Three mysteries lie at the heart of today’s economy. Investors may want to spend a moment pondering them because how these puzzles resolve themselves will have a lot to say about where the market goes next.
The first mystery is why unemployment has remained so persistently low.
The Bank of Canada and the U.S. Federal Reserve started to aggressively hike interest rates a year ago. Their goal was to slam the brakes on economic growth, discourage hiring and put a damper on surging inflation.
So far, labour markets have barely noticed the rising rates. Jobs markets in both Canada and the United States remain red hot. Figures published Friday show Canada added 22,000 jobs in February while the U.S. increased jobs by 311,000. Both gains came in well above forecasters’ expectations.
The continued flurry of hiring is good news for workers on both sides of the border, but it poses a challenge for inflation-fighting policy makers. After the massive interest-rate hikes of the past year, forecasters had every reason to expect employment to be retreating by now. But it clearly isn’t.
The labour market’s current strength may just be a lag effect, reflecting the time it takes rate hikes to work their way through the economy. So long as it continues, though, inflation is going to be difficult to tame. Central banks will likely have to keep interest rates high or take them even higher to put a lid on rising wages and prices.
This brings us to a second mystery: Why are markets so nonchalant about this prospect of higher-for-longer interest rates?
Both the Bank of Canada and the Fed have left no doubt they intend to continue dispensing interest-rate pain until they succeed in wrestling inflation down to more comfortable levels.
It would be unusual if this did not result in a significant downturn. The Conference Board of Canada, a non-profit think tank, is typical of many forecasters – it sees a 94-per-cent chance of a recession in Canada within the next 12 months and an 88-per-cent chance of a similar downturn in the U.S.
Yet markets don’t seem all that nervous. Stock markets have bounced higher and are well above their lows of last October. Bond markets, too, appear relaxed.
You can measure the bond market’s don’t-worry-be-happy mood by looking at credit spreads in the high-yield sector. These credit spreads measure the difference between the rate that risky companies pay to borrow money and the rate that the federal government pays to borrow money for the same period.
Risky companies always pay more than a safe government borrower, but the spread between the two rates tends to vary in line with how investors perceive the economic outlook.
If the economy is slowing and risky companies are facing growing stresses, investors ratchet up the rates they demand from risky borrowers. The higher rates are intended to offset the growing chance that some of these not-so-solid companies will default on their bonds. As a result, credit spreads widen, often dramatically.
Right now, this is emphatically not happening. Credit spreads in the high-yield sector remain stubbornly low. Forecasters may be calling for a recession ahead but credit spreads are nowhere near the levels they typically reach in a downturn. The bond market seems to be saying that it expects any slowdown to be so mild that it won’t really hurt much at all.
The bond market’s optimism is helping to create a third mystery. This one may be the most challenging of them all: How can rising interest rates succeed in slowing down the economy if no one expects rising interest rates to actually pinch?
The mystery of the home sector
Home starts are plunging in the United States, but construction
employment is rising. No, this doesn’t make a lot of sense.
New privately-owned housing
units started, thousands
All employees, residential
building construction, thousands
1,000
2,000
950
1,750
900
1,500
850
1,250
1,000
800
I
I
I
2021
2022
‘23
the globe and mail, Source: federal reserve bank of st. louis
The mystery of the home sector
Home starts are plunging in the United States, but construction
employment is rising. No, this doesn’t make a lot of sense.
New privately-owned housing
units started, thousands
All employees, residential
building construction, thousands
1,000
2,000
950
1,750
900
1,500
850
1,250
1,000
800
I
I
I
2021
2022
‘23
the globe and mail, Source: federal reserve bank of st. louis
The mystery of the home sector
Home starts are plunging in the United States, but construction
employment is rising. No, this doesn’t make a lot of sense.
New privately-owned housing
units started, thousands
All employees, residential
building construction, thousands
1,000
2,000
950
1,750
900
1,500
850
1,250
1,000
800
I
I
I
2021
2022
‘23
the globe and mail, Source: federal reserve bank of st. louis
In the past, rising interest rates exerted much of their effect through the housing market. Mortgage rates would go up, home sales and home building would go down. The housing slowdown would send shock waves through the entire economy. Among its most noticeable impacts would be mass layoffs in the construction industry.
This time around, there is no trace of that. Paul Krugman, the Nobel laureate economist, says “the most puzzling chart in economics right now” is the one that shows the number of U.S. home starts plunging while construction employment keeps on rising. No, this doesn’t make a lot of obvious sense.
One possible explanation is that home builders are hoarding labour. Developers may expect any economic downturn to be so mild that they are willing to overlook short-term bumps and keep stockpiling the workers they figure they will need over the longer term.
If so, that poses problems for central bankers. They are trying to slow the economy and cool labour markets, but if employers aren’t co-operating by trimming their work forces, central bankers will have to take interest rates considerably higher than they are now to achieve their ultimate goal of tamping down inflation. That would not be good for stock prices.
Investors may want to keep that possibility in mind. “We are increasingly wary of the performance of global equity markets as most central banks remain in tightening mode,” analysts at National Bank of Canada wrote this week. “This month we are further reducing our equity allocation in favour of fixed income.” Given the market’s current mysteries, that seems rather sensible.
Ian McGugan