Connor Hare

Next week the Federal Open Market Committee (FOMC) will meet for the fourth time this year to discuss whether the current level of stimulus is appropriate for the U.S. economy. During their discussions they will evaluate the health of the economy, wage and price pressures, and emerging risks before deciding on revisions to their outlook for economic activity, inflation, and the future path of the fed funds rate.

The U.S. economy is firing on all cylinders at the moment. Growth in the second quarter is currently tracking a blistering 4.0% annualized pace, helped along by a strong rebound in household spending, firm business investment, and surprising strength in net exports. What’s more, growth is expected to continue at a 3.0% annualized pace on average for the remainder of the year, with fiscal stimulus contributing about half a point.

Strong economic activity is working to absorb any remaining spare capacity. The unemployment rate is at an eighteen year low, and as of April there were more job openings than there were job seekers (Chart 1). Wage growth is healthy by historical standards, but should move even higher as skilled labor becomes scarce. But, wages typically keep up with productivity growth, and on that front the U.S. economy continues to perform below historical trends (Chart 2).

Consumer price inflation is above 2.0%, a sign that the U.S. economy is bumping up against capacity constraints. Add higher fuel prices, higher import prices due to increased tariffs, and strong wage growth, and it’s just a matter of time before profit margins get pinched enough for firms to pass on rising costs to consumers. All told, headline consumer price inflation is likely to peak at 2.7% this year, with the Fed’s preferred measure, the core personal consumer expenditure deflator, holding near its target of 2.0% through the end of this year.

Altogether, this solid outlook should be more than enough to convince the FOMC that the U.S. economy does not require the amount of monetary stimulus currently on offer. As a result, the fed funds rate is likely to move up by 25 bps next week, with another hike or even two embedded in the updated dot plot summary for this year.

That said, although further rate hikes are certain, their exact timing is still open for debate. Geopolitical risks remain elevated, and a policy misstep or two may be just enough to send financial markets, business confidence, and global trade into a tailspin. Trade skirmishes could easily escalate into trade wars, particularly if talks fail to make progress between the U.S. and its major trading partners. Although much better prepared than in past tightening cycles, emerging markets remain at the mercy of nervous investors who are more concerned with capital retention than returns in such an uncertain environment. Argentina and Turkey were the first victims of speculative attacks, but they surely will not be the last during this tightening cycle. All told, in light of these and other risks, the FOMC is likely to stay on its current path of gradual rate hikes.

Fotios Raptis, Senior Economist | 416-982-2556

The theatrical twists and turns of this week’s events are worthy on an opera, with the opening act set in Italy. Political turmoil and fears that new elections in Europe’s fourth largest economy could strengthen the grip of Eurosceptic parties spooked investors, who began to unload Italian assets. This sent yields on short-term government debt skyrocketing (Chart 1). Investors also steered clear of other southern European debt, with short-term Spanish, Greek and Portuguese bonds also selling off. Concerns regarding new elections subsided as the week wore on, and these moves began to reverse course. By the end of the week the populist coalition was allowed to form a government. Still, the fact that the new Italian government – which favors tax cuts and spending increases – is likely to clash with the E.U. on a number of issues, suggests that this is merely a new chapter which may further tests the bloc’s stability. The sheer size of Italy’s economy – roughly ten times that of Greece – will warrant special attention.

Markets were thrown another curve ball when the White House announced that it would be pushing ahead with tariffs on $50B of Chinese goods and end the exemption on steel and aluminum tariffs for the E.U., Canada and Mexico. These normally close allies pledged to challenge the tariffs through the WTO and NAFTA channels and levy retaliatory tariffs. At around $12.6B and $7.7B of U.S. products targeted by Canada and the E.U. respectively, and an estimated $4B in trade with Mexico, the amount of affected trade is still quite small. But the wide list of products marked for tariffs, which stretch from agricultural products to motorcycles, are sure to strike a sour cord with the U.S. Ultimately, the tariffs will make goods more expensive for the American consumer. In a prior analysis, in which we expected the exemptions for the allies to stay, we estimated that the tariffs would have a muted direct impact on U.S. economic activity and inflation. The recent events make us more confident that while the impact on U.S. economic activity is still expected to be limited, the tariffs are likely to boost consumer price inflation by at least 0.1 percentage points this year and next.

Behind the curtain of the unfolding Italian and trade sagas, U.S. economic data was broadly positive. American consumers were back in full force in April, with personal spending rising by a robust 0.4% in real terms, building on a solid March print. The back-to-back gains point to a 3.5% rebound in second quarter consumer spending after a soft first-quarter print (1% Q/Q ann.). This narrative is further reinforced by a strong labor market. In May, payrolls gains (223k) beat expectations, the unemployment rate fell to an 18-year low (3.8%) and wage growth accelerated to 2.7% y/y (Chart 2). Rounding out the good economic news was an above-consensus print in the ISM manufacturing index, which pointed to manufacturing activity accelerating in May.

The latest data cement the case for a Fed rate hike on June 13th. But this is no time to fall asleep, with further policy rate normalization also requiring a watchful eye on developments out of Europe and the potential fallout from heightened trade tensions. For now, Nessun Dorma.

Admir Kolaj, Economist | 416-944-6318

The FOMC minutes, renewed trade tensions and a cancellation of the June summit with North Korea made the week anything but boring for investors. It was also a politically-charged week across the Atlantic. U.K. negotiations with the EU soured over U.K.’s participation in the Galileo satellite project, while the new Italian Eurosceptic government appointed Giuseppe Conte as prime minister.

Financial markets rallied on Monday on the news of positive weekend developments in the U.S.-China trade dispute. Details of the agreement were vague and largely unquantifiable as far as trade deficit reduction targets are concerned. In the follow-up statement China agreed to  “meaningfully” increase imports of U.S. agricultural and energy products, and lowered tariffs on imports of autos and parts. These relatively limited concessions were sufficient to put the proposed tariffs on $50 billion worth of Chinese goods set to take effect on May 21 on hold.

Although U.S. trade tensions with China have eased for now, they have flared up elsewhere, weighing on market sentiment later in the week. On Wednesday President Trump ordered a review of automotive imports, citing national security concerns. The decision drew sharp international criticism and warnings of retaliatory tariffs, but was also opposed domestically. Automakers as well as Republican lawmakers expressed concerns that, if imposed, auto tariffs will raise auto prices for consumers, disrupt supply chains, start trade wars and alienate U.S. allies.

Worries about trade also showed up in the FOMC minutes. Specifically, the FOMC members acknowledged that trade uncertainty could hurt business sentiment and investment intentions. As for the monetary policy discussion, the FOMC members agreed that they would soon need to “take another step” in removing monetary accommodation, with a June rate hike looking like a done deal. At the same time they stressed that the Fed’s inflation objective is “symmetric”, suggesting they will allow inflation to temporarily overshoot 2%. All told, we remain of the view that a total of three rate hikes this year the is most likely outcome.

Higher interest rates will certainly have an impact on the housing market. After declining by 6% in the first quarter, existing home sales have started the second quarter on a weak footing as activity fell 2.5% in April. Sales of new homes also took a break in April, declining by 1.5%. Since the start of the year, the average rate on a 30-year mortgage rose by 70 basis points. Rising rates alongside brisk growth in home prices have dented affordability; however, this is only part of the story behind relatively tepid home sales. Low inventory of houses on the market has  been the most important factor restraining resale activity (Chart 1), but the pace of construction remains modest and will likely be contained by labor shortages and rising input costs. The price of American steel rose 40% this year, while lumber prices are up 34%. Some relief to the housing shortage may come as more existing homeowners, with fully rebuilt home equity (Chart 2), become encouraged to list their homes. However, the overall pace of activity in the housing market will likely once again remain modest this year.

Ksenia Bushmeneva, Economist | 416-308-7392

The past week featured plenty of events for equity markets to fret about, from uncertainty surrounding U.S. trade negotiations, to a eurosceptic right-wing coalition in Italy. Concerns about emerging markets (EM) have led to the worst week for EM currencies in a year and a half, as the U.S. dollar continues to rise. And for Americans, it seems like everything is going up these days, from mortgage rates to gasoline prices (Chart 1).

Drivers may be getting sticker shock as they fill up their tanks, with the national average gasoline price approaching $3 per gallon. However, about half of the 10% rise in gasoline prices since March is the typical seasonal increase. Still, this will leave a bit less cash in wallets for spending on discretionary items. To put some numbers to it, in 2017 each American consumed about 442 gallons of gasoline per year, so a 5% increase works out to about $62/month for a family of four.  

Higher oil prices are acting to drive inflation expectations, and consequently Treasury yields, higher. The 10-Year yield reached 3.11% on Thursday, the highest level since mid-2011. For much of last year, we argued bond yields were too low, and now things are looking much more reasonable. What’s more, the latest readings on the economy are consistent with higher bond yields. A healthy retail report for April demonstrated that consumers are back in action after taking a breather in Q1 Consumer spending growth in the second quarter is tracking close to 3% annualized, which would help to support a similar growth tally for the economy as a whole.

Mortgage rates have followed Treasury yields higher. The average rate on a 30-year fixed-rate mortgage rose to 4.61% this week, very close to the 2013 taper tantrum episode highs. The impact of higher mortgage rates is less far reaching than gasoline prices. It will only affect new borrowers and homeowners who are refinancing. The average new mortgage was $317,300 in March, so the impact of the 74 basis point increase in rates since the beginning of the year will raise the average monthly payment about $138 per month. This should hinder affordability in the housing market, and lean against demand.

That said, we remain confident that the positive fundamentals for housing will underpin gains in residential construction going forward. Housing starts may have been off a bit in April, but looking through the monthly volatility, the trend in the forward-looking permits data is still positive (Chart 2). Moreover, the monthly decline was due to the always volatile multi-family component. True, there are headwinds to homebuilding activity, including labor shortages in the construction industry, rising building material costs and a lack of buildable lots. But, after some weakness over the winter, homebuilder sentiment took a tentative step higher in May, suggesting these barriers are not insurmountable.

The pinch of higher prices and borrowing rates is expected to restrain consumer spending and housing investment slightly versus 2017’s performance. But, for the remainder of 2018 we expect business investment and government spending to power real GDP growth of around 3%.

Leslie Preston, Senior Economist | 416-983-7053

Events this week remind us of how uncertain the world can be at times, and how unpredictable financial markets can be. On Tuesday President Trump announced that his administration will no longer be part of the current Joint Comprehensive Plan of Action (JCPOA). That was a 2015 deal agreed to by the U.S., UK, EU, Germany, France, Russia, and China that lifted sanctions against Iran in return for a promise to pause its nuclear program. Although pulling out of the agreement will have limited direct economic implications for the U.S., the imposition of sanctions on Iran and the threat to do so on those nations that continue to do business with it, is likely to deal a blow to its trade partners (Chart 1).

Financial markets were caught somewhat off-guard by the decision, with conflicting news headlines generating gyrations throughout the day. Since a renegotiation of the deal is a possibility, markets shrugged off the news, with domestic equity markets likely to end the week up 2%. WTI oil prices also moved higher this week, holding above US$70 on this and other news of escalating Middle East tensions.

Oil prices have been rising steadily over the past five weeks, with implications for the domestic and global economy. Higher energy prices should help support domestic investment and overall economic activity in oil exporting countries such as Saudi Arabia, Canada, and increasingly the United States. However, consumers will likely feel the pinch from higher energy prices, as the rising price of gas reduces their overall purchasing power.The pass-through to consumers from rising energy prices is usually quite brisk, and this time is no exception (Chart 2). The U.S. CPI report for April saw prices rise 2.5% over the past twelve months, largely owing to a strong upward move in the price of gasoline (+13.4% y/y). Aside from energy, shelter costs continue to tick up, a reflection of tight housing inventories in many U.S. cities that is sending home prices higher.

Abstracting from energy and other volatile prices, underlying price pressures remain fairly subdued despite strong economic activity and tightening labor markets. Core inflation lost some momentum in April, as price growth in core services slowed a touch. Still, core inflation registered a 2.1% gain year-on-year, but that includes a fading base-year effect from the dip in telecommunications prices last year that is acting to prop up inflation.

The loss of inflation momentum may help reduce concerns that the Fed isn’t moving fast enough to cool off a hot economy. Inflation is likely to hold near the Fed’s 2% target for the remainder of the year, with the economy running just hot enough to warrant two more rate hikes this year. That said, downside risks to the domestic and global outlook continue to materialize.  Although they have had limited impact thus far, things can quickly escalate. While the Iran sanctions act to elevate the risk of a trade war between the U.S. and its trade partners, all parties appear open to dialogue. Still, this decision adds further pressure on Europe and China to settle trade imbalances with the United States.

Fotios Raptis, Senior Economist | 416-982-2556

The start of May has been busy for investors with a mid-week Fed rate decision and plenty of economic data to sift through. Domestic data generally outperformed, sending the U.S. dollar and rates higher, but yields pulled back a touch towards Friday. Higher dollar and rates weighed on U.S. equities, while international stocks saw some upward movement on lower yields and exchange rates – related to somewhat weaker data.

International data this week revealed that economic momentum continued to slow in April. The most recent international PMIs softened somewhat, however much of the softness can likely be attributed to heightened trade uncertainty. Protectionist themes and tariffs have been making headlines on a regular basis, denting business confidence and stifling expansion plans. For instance, this week the Trump administration doubled down on demands for China to reduce its trade surplus with the U.S. by $200 billion.

Most critically, domestic businesses appear unable to escape the rising tide of trade protectionism. Both the manufacturing and non-manufacturing ISM indices pulled back 2 points apiece in April. However, they remain near cycle highs, and are indicative of ongoing healthy pace of growth.

mestic data confirms that growth remains solid despite the downside risks. Personal income rose by a healthy 0.3% in March, while consumer spending rose 0.4%, consistent with the narrative of tax cuts and rising jobs and wages motivating Americans to shop. A rebound in spending in the second quarter supports an outlook that sees economic activity expanding around 3%, a trend that we anticipate to hold through the end of the year.

The persistence of strong, above-trend growth is driving price pressures higher. Inflation strengthened in March, reaching 2% according to the PCE deflator (the Fed’s preferred measure). The core PCE deflator (which strips out the most volatile components) also strengthened to 1.9%, just a hair below the FOMC target of 2%. The Fed took notice of this data during their meeting this week. Although it kept rates on hold, some notable changes to the wording were made. All told, the Fed’s confidence regarding inflation and its outlook should provide it with the conviction to keep moving rates higher, assuming wage and prices rise as expected.

This morning’s payroll report for April was consistent with this view despite the headline miss. Although wage growth slowed a touch, the drop in the unemployment rate to a 17-year low of 3.9% suggests that wage and price pressures should continue to gradually build.

Ultimately, inflation holding near target is consistent with our call for two more rate hikes from the Fed this year, with the next hike likely coming in June. That said, it’s not out-of-the question that the Committee raises rates by another 75 basis points this year. This gradual pace of tightening should help minimize the risk of slowing activity too quickly and resulting in a recession, something the FOMC officials are keenly trying to avoid..

Michael Dolega, Senior Economist | 416-983-0500

Over the past few years, first-quarter growth has slowed notably from the fourth quarter, often attributed to a phenomenon known as residual seasonality This year was no exception. First-quarter growth came in at 2.3% (annualized) – slower than the 2.9% recorded in the fourth quarter, but still better than market expectations for a 2.0% advance. Economic activity was supported by improved business investment, which recorded a solid performance thanks in part to a surge in activity in the petroleum and natural gas sector (+43% Q/Q ann.), and by an unexpected small positive contribution from net trade (Chart 1).

Following a 4% annualized expansion in the fourth quarter that was partly boosted by post-hurricane recovery spending, consumer spending slowed markedly, contributing just a measly 0.7 percentage points to growth. Consumer spending should regain a firmer footing ahead, buoyed by upbeat consumer confidence, a healthy labor market and tax cuts. This narrative is corroborated by stronger monthly spending toward the end of the first quarter, including the surge in March retail sales and a second consecutive monthly gain in existing home sales. The latter rose 1.1% m/m, but the recent performance would have likely been even better if it weren’t for very tight inventories.

Overall, the better-than-expected GDP outturn and healthy outlook ahead may augur a faster pace of rate hikes. But the evolution of price pressures will be the deciding factor. On that front, higher oil prices this week –WTI reached $68/barrel for the first time since late 2014 – accentuated concerns about rising inflation. This helped push Treasury yields higher, with the 10-year yield briefly breaching the 3% mark for the first time since 2014. The rise in yields propped up the trade-weighted U.S. dollar and weighed on equity valuations midweek. But a slew of broadly positive earnings reports, coupled with the upside surprise on GDP, eventually helped markets recover losses.

This week’s selloff reinforces our view that volatility has made a comeback (see report). The return of volatility, something which is likely here to stay, suggests that investors are now responding to rather than shrugging off negative news. Perhaps one of the best examples of this reality is the market reaction to elevated trade tensions between the U.S. and China earlier this month.

Ultimately, we believe that there is still time for the U.S. and China to settle their trade differences without much collateral damage – something that appears more likely now with the Treasury secretary scheduled to embark on a trip to China shortly. However, there is still a possibility that the talks fail and tariffs are implemented, with this scenario expected to weigh on economic growth. In a recent report that considers the impact on regional economies, focusing on TD’s East Coast footprint, we find that the Eastern Seaboard is roughly half as exposed to trade with China compared to the rest of the country combined (Chart 2). This would enable most states in the footprint to duck much of the blow from the prospective tariffs. That said, South Carolina’s elevated trade with China leaves it’s economy more vulnerable to the economic drag from protectionist trade policy.

Admir Kolaj, Economist | 416-944-6318

Markets moved sideways this week, rising in the first half and sliding thereafter, even as energy stocks rallied. Still, there was no shortage of economic data and Fed speeches, giving investors plenty of news to digest.

For its part, economic data surprised to the upside. After three lackluster months, retail sales jumped 0.6% in March and the core measure rose by 0.4%, beating market expectations. March was the first full month where taxpayers would have felt the impact of tax cuts on their paychecks, raising the bar for retail sales. This week’s report did not disappoint. Consumers responded to higher after-tax income by ramping up spending on most categories of products, particularly on discretionary and big-ticket items, such as autos, furniture, electronics & appliances, as well as at online retailers. While the strong print in March comes a little too late to save first quarter consumer spending, it sets up second quarter for a healthy rebound, with consumer spending likely to grow around 3%.

Housing starts also posted a decent rebound in March, rising by 1.9%. However, details were slightly softer than suggested by the headline. The gain was concentrated in the volatile multi-family segment, while single-family starts declined. For the first quarter as a whole, homebuilding has outperformed our expectations; however, it remains low relative to underlying demand and history. Even though economic fundamentals remain strong, a shortage of workers, available building lots, as well as risings costs of labor and materials continue to weigh on homebuilding activity. These headwinds are contributing to tight inventory of houses on the market.

Rising inflationary pressures also stood out prominently in the latest Federal Reserve Beige Book. Businesses reported rising steel prices in the aftermath of the tariff announcement. Prices for building materials, such as lumber, drywall, and concrete, also continued to rise briskly. Transportation costs, meanwhile, increased on the back of higher fuel prices, with oil prices rising to the highest level in more than three years this week. Labor shortages were also reported across a wide range of industries and skills. All in all, businesses are increasingly facing rising input costs for both labor and raw materials, and with declining unemployment, strong economic growth and the risk of further tariffs, this trend looks set to continue. It is likely only a matter of time before companies pass these higher costs onto consumers, ultimately pushing inflation higher (see our recent report).

Nonetheless, this week’s many Fed speakers downplayed the need for faster rate hikes. New York Fed President William Dudley said that the case for “tightening policy more aggressively is not compelling”. Meanwhile, Federal Reserve Vice Chair Randal Quarles said that he didn’t view recent flattening of the yield curve as a signal of an imminent recession. This suggests that the Fed remains on track (but not in a hurry) for continued gradual interest rate normalization.

Ksenia Bushmeneva, Economist | 416-308-7392

Politics dominated headlines this week. Financial markets recovered from last week’s selloff, as the fear of a full blown trade war between the U.S. and China receded for at least a few days. However, geopolitical tensions remain elevated as more economic sanctions against Russia took effect and the U.S. administration considers military action against Syria, providing a strong bid on gold and oil.

Although there has been more bark than bite on trade protectionism from the U.S. administration thus far, a hot trade war could do a lot of damage. However, events this week provide some hope that a trade war can be averted. Speaking at the Boao forum for Asia, Chinese President Xi repeated past promises to expand intellectual property protections and open various sectors of China’s economy to foreign investment. Later in the week, word spread that President Trump was directing officials to explore returning to the Trans Pacific Partnership, an agreement that he withdrew from shortly after coming to office.

With heightened uncertainty about the future trading relationship between the world’s economic heavyweights, business confidence could start to wane. Small business optimism pulled back in March, but the decline comes after the index reached a 35 year high in February. While a pullback was expected, one cannot rule out that rising trade tensions contributed to the greater-than-anticipated decline. What’s more, the report reinforced the labor market themes we’ve seen from the ISM surveys: rising labor shortages driving up wages as firms act to attract and retain workers (Chart 1).

Rising wages and input costs will eventually drive consumer prices higher. For the month of March, consumer prices rose 2.4% (year-on-year), but a more meagre 0.1% monthly change owing to decline in gas prices. Most importantly, core inflation (CPI ex-food and energy) ticked up to 2.1% y/y from 1.8% in the previous month, largely on the back of base-year effects (Chart 2). Still, core inflation rose a healthy 0.2% on the month, suggesting that a hot economy is leading to a broad build-up in price pressures.

Labor shortages, solid wage growth, and rising prices should reassure the Federal Reserve that higher interest rates are warranted. Although there was little new information in the March FOMC meeting minutes released this week, there were still some discussions worth noting. Strong economic growth along with rising price pressures are evidence that the economy is coping well with past rate hikes and can absorb more. In fact, some participants think that a total of four rate hikes may be warranted this year, while also suggesting that the language in the monetary policy statement be changed to reflect a view that interest rates are exerting a more neutral rather than accommodating impact on economic activity. Still, uncertainty about the ultimate impact of fiscal stimulus on output and the downside risks posed by trade protectionism is more consistent with a total of three rate hikes this year.

Fotios Raptis, Senior Economist | 416-982-2556

Equities have been on a rollercoaster ride this week, driven by shifting headlines on U.S.-China trade tensions. Initially, the U.S. announced details on its plans to levy a 25% tariff on $50 bn worth of goods imports from China, targeting some 1,300 items, including aircraft parts, batteries and medical devices. In a tit-for-tat move, China announced it would respond by mirroring the tariffs on American goods imports. The range of products targeted by China however, which included soybeans, cars, aircraft and chemicals, was narrower at 106 products. Later in the week, Pres. Trump instructed the U.S. Trade Representative to consider an added set of tariffs on $100 bn worth of imports. In what’s looking like a high-stakes poker game, China’s Ministry of Commerce said that China was prepared to “hit back forcefully” – reigniting trade war fears.

It is important to distinguish between tariffs that we already have details on and the latest inflammatory rhetoric. The former are not overly concerning. We estimate that the U.S. tariffs (including enacted tariffs on steel and aluminum) could shave off about 0.1 pp from annual GDP growth over the next few years, and could add up to 0.1 pp annually on inflation. Depending on what’s finally enacted following a consultation period, the price and demand impacts could be somewhat more pronounced if the tariffs are applied largely on consumer goods rather than business investment goods. On the other hand, China is targeting roughly 38% of American goods exports to China, which represent only about 0.3% of U.S. GDP. We estimate that these tariffs would reduce U.S. growth by up to 0.1 pp annually for the next two years. In this vein, slightly weaker U.S. demand could also act to offset some of the price pressures from the U.S. import tariffs.

The potential for the conflict to escalate is much more concerning. U.S. exports to China totaled $130 bn last year. This means that if the U.S. went ahead with tariffs on $100 bn of goods on top of what’s already being considered, and China reciprocated, the direct impact from exports would be much harsher given that all U.S. goods exports to China would face tariffs. The indirect impacts related to supply chain disruptions and the hit to business confidence and investment would also be more pronounced.

Developments on the trade front overshadowed decent signals from the economy. Auto sales came in slightly better than expected in March, and the ISM indices remained well in expansionary territory, despite easing off slightly (Chart 1). Payrolls gains slowed to 103k on the month, but this came atop of a very strong showing in February at 326k (Chart 2). Looking past the monthly noise, the underlying job market remains healthy, as demonstrated by increased wage gains – up 2.7% y/y.

Tax cuts and increased government spending are expected to add fuel to the labor market and the economy, with the latter expected to run at roughly 3% over the next few quarters (see forecast). In short, the U.S. economy remains on a solid course, but further escalation in the trade conflict poses a material downside risk. The hope and expectation is for the conflict to be resolved through the ‘The Art of the Deal’ rather than ‘The Art of War’.

Admir Kolaj, Economist | 416-944-6318