Inflation: Don’t celebrate just yet

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Are the inflation wars over? Investors seem to think so, as plunging CPI data in Canada and the United States have spurred a rally in bond and equity markets. In their Canso Market Observer for July 2023, however, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. analyzes whether investors should curb their enthusiasm. Looking back at history (spoiler alert: the 1970s) and forward to the belated renaissance of monetarism at central banks, the newsletter explores the potential for inflation and tight monetary policy to rain on the markets’ parade.

 For the full July 2023 Canso Market Observer Newsletter, click here.

Inflation is dropping. Yay?

The debate about interest rates, monetary policy and bond markets remains the same as it has been throughout the year. As the Canso team put it, “The question is how high do interest rates need to go to slow down inflation.” The corollary: “Whether and when will central banks actually lower interest rates?”

Bond investors have apparently come up with an answer, looking on the very bright side of the recent drop in Canadian monthly inflation to 0.1 per cent in June. That decline was met with “much market enthusiasm … despite the best efforts of central bankers to signal their continued resolve on fighting inflation,” the newsletter noted.

And yet the Canso team also pointed out that bond investors had already believed for some time that inflation was at or near central bankers’ 2 per cent target, judging by suppressed yields on long bonds. Investors’ “faith in their ‘2 per cent inflation forever’ forecast has not been shaken by the obvious fact that they have been very wrong,” the team wrote. “The absence of supportive facts seems to have made their longing for the happy days of very low interest rates even stronger.”

Looking at the data rather than longing for the good old days, the Canso analysts did not find much reason to share such nostalgic optimism: “To us, the current low level of bond yields is the ultimate expression of bond managers’ ‘Back to the Future’ mass psychosis.”

 Cross examination

The newsletter noted that central bankers have not been very reliable expert witnesses on recent inflation trends. First, they failed to see inflation arising from the Zero Interest Rate Policy (ZIRP) of the pandemic. “Why would they, given recent monetary history?” the Canso team asked. “Central banks had printed money galore for years, with nary an inflationary consequence.”

Then, when they belatedly acknowledged that rising prices had turned from “transient” to “sticky,” policymakers were surprised at how unresponsive to their monetary machinations inflation proved to be. Shouldn’t their interest rate “shocks” have whipped it more quickly?

Maybe not. For one thing, rates are not abnormally high when you look at historical data. Canso analyzed 5-year Canada bond yields from 1991 (when the Bank of Canada adopted the 2 per cent inflation target) to 2011 (when the era of highly accommodative monetary policy began). During those20 years, there were wide variations in bond yields, but 4 per cent to 6 per cent was the norm. “We note that inflation has averaged 2 per cent from 1991 to 2019, so given that inflation is far above that at present, [today’s] 5-year Canada yield of 3.8 per cent cannot really be considered abnormal.”

It is, however, abnormal if you look at the data from 2011 to today. During those 12 years, the mean 5-year Canada yield was between 1 per cent and 2 per cent. “But what if,” the Canso team asked, “the recent past in interest rates was the exception, not the rule?”

Certainly, the evidence from the 20-year period before 2011 supports that contrarian position. Yet central bankers (and homeowners, who have continued to buy houses despite fast-rising borrowing costs) seem to have fallen victim to recency bias, “where more recent experiences dominate those farther in the past,” the newsletter suggested. “Interest rates were low, so they’re going to stay low, processes the unthinking and very illogical human brain.” 

Mission accomplished?

But what about that 0.1 per cent monthly inflation reading in June, which implies an annualized rate below the Bank of Canada’s 2 per cent target? Surely it’s a sign that central bankers’ “command and control” of interest rates has worked and the tightening cycle is ending or over already, right?

Not so fast, the Canso team said. They pointed out that one month of data does not make for a trend. As well, neither central bankers nor bond markets are very good at predicting where inflation is headed. In short, they wrote, “all we can say is that we are absolutely certain that nobody has any idea of next year’s inflation, especially central bankers.” And history suggests that reports of inflation’s demise may be premature.

During the last extended period of higher inflation, in the 1970s, central banks looked like they had won by the middle of the decade. In the U.S. and Canada, inflation dropped by seven percentage points between 1975 and 1977, and central bankers “prematurely declared victory and loosened monetary policy,” the newsletter noted. And then inflation began another upward march. By the early 1980s, it had topped out at above 12 per cent in Canada and at 14 per cent-plus in the U.S. That forced central bankers to implement “very tough love rate hikes that well and truly stopped the inflationary spiral.”

As the Canso team wrote, today’s Fed and Bank of Canada surely recognize the mistakes of their 1970s predecessors – and their own missteps in keeping rates too low for too long. “The central bankers know they blew it with letting money supply expand too much and for too long,” the team noted. “That makes it more likely that they will do the opposite [and] in their fervour to contain inflation, they will keep policy too tight for too long.”

What it means for markets

In short, the Canso team is skeptical that the inflation war is won or that central banks will relent on rate hikes. Tight monetary policy could well continue, as “born-again monetarists” at the Fed and try to make up for past mistakes. For the economy and financial markets, the team wrote, “the end game … is not pretty.”

So, while markets have rallied, Canso has become more conservative in its portfolio management. It’s a contrarian view, the newsletter acknowledged. “When investors are more worried about missing upside than the downside risk, it’s time to batten down the hatches and prepare for heavy weather,” the team wrote. “It’s very hard to watch a party from the sidelines, but that’s the discipline we need to … take advantage of the inevitable sell off to come.”

The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Canso Investment Counsel Ltd, which is a member and content provider of this publication.