Douglas Porter, CFA
April 23rd, 2021
- Textbook economics tell us that a looser fiscal policy combined with a tighter monetary policy usually leads to a stronger currency. Apparently, the textbooks are still sometimes correct. The Canadian dollar forged above 80 cents(US), firming on net in a week that saw a pair of heavyweight events. While the broad strokes of the Federal budget and the Bank of Canada’s Monetary Policy Report were no big surprise, both landed on the very far end of the expectations spectrum. After an earlier pledge to spend an extra $70 bln-to-$100 bln over the next three years to support the economy, the budget in fact offered up $101 bln, with almost half front-end loaded into the current fiscal year (i.e., an extra 2% of GDP this year alone). Two days later, the currency really got a charge when the Bank tapered QE purchases from $4 bln to $3 bln per week, as widely expected, but piled on with at least four surprisingly hawkish signals for good measure. Briefly:
- The tapering was bluntly billed as a response to economic progress, and not as a technical measure. In fact, the Bank didn’t even attempt to soften the blow by suggesting any change in the maturity of bond purchases.
- The Bank now sees economic slack as being absorbed by the second half of 2022, much earlier than the previous “some time in 2023”.
- The Bank projected inflation to be above 2% out in 2023 (in fact, 2.4% Q4/Q4), clearly setting the stage for a potential justification of rate hikes well before then. The CPI report earlier that day already revealed a March pop in headline trends to 2.2%, and above 2% for two of the BoC’s core measures.
- As if to add an exclamation point, the Bank’s GDP growth forecastsuddenly jumped to the top of the class, calling for 6.5% this year, up from 4.0% just three months earlier, and well above even what the budget was premised on just two days earlier (5.8%, according to the private sector consensus).
- Effectively, in one stroke, the Bank has gone from being among the most cautious forecasters on the Canadian growth outlook this year to the most optimistic. True, we had also been calling for a strong 6.5% advance this year, but we trimmed our projection to 6.0% this week (while simultaneously lifting next year a similar amount to 4.5%). Even with the spending blast from the budget, the wave of renewed and deepening restrictions across much of the country has prompted us to rein in our estimate of Q2 GDP to nil. While we do expect a hearty rebound as things reopen, the fact is that some activity will be lost for good by these latest lockdowns. The Bank did allow that the third wave is a new challenge for the economy, and readily noted that the forecasts still carry great uncertainty. But it is quite the statement that the Bank chose to take its growth call to the very high end of consensus.
- The Bank may also be more willing to build in a fiscal multiplier from the heavy-duty federal spending than most others. The direct contribution from government outlays is expected to alone boost GDP by 1.5 percentage points this year. Its forecast assumed a middle ground of $85 bln of additional spending, so the budgetary measures may even give some upside risk to their view.
- Sidebar: One of the more notable moments of the press conference was when Governor Macklem was asked about the discrepancy between the assumption on extra government spending and the $101 bln reality. He essentially brushed off the $16 bln difference. In days of yore—like 16 months ago—that amount of money would have made a big difference for forecasts, weighing in at 0.7% of current GDP. Such is life in days of triple-digit budget deficits.
- There was much less market reaction to the budget, despite the heavy-duty build-up to the event. Clocking in well above 700 pages and containing—by our count—276 separate new initiatives, perhaps the document simply overwhelmed. And, while there’s always some mystery around new measures and the big figures on the deficit, there were no shocks on either front. The showpiece child care plan was well telegraphed, and still requires negotiations with the provinces. On the deficit, the current year did come in higher than many expected (not us) at $155 bln (or 6.4% of GDP), and the prior year’s record shortfall was equally chopped to $354 bln (16.1%). And, next year’s gap is still expected to narrow sharply to just below $60 bln (a manageable 2.3% of GDP).
- The one significant market response was a sell-off at the long end of the yield curve, as Ottawa tilted this year’s borrowing plan heavily to the long end. After the dust settled, Canada’s 30-year bond yield finished the week about 5 bps higher at just above 2%, in a week when long-term Treasuries dipped 3 bps to just below 2.25%—a large relative move. The short end of Canada’s curve eventually also saw yields move higher on the blatantly hawkish BoC message.
- One small mercy in the wide-ranging budget was the absence of broad tax hikes. No doubt, there were some targeted measures, including a tax on luxury goods, digital services, a limit on corporate interest deductions, and a 1% levy on vacant homes owned by non-residents. The latter was a mild effort to tame the raging housing market, which flashed yet more signs of wildness this week. New home prices ratcheted higher again last month, but the real eye-popper was the blow-out 335,000 housing starts in March—the highest monthly tally recorded in 30 years of data. (The all-time annual apex was set in 1976 at 273,203 units.)
- Sidebar II and a not-so-modest proposal: In some sense, it’s passing strange that we are even talking about tax hikes at all. After all, isn’t Ottawa attempting to stimulate, or “jumpstart” (in its words), the economy? Pray tell, why then is all the fiscal room taken up by the spending side, and not at least some space for lower taxes to help support the economy’s competitiveness? We would assert that trimming marginal income tax rates could, in one fell swoop: a) help housing affordability by providing more after-tax income; b) help defray child care expenses; c) incent more to join the labour force by reducing the cost of work; and, d) boost spending power and stimulate consumption. If Ottawa is perfectly fine with running deficits as far as the eye can see, in good times or very bad, then why can’t some of the gap be aimed at fundamentally lower taxes rather than permanently higher spending?
- While Ottawa’s budget didn’t talk about large tax increases—yet—the topic is now very much on the U.S. table. First, President Biden’s huge infrastructure proposal is expected to be at least partly funded by a hike in corporate taxes. Second, and the new news this week, was the proposal to lift capital gains taxes sharply for those earning more than $1 mln annually. This is expected to help pay for the next leg of the President’s domestic agenda, including a child care plan. Normally, we may be tempted to step in with the same comment as above; i.e., if deficits suddenly don’t matter… but, the starting point for U.S. finances is weaker, and the wave of stimulus programs have already been much more overwhelming in recent months than anything seen from Ottawa. While the latter’s deficit is expected to moderate to around 1% of GDP within a few years, there is no such prospect of anything in that time zone from Washington.
- Financial markets suffered a one-day hit from news of the U.S. capital gains tax plan. However, the damage didn’t prove lasting, as the reality of its challenging approval process meant cooler heads prevailed. U.S. equities dipped only slightly on the week, finding support from generally solid earnings. It was an otherwise quiet week for U.S. economic releases and for markets—aside from Bitcoin, which suddenly finds itself in a bear market, falling more than 20% in a week, perhaps crowded out by Dogecoin. And there is no truth, none whatsoever, that Bitcoin stands for Bigger Idiot Theory Coin…none. Zero.
- Next week, the U.S. economic calendar gathers some serious momentum, with the highlight reel events the FOMC meeting on Wednesday and Q1 GDP the next day. We are expecting a crackling 7% annualized advance for the latter, driven by some reopening and the two-stage fiscal stimulus packages in the quarter. Also keep an eye on Friday’s income and spending figures for March, which are likely to be ginormous amid the $1,400 payments. That same day will also bring Canada’s monthly GDP figures for February, and a flash estimate for March. Not unlike the U.S., we anticipate a whopping March advance as the economy opened a touch last month. Sadly, it’s almost a certainty that April will bring a big reversal, as shutdowns have since swept across the country, even to places like Nova Scotia and British Columbia, which had previously avoided the worst of the pandemic. However, we fundamentally believe that the flashes of strength we shall see for March simply provide a hint of what lies ahead when the economy can more fully and safely reopen.
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