Douglas Porter

October 14, 2022

Question: A few months ago, whose bingo card had Britain as the first financial market to buckle under the weight of this year’s breakneck tightening spree, causing global waves of volatility? Yet, the ongoing U.K. political and economic drama continued to make ripples across financial markets three weeks after the epically ill-advised “maxi” budget. A further U-turn on the proposed measures, and the replacement of the Chancellor—Jeremy Hunt now substituting in for the injured Kwasi Kwarteng—helped temporarily calm the waters late in the week. In fact, the pound is now back above levels prevailing prior to the budget bungle, but Gilt yields took only a small step back from their second abyss. Unresolved are the fate of Prime Minister Truss, who gamely pledges to carry on, and the potential need for further BoE bond-buying.

The backing down on some of the key U.K. fiscal measures—notably on corporate taxes (a rate hike will now proceed)—has turned down the heat and may make further BoE intervention unnecessary. Still, Gilt yields have, on net, been punished heavily by this episode; prior to the ill-fated budget, 10s were 20 bps below their U.S. counterparts (and 90 bps below as recently as three months ago) but are now bobbing around 30 bps higher than U.S. yields. We would assert that perhaps U.K. yields now more properly reflect the underlying economic reality. After all, did 10-year bond yields really have any business hovering below 2%—as they were just two months ago—with inflation close to 10%, and large twin deficits? To ask that question is to answer it.

The U.K. was not the only drama in town this week, as yet another outsized U.S. core CPI reading cranked up Fed rate hike expectations further. The 0.6% rise in the ex-food & energy group provided an eerie replay of last month’s report and took the yearly core rate to a 40-year high of 6.6%. While headline inflation of 8.2% has backed off from its June peak by nearly a percentage point, the fresh high on underlying prices casts some serious doubt on the “inflation has peaked” theme. What was particularly notable in September was the pronounced shift from goods inflation to services inflation (Chart). The former truly has rolled over as many commodity prices have moderated, shipping rates have dropped, and global supply chain pressures have eased. Short-term metrics for core goods prices peaked right alongside the worst of the supply snarls late last year. And last month saw a variety of goods prices pull back, from used cars, to clothing, to drugs.

Unfortunately, services prices are picking right up where goods prices left off. Core services posted their fastest monthly rise since 1982 last month (+0.8%), with the gains spread broadly. The six-month trend is a piping hot 7.8% and running well above the 6.6% annual pace. In the two decades prior to the pandemic, core services inflation tended to run about 3 ppts above core goods inflation (roughly 3% vs nil)—and that very spread has re-emerged in the past six months. The main point is that we can take little solace in all the stories about retail discounting, easing commodity prices, and lower shipping rates—that’s not where the inflation action is now.

A few months ago, whose bingo card had Britain as the first financial market to buckle under the weight of this year’s breakneck tightening spree, causing global waves of volatility?

The single biggest driver of the upswing in services inflation has been surging rents and, most notably, the hefty owners’ equivalent rent (OER) metric. We pounded the drum through last year, warning of the coming storm on that front, due to surging home prices. Well, now the peak may be within sight. OER correlates well with a variety of home price measures, with the latter leading the way by 12-to-18 months. Median existing single-family home price increases peaked in the spring of 2021. If we follow the usual playbook, rents and OER should thus start relenting in the months ahead. Real-time indicators of rent corroborate that view. After rising by a punishing 0.8% in September (a 30-year high), some relief in OER can’t come soon enough.

Markets suspect that such relief won’t come soon enough, further nudging up rate hike expectations to a terminal rate closer to 5%. Adding to the mix, the latest reading on consumer inflation expectations from the University of Michigan ticked up to 2.9% over the next five years, after grinding lower in the prior three months. Still, San Francisco Fed President Daly opined that even with the meaty CPI, she still viewed 4.5%-to-5.0% for the terminal rate as “really reasonable”. Technically, that’s a subtle widening of the bands from the latest dot plot (and our official call) of 4.5%-to-4.75%, from a relatively middle-of-the-road Fed official. The more hawkish KC Fed’s George bluntly opined that the terminal rate “may have to be higher”.

The further shift in Fed views lifted the entire Treasury curve in a topsy-turvy week, which saw 10-year yields bolt as high as 4.07% (a 14-year high). By week’s end, 10s were toggling around 4%, up more than 10 bps, while 2s were up almost 20 bps at 4.5%. The renewed bond sell-off cut short a fledgling rally in stocks, leaving the S&P 500 roughly unchanged on the week and down 24% for the year. An even tougher Fed means an even stronger greenback, and the currency cruised past ¥148, and to almost C$1.39 (or 72 cents) against the loonie.

Canadian yields also nudged higher for the week; yet, they fell further behind U.S. levels. Even with a 10 bp rise in 10s to 3.5%, this still left GoCs more than 50 bps south of like-dated Treasuries. With next week’s U.S. data offerings mostly of the mid-tier variety, domestic attention will focus squarely on Wednesday’s Canadian CPI and Monday’s Bank of Canada Business Outlook Survey. These two key reports will set the table for the Bank’s October 26 rate decision. We had been pencilling in a 50 bp hike at that meeting, but any high-side surprise in the CPI/BOS could easily tilt that decision to 75 bps.

The sudden spill in the Canadian dollar complicates the Canadian inflation outlook—the loonie is now down more than 10% from a year ago, its sharpest yearly drop in almost seven years. This weakness will almost instantaneously translate into higher food and energy prices, and will also seep into a wide variety of other imported costs. Still, we expect CPI to ease in next week’s report to below 7% on lower gasoline prices, while we also look for some further retreat in core inflation. Notably, two of the biggest drivers of U.S. core CPI—OER and hospital fees—are non-factors in Canada’s CPI. Thus, Canadian core inflation will appear to be going in the opposite direction of the still-rising U.S. trend, at least for now.

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.