Know both halves of the glass
You could argue 2015 ended with so much negativity — Canadian stock markets down, oil prices continuing their long, slow decline, mixed economic news, and so on — that it’s a disservice to everyone to enter 2016 with more worrisome stuff.
On balance, we tend to be sanguine about the investing climate in a new year following a bad one. Maybe it’s the holiday high, or maybe it’s just part of a natural human response to calamity, to wit: yes, that was bad, but it probably can’t get any worse.
The thing is, though, that it can get worse. And while I, for one, am in the largely optimistic camp for 2016 markets, there are potential hot zones out there.
Let’s focus close to home, with a bucket of concern around interest rate policy, oil prices, the Canadian dollar and the housing market.
For the moment, it looks like the Bank of Canada is in stand-pat mode, as it continues to wait for the impact of two interest- rate cuts in 2015 to play out. That desired impact would be stimulus, particularly in sectors other than energy, which (no news here) has been decimated by plummeting world prices.
That stimulus hasn’t had a real effect, at least not yet. In fact, manufacturing sales — which were supposed to be the big beneficiaries of lower rates and a correspondingly lower loonie — fell more than expected in October, to a mark significantly lower than they were the year before, when the Bank of Canada’s overnight rate was one per cent.
Here’s the thing: If oil prices continue in their rut or fall even further, if manufacturing fails to pick up the economic slack, or if there’s another shock to the global economy ( say, a credit crisis — see below), then the central bank might well lower rates again.
After all, what is t he rationale for Canada’s benchmark rate sitting at 50 basis points when e c onomic growth is coming in at 1.2 per cent (maybe)? The European Union will notch growth of nearly two per cent in the third quarter, and the European Central Bank’s benchmark lending rate is near zero. Even with the Fed lifting in December, U.S. rates there are still lower for an economy that probably grew by more than two per cent in 2015.
Markets are currently pricing in a less than 50 per cent chance of a Canadian rate increase before May, but that could change if growth continues weak. And Bank of Canada Governor Stephen Poloz has surprised investors before.
If rates go down, however, we run smack dab into another problem: the housing market. It’s already overheated in the major cities of Toronto and Vancouver, and another rate cut would likely pump that bubble up even more. We know how that story tends to end.
The Bank of Canada, obviously, knows this risk. Yet it is stuck between a rock and a hard place. If it holds on rates while the economy (and jobs and salaries and all that) stumble, then the sensitive housing markets could implode. If it lowers rates to stimulate the economy, those housing markets inflate and the eventual landing (when it comes) will probably be all the harder when/ if rates rise. Meanwhile, the loonie will likely fall even further, putting strain on households that are already spending more for the imported things (like food) they have to buy.
So far, the Bank seems to be favouring the middle ground, holding rates steady since last July while it talks down the dollar, even if not intentionally, by floating the possibility of negative interest rates if needed. We will see whether it can maintain that stance until the economy shows more signs of strength.
As we ponder these risks, we have to remember that Canada does not exist in a vacuum.
Globally, there are some warning signs: China’s manufacturing and investment slowdown, which has punished commodity prices and probably will for a while; the deleterious effects of political instability and terrorism, which show no signs of abating in 2016; and oil prices, which could go even lower in a world awash with supply.
Meanwhile, t here are flashpoints of stress in fixed income markets. The freezing of redemptions in two U. S. distressed-debt funds in December highlighted a liquidity crunch in at least the riskiest part of the FI market.
Then there’s the relationship between U. S. Treasury yields and interest rate swaps. Swaps are derivatives in which counterparties “trade” one stream of interest for another, typically fixedrate for floating-rate. Swaps are a huge market — valued at more than US$320 trillion by the Bank for International Settlements — and yields have fallen in part because corporations have been buying them up as a countermeasure to the flood of fixedrate debt they’ve issued in recent years.
Just for reference, the total notional value of interest rate swaps, according to the Bank for International Settlements, was US$320 trillion in mid2015 — almost three times the GDP of the world in 2014.
Usually, you pay a premium over the “no- risk” Treasury yields (which reference the benchmark for floating- rate interest) when buying a swap. Yet yields on five- year swaps are actually lower than on five- year Treasuries, and have been for a while. On the surface, that suggests the market believes a default by the U. S. government in five years is more likely than the financial system defaulting on trillions of dollars in swaps.
Of course, nobody really believes the U.S. government is set for a default. But negative swap spreads are a sign of liquidity constraints. Simply put, investors are finding it easier to place side-bets on interest rates, and banks are finding it easier to make markets for those bets, than to actually buy and sell bonds.
Liquidity in fixed income is a challenge now and could have global implications in future. The concern is what happens if another shock to the economy prompts a broad- based wave of bond redemptions or corporate defaults.
Again, nobody likes to worry in a new year, and there may be plenty of reason for renewed optimism. But to be an effective optimist, you also need to know what to be concerned about.