Global investment outlook

Our latest quarterly Global Investment Outlook is now available.

Banking stress

Banking stress has dominated the economic and market landscape since our last #MacroMemo. Let us work through the key developments and implications.

What happened

Two U.S. regional banks failed in early March: Silicon Valley Bank and Signature Bank. While neither financial institution was among the handful of largest banks in the country, neither were these small institutions. Both ranked in the top 25 of U.S. banks and had over $100 billion in assets.

Each bank was felled by a classic bank run in which too many customers attempted to withdraw their deposits at the same time. The banks were not able to accommodate this due to a combination of insufficient liquidity and ultimately insolvency as losses on the banks’ bond investments were crystallized.

As this played out, clients at other banks became nervous. Money began flowing out of a widening set of banks. This created the risk of cascading bank failures.

Where did the underlying problems come from?

The problems in the U.S. banking sector primarily arose from the sharp increase in interest rates over the last 18 months. Banks frequently hold a fraction of their assets in bonds. The value of those bonds fell substantially as interest rates rose.

It is important to note that mid-sized U.S. banks don’t have to mark their bond holdings to market unless they are selling the bonds. The banks would normally hold these bonds to maturity, at which point the bond value reverts to par. As such, the hit to their capital base was both concealed and largely theoretical.

There is still some fear among depositors and investors in U.S. banks. The fear among depositors is understandable but now mostly unfounded after recent government intervention.

However, the clients of Silicon Valley Bank in particular were heavily skewed to the tech sector. As the sector cooled over the past year and venture capital funding dried up, many of these clients were withdrawing their bank deposits to fund their businesses.

This in turn forced the bank to start selling its bonds, crystallizing some of the bond portfolio’s losses.

Bank customers rapidly became concerned by this development. The tight-knit nature of the tech community meant that news travelled fast. An unusual fraction of the bank’s clients had large deposits that exceeded the US$250,000 deposit insurance limit, rendering their money theoretically vulnerable to a bank failure. Furthermore, in this new world of electronic banking, tech-savvy clients were able to rapidly shift their funds out of the bank with the click of a button.

These outflows became sufficiently large that the realized bond losses rendered the bank insolvent. The Federal Deposit Insurance Corporation (FDIC) had to take over the bank.

The situation at Signature Bank had some similarities:

• a relatively small number of high-value clients
• a connection to the struggling tech sector and to cryptocurrencies
• bank assets held disproportionately in bonds.

In the end, the problems at Signature Bank were probably not as great as that of Silicon Valley Bank. But the failure of the first entity stirred up sufficient anxiety among Americans that Signature Bank suffered the same fate as Silicon Valley Bank.

Most banks are less vulnerable

It is important to understand that the positioning of most banks is less concerning than that of the two failed entities:

• Most banks have a more heterogenous set of customers. They don’t all struggle or withdraw their money at once.
• Most banks don’t hold such a large fraction of their assets in loss-making bonds.
• Most banks did not grow as quickly as Silicon Valley Bank did in recent years. This means they did not acquire a large fraction of their bond portfolio at the absolute peak of the bond market.
• Even among banks with substantial bond holdings, many hedge their positions so that rising interest rates do not trigger large loses.
• Many banks – and most large banks – are run less aggressively, with a higher capital ratio.

As such, even though there remains some vulnerability, it is far from automatic that other medium- or large-sized banks will suffer the same fate.

Efforts to halt additional bank runs

The U.S. government also stepped in to prevent further bank runs.

The main initiative was to create a Bank Term Lending Facility at the Federal Reserve. This facility allows U.S. banks to swap their bond holdings at face value for a cash loan for up to a year. The key element of this is that the bonds are swapped at their face value, not at their market value. Thus, even if some banks are indeed temporarily insolvent due to bond losses on paper, these will eventually reverse as their bonds reach maturity and banks can still secure the necessary liquidity to deal with customer withdrawals over the next year.

Over the medium and long run, regional U.S. banks will surely come under greater government scrutiny in the future and will likely be subjected to more stringent regulations.

More than U.S.$300 billion of this facility has been tapped in just the past two weeks, reflecting its success. It also shows the stress that other banks are currently experiencing as customers re-evaluate where they want their deposits to be held. Cumulatively, banks have suffered nearly U.S.$700 billion in market-to-market bond losses (see next chart).

Bank unrealized gains (losses) on investment securities reflect stresses on banks

As of Q4 2022. Source: Federal Deposit Insurance Corporation, Macrobond, RBC GAM

The new liquidity facility is not a gift. The cost to borrow at the window is fairly expensive: a 4.7% interest rate. It is therefore not a permanent solution for any banks that are fundamentally unprofitable. Rather, it is a bridge for otherwise viable banks to survive a near-term bank run.

In theory, the facility should be enough to halt further bank runs. In practice, there is still some stress in the market. While the FDIC opted to guarantee all deposits, even beyond US$250,000, for the two banks that failed, it has so far refused to extend that privilege to the rest of the banking sector. This option remains in the back pocket of regulators should conditions deteriorate further, though it is theoretically redundant given the steps taken already.

The current situation

There is still some fear among depositors and investors in U.S. banks. The fear among depositors is understandable but now mostly unfounded after recent government intervention.

However, it is fair to recognize that, from an investment perspective, the banking sector is not thriving amid rising rates and given a potentially weakening economic environment. Furthermore, the cost of saving the depositors of the two failed banks will likely be recouped by the government in the form of a special levy on the banking sector. Over the medium and long run, regional U.S. banks will surely come under greater government scrutiny in the future and will likely be subjected to more stringent regulations.

Canadian banks

The situation for Canadian banks is different. To be sure, rising interest rates do impose losses on Canadian bank bond portfolios. Canada’s high household leverage and weak housing market represent challenges of even greater consequence to Canadian banks than American ones. But these Canada-specific issues are not new and are fairly well understood already.

Canadian banks have a history of stability even when U.S. banks encounter distress, as per 2008.

Critically, Canada’s banking sector has several advantages over the U.S.

• It has larger, more concentrated, more diversified and better capitalized banks relative to the U.S.
• Historically, the Canadian deposit base has also been stickier than in the U.S. This reduces the likelihood of bank runs.
• Canadian banks also enjoy a single national regulator, whereas the U.S. system operates under the purview of a patchwork of state regulators with varying degrees of stringency.
• Canadian banks have a history of stability even when U.S. banks encounter distress, as per 2008.

In the context of current stresses, Canadian banks place a smaller fraction of their assets into long-dated bonds. They mark those bonds to market such that there are no hidden losses off balance sheet. A significant fraction of the bond portfolio is hedged, such that the resulting losses from rising interest rates are manageable.

Credit Suisse problems

Swiss bank Credit Suisse recently experienced considerable duress. This culminated in Swiss regulators guiding the troubled bank into the hands of its archrival UBS.

The root cause of Credit Suisse’s problems is longstanding mismanagement of the bank. Ever since the global financial crisis, the institution has underperformed against its peers.

Does this represent the globalization of problems with U.S. regional banks? Yes and no. Yes, in that U.S. banking distress has undeniably encouraged greater scrutiny of the banking sector. Weaker banks such as Credit Suisse have experienced some copycat deposit outflows and a re-evaluation of their true stock market worth.

But, in our view, the root cause of Credit Suisse’s problems is longstanding mismanagement of the bank. Ever since the global financial crisis, the institution has underperformed against its peers, becoming ensnarled in a series of misdeeds and strategic errors. Banking is generally a profitable industry, yet Credit Suisse was expected to suffer steady losses over the next several years – even before the Silicon Valley Bank stresses arose. The bank was simply not a viable entity and markets decided they had had enough.

The new, combined entity of UBS and Credit Suisse appears to be amply capitalized and to possess sufficient liquidity to avoid succumbing to further trouble in the near term.

CoCo bond side-effect

However, the rescue of Credit Suisse created an unintended side-effect. As the Swiss government arranged for UBS to acquire Credit Suisse, it wiped out the value of Credit Suisse’s Contingent Convertible (CoCo) bonds. This was always theoretically possible if a bank failed spectacularly. But CoCo bonds usually sit above equities (though below other bank debt) in the capital structure. As such, you would normally expect all shareholders to be wiped out before the first dollar of losses hit CoCo bondholders. In this case it was topsy-turvy as shareholders didn’t lose all of their value (though they lost most of it). CoCo bondholders, however, lost everything.

This briefly created existential angst in the U.S.$275 billion global CoCo bond market. If CoCo bonds were not actually senior to equities, they would have to be aggressively repriced and were possibly altogether impractical.

Fortunately, we believe that the situation is not actually quite so dire for the CoCo bond market. Other countries have been quick to emphasize that they would not have followed Switzerland’s lead had a bank failed under their purview. CoCo bonds are still viewed by all regulators who cared to opine on the matter as being senior to equity. Furthermore, and substantially explaining the Swiss decision, there is a clause in Swiss CoCo bonds that apparently allows for this adverse outcome. This clause does not generally exist in CoCo bonds elsewhere in the world.

The bottom line is that the international CoCo bond market should live to fight another day. Investors still enjoy a superior position in the capital structure relative to equities in exchange for an attractive yield.

How is this different than the global financial crisis?

The global financial crisis of 2007—2009 was quite different and considerably worse than recent banking sector stress.

With the exception of the operational issues at Credit Suisse, the modern-day problems are those of a classic bank run at a handful of particularly vulnerable financial institutions – which the U.S. government has credibly addressed via policy solutions.

Banks were much less well capitalized going into the global financial crisis, and less well regulated. The average bank has two to three times more capital today. Bank losses were significantly greater during the global financial crisis due to severe housing market problems, lax lending standards and the creation of exotic securitized assets. The problematic disintermediation of toxic assets and a lack of transparency made it difficult to anticipate where problems would arise.

In contrast, with the exception of the operational issues at Credit Suisse, the modern-day problems are those of a classic bank run at a handful of particularly vulnerable financial institutions – which the U.S. government has credibly addressed via policy solutions.

Things to watch going forward

In the near term, in the context of elevated concerns about bank runs, it remains important to watch several key indicators, including:

• the extent to which depositors are pulling money from stressed banks
• the extent to which banks are tapping the Fed’s new liquidity facility
• whether deposit insurance is extended beyond US$250,000
• how bond valuations evolve.

More generally, when interest rates rise, leveraged players and/or bond investors usually suffer to some extent. Crises frequently manifest in one corner of the market or another. Indeed, part of the dampening effect of interest rate increases on economic growth is via the channel of financial distress.

This financial distress has already been visible in several places. British pension funds struggled with a sudden increase in British borrowing costs last fall. Housing markets across the world have softened. Now, some banks are suffering. Each sector continues to merit further attention.

More generally, when interest rates rise, leveraged players and/or bond investors usually suffer to some extent.

• There may well be a handful of additional banks scattered across the world that will experience particularly adverse consequences from higher interest rates over the next few years.
• Private markets often rely on substantial leverage. This presents another potential hot spot, though such markets have the advantage of limited liquidity obligations.
• Government borrowing costs are certainly rising – potentially a problem for some countries.
• China’s local government finances are especially concerning given a reliance on now-sputtering land valuations, though this has at most an indirect connection to higher borrowing costs.

Economic implications of banking stress

We have long maintained a below-consensus growth outlook for 2023, anticipating a recession. Recent banking sector troubles and the accompanying tightening of financial conditions strengthen our conviction in that forecast. Reflecting this, we have further reduced the tactical risk-taking in our investment portfolios.

Central banks have a difficult challenge in front of them. Excessive inflation continues to argue for higher interest rates, while financial distress now argues for lower rates. Recent central bank actions demonstrate that central banks are still opting to raise rates, recognizing that inflation absolutely must be tamed, whereas financial distress can be resolved via other means such as liquidity measures and deposit guarantees. Furthermore, a few additional rate hikes do not have a material effect on the solvency of most banks relative to the substantial tightening that has already happened over the past year.

Still, to the extent that central bank tightening may now be incrementally less than otherwise, resolving inflation becomes a little bit harder.

China’s economic recovery

China’s economic recovery continues now that it has lifted its pandemic restrictions. However, and as we have been saying for several months, the recovery should be robust but not ebullient. Yes, the housing market is tentatively reviving. But home sales and home prices are hardly soaring (see next chart).

China’s property sector shows signs of revival

As of Feb 2023. Home price change is an average of price changes in primary and secondary markets. Source: China National Bureau of Statistics, Macrobond, RBC GAM

Chinese plans to travel internationally have spiked, but the fraction of people with such plans is still quite low. There has been no lasting bump in domestic travel plans (see next chart).

Chinese consumer sentiment: items that one would like to buy in the near future

As of 2023 Week 11 (March 13-19). Source: Macromill, Macrobond, RBC GAM

Meanwhile, plans for eating out and going to shows have retreated back to pandemic-era levels after a brief (and likely Lunar New Year-induced) surge (see next chart). Chinese people simply don’t appear to have plans for so-called “revenge” spending.

Chinese consumer sentiment: more items that one would like to buy in the near future

As of 2023 Week 11 (March 13-19). Source: Macromill, Macrobond, RBC GAM

Our own aggregate measure of Chinese consumer activity shows a rebound, but only a modest one (see next chart).

Consumer activities inched up after China exited zero-COVID policy

As of February 2023. Index constructed using 11 proxies for Chinese consumer activities. Source: CNBS, CAIAM, People’ Bank of China (PBoC), Souf un-CREIS, Haver Analytics Macrobond, RBC GAM

Similarly, real-time measures of Chinese traffic congestion and subway traffic reveal that the initial post-pandemic spike is now beginning to fade back toward more normal readings (see next two charts).

Chinese traffic congestion index is returning to normal

As of 03/22/2023. Congestion index measured as 7-day moving average of weighted average of daily peak congestion levels and number of vehicle registrations in 15 cities with highest number of vehicle registrations in China. Source: Baidu, Bloomberg NEF, RBC GAM

Subway traffic in major Chinese cities also levelling off

As of 03/26/2023. Index is the weighted 7-day rolling sum of subway trips in Beijing, Chengdu, Chongqing, Guangzhou, Nanjing, Shanghai, Suzhou, Wuhan, Xi’an and Zhengzhou. Source: Chinese metro agencies, Macrobond, RBC GAM

In short, the Chinese economy is reviving, but not at break-neck speed. In turn, we continue to anticipate 5% real growth of Gross Domestic Product (GDP) in 2023. This is a big improvement relative to 2022, but nothing too special relative to the pre-pandemic norm, despite the prospect of some catch-up activity this year.

Economic developments

Turning to the developed world, economic news has continued to hold up surprisingly well in recent weeks. There is no recession yet, anyhow.

North American employment numbers for February were robust, if less impressive than the prior month. U.S. payrolls added a big 311,000 new positions and jobless claims have remained low in subsequent weeks. We continue to flag that metrics like the quits rate and labour turnover are falling, but this hasn’t yet morphed into job losses.

In Canada, February brought a solid 22,000 new workers. This was underwhelming relative to the prior month, but a reasonable sum and entirely full-time in nature.

Turning to the developed world, economic news has continued to hold up surprisingly well in recent weeks. There is no recession yet, anyhow.

Elsewhere in the U.S. data landscape, the evidence was mixed:

• February retail sales fell by 0.4% on a monthly basis, but only after rising by a massive 3.2% the prior month.
• Industrial production was flat.
• Core capital goods orders were up by 0.2%.

Those may not be strong numbers, but neither are they definitively recessionary.

The real-time economic data was admittedly somewhat softer. The Bank of America’s real-time card spending measure claims consumer spending is no higher than a year ago (see next chart). But this is contradicted by stronger retail sales and higher personal consumption over the same period. The card-based data should not be ignored, but it is not yet clear that it deserves greater attention than the more traditional metrics.

U.S. aggregated daily card spending remains unchanged from a year ago

As of 03/18/2023. Total card spending industries total Bank of America (BAC) card activity which captures retail sales and services paid with cards. Does not include Automated Cleaning House (ACH) payments. Source: BoA Global Research, RBC GAM

Canada’s real time Business Conditions Index appears to have plummeted, but it is hard to disentangle this from a series of winter storms in late February and early March (see next chart).

Business conditions in Canada dropped again after a brief rebound

As of the week of 03/13/2023. Equal-weighted average of Business Conditions Index of Calgary, Edmonton, Montreal, Ottawa-Gatineau, Toronto, Vancouver and Winnipeg. Source: Statistics Canada, Macrobond, RBC GAM

Probing extra household savings

We recently wrote about how U.S. households have been spending the excess savings they accumulated over the pandemic. Chinese consumers may also deploy some but not all of the more moderate sums that they have saved.

We now broaden this investigation to a handful of other countries (see next chart). Interestingly, the U.S. is the only one of the countries to have eaten into its excess pandemic savings. The others – including Canada, the U.K., Germany and Japan – are all continuing to save at a faster rate than before the pandemic. This means their accumulated savings continue to grow.

Considerable excess household savings due to pandemic

As of June 2022 for U.S. Q1 2022 for Canada, Germany, Japan and U.K. Cumulative excess savings vs. 2019 average since March 2020. Source: Macrobond, RBC GAM

Canada and the U.K. are particularly notable, with excess household savings that are now greater than 12% of GDP. The U.S. was once on a similar trajectory but has since spent that down to 6% of GDP. Germany and Japan never accumulated as much in excess savings as the others, but their sums continue to gradually increase.

Savings rates are no longer nearly as high as they were during the initial phase of the pandemic, but nor are they as low as they were before the pandemic.

These excess savings should be interpreted as good news as they represent latent spending capacity for these countries, or at least a buffer against future stressors.

But it is fair to concede that consumers have now had several years in which they could have started deploying this money, and yet they haven’t. We therefore probably shouldn’t expect a big spending surge in the future. Instead, households may be recognizing that they were under-saving beforehand, especially now that home prices are falling, financial assets are wobbling and costs are rising.

For clarity, savings rates are no longer nearly as high as they were during the initial phase of the pandemic, but nor are they as low as they were before the pandemic (see Canada as an example in the next chart).

Canadian household saving rate has dropped but remains high

As of Q4 2022. Source: Macrobond, RBC GAM

Backlog of demand?

There remains a backlog of demand for certain products. Even as supply chain constraints go away, not all companies have the necessary spare capacity to produce enough to make up for their substantial underproduction over the past several years.

The classic example of this is the auto sector. In the U.S., approximately 7.9 million fewer cars were sold than normal since the pandemic began (see next chart). That’s nearly half a year’s worth of normal sales.

Backlog of demand for cars will take some time to clear

As of February 2023. Pent-up demand for cars since the start of the pandemic (not annualized), measured as cumulative differential of car sales versus 2019 average sales. Source: Macrobond, RBC GAM

In our view, it would be unrealistic to think that all of those missing cars will be sold in the future. Most people simply nursed their existing car for longer. The average age of the U.S. car fleet is now noticeably higher than it was. But some fraction of the underselling can be caught up over time.

The point of this observation is that if economic weakness looms, it is possible that some sectors will avoid the worst of this experience due to pent-up demand. But it is unlikely that there are enough such sectors to avoid a recession altogether.

Recession update

We still expect a recession over the coming year. Recent developments push in different directions. On the one hand, ongoing economic resilience argues that the recession risk is falling. On the other, financial stress and insufficiently cooperative inflation (and the need to tame it with monetary policy) argue that the recession risk is rising.

We are inclined to think that the risk has gone up somewhat. Whereas the risk of a U.S. recession over the coming year was at around 70% a few months ago, perhaps it is now up to an 80% chance. A soft-landing remains technically possible, but it is harder to achieve than before.

Stubborn inflation

Inflation continues to descend from its peak, but in recent months the rate of improvement has distinctly slowed. Work remains to be done.

Fortunately, we can begin to see the sheer breadth of U.S. high inflation starting to turn. The latest month reveals that a shrinking share of the price basket is experiencing extreme inflation.

In February, U.S. Consumer Price Index (CPI) fell from 6.4% year over year (YoY) to 6.0% YoY. Core inflation merely declined from 5.6% YoY to 5.5% YoY. Beneath this, headline and core prices rose by 0.4% and 0.5% respectively versus the prior month. This is a marked improvement from the spring of 2022, but still annualizes to inflation prints that are in the realm of 5-6% rather than the desired 2%.

Goods inflation is now cooperating nicely, but service-sector inflation remains too high, even if it may be starting to turn (see next chart).

U.S. goods inflation is falling, services inflation may be stabilizing

As of February 2023. Shaded area represents recession. Source: U.S. Bureau of Labor Statistics, Haver Analytics, Macrobond, RBC GAM

The monthly clip of a range of core inflation metrics aren’t running much cooler than a year ago. More progress is certainly needed here, too (see next chart).

U.S. core inflation remains elevated

PCE (Personal Consumer Expenditures) deflator as of January 2023, CPI measures as of February 2023. Shaded area represents recession. Source: Macrobond

Fortunately, we can begin to see the sheer breadth of U.S. high inflation starting to turn. The latest month reveals that a shrinking share of the price basket is experiencing extreme inflation (see next chart).

High inflation in the U.S. is quite broad, but finally narrowing

As of February 2023. Share of CPI components with year-over-year % change falling within the ranges specified. Source: Haver Analytics, RBC GAM

Whilst we see the eradication of high inflation in every sector as a high priority, it has been particularly consequential in four big price categories: motor fuel, transportation ex motor fuel, housing, and food and beverages (see next chart). Fortunately, there’s some good news here:

• The motor fuel driver has completely reversed over the past several months.
• The transportation component is nicely decelerating as used car prices fall.
• Food & beverage prices haven’t yet turned in a major way, but we can see raw food prices reversing further up the supply chain (see subsequent chart).
• The housing component of inflation is not yet cooperating in the least, but we know that home prices are falling and rent increases are slowing. This eventually shows up in the housing component of CPI with a lag.

Housing, food, energy and transportation are driving U.S. inflation

As of February 2023. Source: U.S. BLS, Macrobond, RBC GAM

U.S. food prices soar since the start of the pandemic, but has softened lately

As of 03/14/2023. Source: Commodity Research Bureau, Haver Analytics, RBC GAM

For all their imprecisions, real-time inflation metrics remain firm in their assessment that inflation will continue to decelerate in the near-term (see next chart).

U.S. Daily Price Stats Inflation Index continues to decelerate

Source: PriceStats Inflation Index as of 03/24/2023, CPI as of February 2023. State Street Global Markets Research, RBC GAM

Outside of the U.S., the recent inflation deceleration has also been less favourable than it was in late 2022. Canadian inflation in February may have fallen from 5.9% YoY to 5.2% YoY, but the monthly change was still +0.4% month over month (MoM). The situation is similar to the U.S. in many regards, including the fact that goods inflation is cooperating while service inflation is much more resistant to decline (see next chart).

Goods inflation in Canada is declining, while services inflation is levelling

As of December 2022. Shaded area represents recession. Source: C.D. Howe Institute, Statistics Canada, Haver Analytics, Macrobond, RBC GAM

Eurozone February CPI only descended slightly, from 8.6% YoY to 8.5% YoY. The monthly change was a still-hot +0.8% MoM. Meanwhile, in the U.K., the February inflation print actually accelerated from 10.1% to 10.4% YoY.

Theory says…

The economic theory is still fairly clear that inflation should continue to fall from here. Monetary stimulus has turned into fairly fierce restraint. Commodity prices are falling and supply chain problems have largely vanished. In fact, our favourite measure of supply chain pressures now claims that such problems have now entirely vanished, though this probably is a bit optimistic (see next chart).

Global supply chain pressure has largely resolved

As of February 2023. Shaded area represents U.S. recession. Source: Gianluca Benigno, Julian di Giovanni, Jan J.J. Groen and Adam I. Noble. A New Barometer of Global Supply Chain Pressures.” Federal Reserve Bank of New York Liberty Street Economics, Macrobond, RBC GAM

Computer chip shortages are not only easing but there are now concerns about a future glut. The benchmark computer chip that we track has now more than fully reversed its earlier price gains (see next chart).

Chip shortage easing

As of February 2023. Mainstream density DDR4 chip used in the DDR4 8GB 1Gx8 2400/2666 MHz chip. Source: InSpectrum Tech, Bloomberg

Wages genuinely turning lower

Average hourly wages have been decelerating for some time, but a fraction of this trend was compositional in nature. Lower-skilled workers were being hired, dragging down the average level of wages without necessarily saying anything about how the wages of any individual workers were evolving.

In our opinion, a superior wage metric is the Atlanta Fed’s wage tracker, which controls for sector and a variety of other variables. It was long more resistant to decline but is now showing a clear deceleration (see next chart). This bolsters the argument that a full-bore wage-price spiral is unlikely. Our forward-looking composite makes a similar claim on the same chart.

Wage pressure in U.S. is easing

As of February 2023. Wage Pressure Composite constructed using business intentions to raise wages. Shaded area represents recession. Source: Macrobond, RBC GAM

It is a tricky matter to assess whether workers need to be compensated for recent high inflation with a big wage jump in the future. There is no doubt that real wage growth was negative over the past year (see next chart).

Real wage growth in U.S. has dropped significantly

As of February 2023. 3-month moving average of median year-over-year hourly wage growth. Source: BLS, Federal Reserve Bank of Atlanta Wage Growth Tracker, Macrobond, RBC GAM

However, real wage growth was unusually fast earlier in the pandemic, such that wages are still essentially on their normal trend rate of growth (see next chart).

Inflation-adjusted U.S. wages are still in line with pre-pandemic trend

As of February 2023. Source: U.S BLS, Macrobond, RBC GAM

For the record, this isn’t the entire story. Productivity-adjusted real wages have definitely undershot recently, arguing that workers do probably have some room to “catch up.” But the gap may not be as large as one would think if the sole point of reference were the big leap in prices over the past two years.

Central bank priorities

Central banks were previously juggling the need to tame inflation without excessively crimping economic activity. That balancing act just got more complicated now that banking stresses have been added to the list of considerations influencing monetary policy.

Going forward, markets think these central banks are near the finish line of their rate-raising journey.

Markets initially reacted to banking stress in early March by pricing out nearly all anticipated rate hiking in the U.S., and by downgrading expectations in other countries as well. Substantial rate cut expectations were also inserted in some cases, including in the U.S.

But that was probably an overreaction.  The major central banks that have delivered a rate decision since the onset of the banking stress have stubbornly continued to lift their policy rates. The Fed and the Bank of England raised their policy rates by 25 basis points. The European Central Bank tightened by 50 basis points.

Going forward, markets think these central banks are near the finish line of their rate-raising journey. The market grudgingly prices in another half percent rate hike in the U.S. Just 25 basis points of additional tightening is priced for the Bank of England, and only 25—50 basis points for the Eurozone.

In fairness, these central banks are indeed getting fairly close to the finish line. But we wonder whether markets are exaggerating the monetary policy implications of recent banking stress. Those issues can better be addressed on an ad hoc basis, or via bank-targeting liquidity programs and deposit insurance tweaks, rather than abandoning the inflation-fighting process altogether.

The lagged effect of rising rates

A final small aside: interest rates impact the economy with a lag. While most of the effect is felt over the span of about 18 months, a fraction takes even longer to manifest.

In the case of Canada, with a standard 5-year mortgage term, a key consideration is whether mortgage rates are higher or lower than they were five years before (see next chart). This is the change that people with existing mortgages are facing as they roll into their next mortgage term.

For the longest time, from 2009 to 2017, the new rate was always lower than the old rate. More recently, from 2018 to 2021, the new rate was slightly higher than the old rate. But in the past year, the new rate has now leapt to being more than a percentage point higher than the old rate. Significant monetary tightening is hitting this cohort.

Mortgage rates are higher for renewers

As of 03/08/2023. Source: Bank of Canada, Macrobond, RBC GAM