There was a spate of cyber attacks on grocery store freezers last month, and today the French government publicly claimed that the Iranian Revolutionary Guards were the culprits. (The attack involved taking over the control systems and running aggressive defrost cycles that cooked the food that was supposed to be preserved. There were also attacks on other networked hardware, but I will stick to freezers to reduce the word count.)
Results are coming in, but the Democrats clearly won a wave election. My instinct is that this will matter for American domestic political goings on, but on the economic policy front, we will see gridlock. This is arguably positive — by preventing the White House from doing incredibly stupid things, some risk scenarios are avoided. As a result, it may be safe to project current trajectories to go forward.
Canadian Tariffs. Before the election, there was talk of movement on the Canadian trade front. I did not take this seriously, as it appeared that the White House figured out that the trade disputes were hitting battleground northern border states. I can see a deal to eliminate the worst tariffs happening, but so long as Trump is in the White House, there is no point in going beyond that. A real trade renegotiation will require a counter-party that is seen as reliable. The provincial boycotts of American liquor may be hard to unwind, as there are domestic constituencies that benefit from them, and there is more goodwill towards Europe and Southern hemisphere countries that replaced American booze on limited provincial liquor commission shelf inches.
Iran War. The President appears to be in a low energy state dealing with the drubbing. The possibility remains that he could lash out in the lame duck session of Congress. However, my bias is to expect the conflict to freeze, and the status quo will remain. It appears to be an exaggeration to say that the Persian Gulf has become a Persian Lake, but “freedom of navigation” through the Strait of Hormuz is likely to have caveats that benefit Iran. This would allow energy flows to resume, but until there is some sign that the Americans and Israelis accept the situation, taking the passage will likely be viewed as risky (and thus expensive).
Data Centres. Data centres are less popular than the President, and Republicans have discovered that they do not have the margin for error to allow for angering their rural base. I think the arguments over data centres will mainly occur at the sub-national level, but the Republicans got a kicking at the state level as well. Data centres are a major driver of fixed capital expenditure currently, so if animal spirits cool there, the growth drivers for the economy get even slimmer.
U.S. Fiscal Policy. Although the composition might change somewhat, whatever budget trajectory was baked in is likely to remain due to the threat of Presidential vetoes.
Ukraine/Russia. It is likely that the White House will be forced to be less explicitly pro-Kremlin, but whether that translates to American military aid resuming remains to be seen.
NATO Military Procurement. Although there is a strand of thinking that NATO allies should come running back to the American’s side after the election, it is unlikely that the moves for the other ally members to have closer procurement ties would stop completely. In any event, the moves are happening at a glacial pace.
Fed Chair Kevin Warsh made an unusual announcement this week — one Fed Open Market Committee (FOMC) meeting in 2027, and two meetings in 2026 will not be “live”: they will sit around and yack, but will not change rates. And as a reminder to those who are unfamiliar with the FOMC, they have 8 scheduled meetings per year (roughly every six weeks), although they can make emergency rate moves in between scheduled meetings (usually panicked cuts).
One point to note that this is largely a phenomenon in the U.S. rates markets, the other major developed markets do not have as consumer-friendly mortgages as U.S. conventional 30-year mortgages. The U.S. conventional mortgage market was developed with the help of the government-sponsored enterprises (GSEs), that bought standardised mortgages. As will be discussed in this article, hedging the risk of the prepayment option in conventional mortgages is difficult, and securitisation (placing the mortgages in mortgage-backed securities — MBS) was the way to offload the risk of mortgage hedging for banks.
President Trump’s relentless warfighting against price stability has finally paid dividends: conventional 30-year mortgage rates have breached 7% (figure above). We have been at similar levels in the aftermath of the 2020’s Bond Catastrophe, but the chart looks ugly and there is no sign of an end to policies that are designed to raise prices.
There is a fair amount of online controversy regarding the effect of interest rates on the economy, mainly due to the rise of Modern Monetary Theory (although there is also the fringe “Neo-Ricardian Heresy” within orthodox economics). However, the mechanism posited within MMT for the stimulative effects of higher interest rates is that they imply a greater fiscal deficit courtesy of interest spending. (Although neoclassical and conventional economists have kittens/ridicule the MMT position, this mechanism shows up in the orthodox “Fiscal Dominance” “theory,” which is also treated as being a Very Serious Position. Consistency is the hobgoblin of small minds, etc.)
Although I accept the greater interest spending angle, the housing market is the 200 kilogram (31 stone) gorilla in the room.
The above figure shows the 3-month moving average of private housing starts in the United States. If we look at the trend in housing starts when compared to recessions (coloured bars) we see that there is a tight link. Before the 1990s, policymakers followed fairly aggressive “stop-go” cyclical policies, and so housing markets getting whacked was fairly explicitly part of inflation control. The modern era features fairly gradual monetary tightening policies, but the early 1990s and mid-2000s recessions featured housing busts (and COVID saw a whipsaw due to private sector panic/official restrictions on activity). If we look at the mid-2000s, housing starts rolled over well ahead of the recession. (Meanwhile Wall Street economists and the equity market was unconvinced that there would be anything other than a “technical recession” in mid-2008, while the start of the recession was backdated to December 2007.)
A key exception was the recession in 2001. That was a “sectoral recession” — the tech sector blew itself up by making massive fixed investments in telecoms that outstripped the potential cash flows on the assets for some time. (The “dot-com” stocks fascinated the financial press, but they were largely a zero-sum financial trading bonanza. The capital investments in telecoms was what drove the real economy.) If you were in the tech sector, the early 2000s was a terrible time (as an ex-electrical engineer in Canada, I knew a fair amount of ex-Nortel employees). However, the effect on the broad economy was somewhat muted because the aggregate housing market continued its bull market through the tech bust.
Some commentators after the 2008 Financial Crisis tended to expect a repeat of that episode, and any signs of financial stress were taken as to be an indication of a repeat. To a limited extent, financial stress is associated with recessions — we rarely see a contraction in activity without some sector of the economy blowing up. However, it is entirely possible that the stress will be contained to a few sectors, without the solvency of the banking system being called into question. This follows from the arguments of Hyman Minsky — risk-taking within the financial sector follows patterns. The usual pattern is that risk-seeking is rewarded and thus builds up in the system as cycles pass. However, if there is a generational washout of risk-takers, risk-seeking is recalibrated to lower levels. The Great Depression was the most important example of such a recalibration (risk taking culture did not recover until the 1960s), but some lessons were learned after 2008.
Nevertheless, the housing market relies on households being willing to purchase expensive assets with relatively large amounts of leverage. Not every home purchase is highly leveraged — households who already own a home only need to finance the difference in prices between the house they buy and the house they sell. However, in the absence of circular patterns of home sales (people upgrading match people downgrading), new home buyers have to enter the chain of buyers. These new home buyers are critical to allowing chains of transactions to occur in practice — and such buyers need to finance almost the entire home purchase (since not many first-time home buyers have 100% down payments sitting in their bank accounts).
At the same time, new home building is a capital and labour-intensive activity. Which means that this activity is dependent upon the “animal spirits” of home buyers to finance the construction. Which creates a direct mechanical link between recessions and housing contractions: if people are losing their jobs, they are not in a mood to make large leveraged purchases. At the same time, if they stop making those purchases, people in construction lose jobs — ratifying fears about a weaker job market.
This also has a direct effect on profitability in the corporate sector. The Kalecki Profit Equation is an accounting identity that relates aggregate corporate profits to other macro variables (with simplifications made):
(Business Sector Profits) = (Net Investment) - (Household savings) + (Dividend payments) + (Government Fiscal Deficit) - (Net Imports).
Note that household savings subtracts from profits (and net investment adds). The usual propaganda from the financial sector is that household savings are an unalloyed good, but in the real world, they represent a drain on corporate cash flow. (Wages flow out of the corporate sector as an expense, and if they are not returned as current spending, this represents a loss.) Borrowing to buy a house is a form of negative savings, which thus adds to corporate profits in aggregate. Throttling back on housing hits business profits, which then typically causes firms to retrench (which throttles growth). A certain amount of conventional discussion of this topic refers to households “raising precautionary savings,” which is an extremely poor description of this effect. The “steady state” condition of most households is that they have extremely low current savings rates, and the changes from year-to-year are small. However, house (and car) purchases are chunky transactions that dwarf others — delaying those transactions is what matters for the national accounts.
(As an aside, when I first published my pieces on this topic, I discovered that some internet commentators view the Kalecki Profit Equation as The Kalecki Profit Opinion, and then chimed in with their own opinions on how national accounts and profits work. To repeat, the equation is an accounting identity — it is true by definition. The equation I gave is simplified and missing some smaller terms from the national accounts that would work their way into the identity. The Kalecki Profit Equation is also associated with Jerome Levy, who looked at the detailed national accounts to generate the identity. The Levy Institute has a working paper on this topic.)
Returning from theory to the current situation, I do not see the current rise in mortgage rates as being enough to cause a recession by itself. Right now, the housing market is too slow moving when compared to the ability of the White House to enact stupid policies. The obvious risk is the derailment of supply chains courtesy of global energy markets being blindsided by You Know Who. Mortgage rates rising going into a negative economic shock is just the cherry on top of the sundae.
On a final note, I historically downplayed ignored “AI” since (a) the people who care about AI tend to be loons and (b) the fixed investment was not that large in a global context. However, the second point has not been true for awhile (which I have noted) — the fixed investment is getting to be chunky numbers. That said, I am not panicking about an AI bust, as this is still largely an American phenomenon, and some of the firms involved had piles of cash that were sitting uselessly on their balance sheets anyway.
I ran into a couple of interesting articles, and wanted to comment on them. The first is about forward guidance, the second is about a potential American diesel export ban.
The first article is “When central banks say nothing at all” by Stefan Gerlach. I will discuss the article after I do a review on forward guidance. I have written multiple times about this topic, but I was trying to be brief and skipped over the background.
One of the points that is coming up in my news flow is the simultaneous rise in bond yields. This was of particular interest for the United Kingdom, where the chattering classes get deeply excited by rising gilt yields. I looked around at my data sources, and the above chart was somewhat interesting.
I tried taking a break since I had some family commitments, but events have returned. Although I saw an interesting article from a theory perspective that I would like to write about, there have been two big market-oriented topics that have surfaced due to you know who.
The 10-year U.S. Treasury yield (above) has been drifting higher, although it remains within a broad range that it settled into after the post-COVID Bond Apocalypse. Since I am not offering unsolicited investment advice to random strangers on the internet, I officially do not have a yield forecast. That said, the bond (price) weakness is somewhat surprising in retrospect given the economic uncertainty. However, the surprise factor is somewhat reduced by the reality that we now have a White House that is pushing almost every lever it can to raise prices. My bias is based on the post-1990 period where growth trumped inflation for bond yields — since inflation is a lagging variable. The difference is that we did not then have a lot of pro-inflation policymakers in power.
I have mainly been looking at my inflation manuscript. It seems to be in good shape, not entirely sure when I will pull the trigger on it. I updated the figures, and I will need to make sure that comments remain in sync with what is shown. (I started cutting down time ranges to historical periods to avoid issues with what is happening at the end of the chart.)
The U.K. Office of Budget Responsibility (OBR) published its “Fiscal Risks and Sustainability” report (link) and it contains the eye-catching chart above. I will draw your attention to the top line which represents a “worse case” projection of the debt/GDP ratio marching merrily off to 1,000%. I do not expect to be able to pay off on any bets in 2076, but I find it safe to say that the debt/GDP ratio will not do that. Even the low end projection is implausible.
I will first explain why the high projection is nonsensical, which then leads to a discussion why any methodology that produces such a scenario is unsound.
There was a suggestion today suggesting that President Trump will formally “withdraw” from the Canada/Mexico/United States free trade pact (CUSMA/USMCA) tomorrow (Happy Canada Day!). However, unless he radically breaks the rules (always possible), this is just moving the situation towards annual reviews with a potential dissolution in 10 years.
This was already expected to happen, as this gives more negotiating space for the Americans to try to aggressively ram terms down the Canadian negotiation teams’ throats. That said, the Canadian Federal Government is not exactly in a mood for giving ground to the Americans, and the economic outlook for the Americans going into midterm elections is hardly great, and a renewed trade war might not be welcome outside of the White House.
I have been getting ready to leave town, and so wrapping up other projects. The only thing that popped up in my internet browsing was the Return of the Bond Market Vigilantes, this time courtesy of a tweet on May 30th by the U.K. Green Party Leader, Zack Polanski. The short text was “We must stop being in hock only to the bond markets. No one voted for the bond markets.”
Bond vigilantes are a popular topic in financial media. Part of this is that most people find government bonds boring, and they would rather read about equities, which can have more exciting returns as well as more interesting company and sector specific stories. Bond market vigilantes who are about to discipline naughty governments creates a fun narrative hook to a market that is otherwise characterised by daily price changes of around 20 basis points.
Animal spirits have been soaring in the area of Artificial Intelligence (AI), and the surge in spending has shown up in the figure above. It shows the fixed investment in Information Technology Equipment and Software as a percentage of GDP (ends in 2026Q1). The last two quarters of data saw a surge of about 0.4% of GDP.
Although I have not been attempting to do economic forecasts, the current environment is surprising to me, at least with regards to inflation. The above figure shows the 5-year breakeven inflation rate as based on the U.S. inflation-indexed bond (TIPS) market.
The angle appears interesting in that we have a pro-free markets person arguing that we should not need to worry about the American government defaulting on its debt. Given that there is a Republican in the White House, it is perhaps timely for free marketeers to pivot away from debt worrying. The author has fun skewering the professional government debt worryers that dominate “serious” fiscal analysis in the United States.
So far, the gasoline price shock in Canada has not been as bad as what happened after the pandemic, but I am not incredibly optimistic about the medium-term outlook. The above figure is the national average cost for unleaded gasoline (at self-service stations if you want to get even more specific), but the data ends in March, so it is missing the price rise since then. In my neck of the woods in the Greater Montreal Area, the pump price has been around $2 per litre, although Montreal is normally higher than the national average series shown above.
The Carney government announced a temporary suspension of the excise tax on gasoline on April 14th, which dropped the price by about 11 cents per litre. This generated a lot of flak from economists, but I doubt that it will matter that much if the situation does not improve in the Middle East.
The Canadian CPI numbers for March were released today, and core inflation remains stuck at a level above the 2% target. This starting point makes it hard for the Bank of Canada to be too complacent in the face of commodity prices.
The diplomatic situation around the Strait of Hormuz seems muddled, but it is clear that that full traffic flow will not resume immediately. This means that oil and gas fields will be shut in for an extended period, and restarting them will take time. As such, it is clear that regions that are dependent upon the commodity flows from the Gulf are going to be hit hard. Canada is not directly affected, but it will see a lagged effect of slowing growth elsewhere. At the same time, the signals from the White House remain belligerent towards Canada, and an attack on the Canada/Mexico/United States trade pact may occur once attention is drawn again to that topic.
The Bank of Canada’s next scheduled policy rate announcement is April 29th, and I see no reason for them to switch from their last assessment that growth risks are skewed to the downside, while inflation risks are to the upside. In the absence of clear data, it seems unlikely that they will move in the near run.
Although the gasoline excise tax cut was unpopular with economists, it is still a limited measure that targets the fastest rising price in the economy. My uneducated guess is that fiscal policy is going to deviate much from already announced plans. There are currently no measurable growth risks that will cause panic loosening of policy. A global recession due to the commodity shock would take time to hit Canada (and as a commodity exporter, some sectors of the economy will benefit from higher commodity prices). A complete rupture of free trade with the United States is a scenario that might provoke a more rapid fiscal reaction.
Without accommodative fiscal policy, the commodity price hike will tend to squeeze consumers, and so there might not be second-round price effects. (Although Canadian commodity exports would benefit, the employment in primary industries is not large enough greatly push the overall labour market.)
