based on the weekly average). The powerful 15% rally in crude provided almost no lift to the currency, and ditto for a relatively hawkish speech by Governor Macklem on Thursday. An as-expected September jobs report was a mild relief, with the 21,100 gain snapping a three-month losing streak and the jobless rate dipping to 5.2%. But the details were generally sluggish, and we continue to lean to a more moderate 50 bp BoC hike later this month—though the upcoming CPI and Business Outlook Survey still need to weigh in.

The emerging view that the Bank of Canada will ultimately hike less than the Fed has submarined the loonie in recent weeks. The currency had been largely holding its own up until a month ago, even testing longstanding highs on a variety of the cross rates. But the surprisingly mild August CPI and the previously soggy summer jobs data reinforced the view that the BoC will not need to tighten much further. Record-high household debt levels suggest that Canadian consumers may buckle earlier than their U.S. counterparts. And, the preliminary home sales data from major cities point to a 32% y/y drop nationally, which would imply another big step back in monthly terms, with further downward pressure on prices. Recall that housing carries more than double the weight in Canadian real GDP (7.1%) versus the U.S. (3.4%), so the retreat in that sector will weigh more heavily on Canada.

Meantime, expectations for further Fed tightening are grinding higher again after markets had earlier shaved the most aggressive views. Two-year yields are approaching 15-year highs above 4.3% (roughly 25 bps north of Canadian 2s). The hawkish rhetoric was relentless from almost one and all Fed speakers, including some incredibly specific remarks by Cleveland President Mester (“no cuts in 2023”) and Governor Waller (“I anticipate additional rate hikes into early next year”).

Looking ahead, data will speak louder than words, and next Thursday’s September CPI looms largest. Another month of lower pump prices is expected to trim the annual headline rate modestly (albeit holding above 8%), but—as was the case a month ago—beware the core. We are, as usual, above consensus in looking for a meaty 0.5% m/m underlying rise, which would pump up the annual core rate to a cycle high of 6.6%. Suffice it to say, markets and the Fed would not greet that result with open arms.

If September is the cruelest month, then October is the coolest. While there have been some legendary market dives in the month, a number of bear markets have ended in October—often in the first ten days. But looking beyond financial markets, it’s also the only month of the year that all four major sports are in full swing (and the MLS to boot). Okay, baseball will carry into early November this year due to the labour delay at the start of the season. Inflation is even hitting the playoff format, 12 teams will be vying for the World Series this year (including, of course, the Jays and both New York squads). So, in these tumultuous inflationary times, even the most traditional sport is changing traditions.

Douglas Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.