PrefBlog

Well, here’s a paper that will receive some attention! One of a long series, I’ll bet … The 2021–22 Surge in Inflation by Oleksiy Kryvtsov, Jim MacGee and Luis Uzeda:

The rise in inflation in 2021–22 sparked a growing literature and debate over the causes of the surge as well as the near- and medium-term path for inflation. This review offers three key messages. First, the exceptional nature of shocks resulting from the COVID-19 pandemic and geopolitical events drove the surge in inflation and the initial underestimation by many central banks of the extent of inflationary pressures. Second, the pandemic may have
accelerated structural changes in goods and labour markets, which are likely to put pressure on goods prices and wages in the medium and long term. Third, the resulting shifts in relative prices for goods, services and labour are unlikely to be large enough to threaten a return of inflation to target but may require somewhat higher interest rates than those in the decade before the pandemic.

My favourite chart is:

TXPR closed at 576.60, down 0.65% on the day. Volume today was 1.21-million, near the median of the past 21 trading days.

CPD closed at 11.47, down 0.78% on the day. Volume was 93,580, slightly below the median of the past 21 trading days.

ZPR closed at 9.525, down 0.16% on the day. Volume was 171,820, well below the median of the past 21 trading days.

Five-year Canada yields were were down to 2.90% today.

The preferred market was weak all day, but it was a late day collapse that did the damage in our sector. More generally, pundits blamed earnings:

The S&P 500 ended nominally lower on Wednesday as a string of corporate earnings ran the gamut from downbeat to dismal, reviving worries over the economic impact of the U.S. Federal Reserve’s restrictive policy. The TSX also closed with a modest loss, as market players took in what could be the final Bank of Canada rate hike for this monetary tightening cycle and began aggressively pricing in the possibility of interest rate cuts before year end.

The S&P/TSX Composite index and all three major U.S. stock indexes pared their losses throughout the afternoon to close well off session lows, with the blue-chip Dow eking out a small gain in the final minutes.

The tech-laden Nasdaq was weighed down after Microsoft Corp, the first major technology firm to post quarterly results, offered dour guidance and raised red flags with respect to its megacap peers which have yet to report.
…
Interest rate probabilities show about 89% odds of the bank making no change to its overnight rate at its next announcement on March 8, according to Refinitiv Eikon data.

But following the bank’s 10 am announcement and Monetary Policy Report, credit markets started making their most aggressive bets yet that the central bank’s key lending rate will start coming down later this year as the bank shifts from inflation fighting to providing support to a slowing economy. They are now fully pricing in a 25 basis point cut by the Oct. 25 Bank of Canada meeting. And they are positioned for an overnight rate of 4.07% by the Dec. 6 meeting. That implies money markets are getting close to pricing in a 50 basis point cut in the overnight rate by the end of this year.

PerpetualDiscounts now yield 5.99%, equivalent to 7.79% interest at the standard equivalency factor of 1.3x. Long corporates yielded 4.89% on 2023-1-20 and since then the closing price has changed from 15.51 to 15.59, an increase of 52bp in price, with a Duration of 12.36 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies a decline in yield of about 4bp since 1/20 to 4.85%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed to about 295bp from the 305bp reported January 18.

Here’s a few more interesting papers on the inflation risk premium, for those who have been clamouring for them. At some point I hope to highlight them properly, but for now I just want to store the links, because finding them was a pain.

• Inflation risk and the inflation risk premium, Geert Bekaert and Xiaozheng Wang
• ESTIMATING INFLATION RISK PREMIA USING INFLATION-LINKED BONDS: A REVIEW, Alexander Kupfer
• The impact of liquidity on inflation-linked bonds: A hypothetical indexed bonds approach, Julia Auckenthaler, Alexander Kupfer, Rupert Sendlhofer
• Accounting for Low Long-Term Interest Rates: Evidence from Canada, Jens H. E. Christensen, Glenn D. Rudebusch, Patrick J. Shultz

Update, 2023-1-25: I was interested in the claim by Kupfer in the second link that:

For the United Kingdom, a publication by the Debt Management Office reveals that ILBs ‘have led to a significant reduction in the cost of funding’ (UK Debt Management Office, 2001, p. 39)

… so I looked up the reference:

Index-linked gilts have proved a valuable addition to the Government’s portfolio. In addition to increasing the diversity of the portfolio, index-linked gilts have led to a significant reduction in the cost of funding. This has partly been due to the reduction of inflation risk but more importantly because of the fact that market expectations of inflation have exceeded the inflation outturn for much of the last 20 years

Nice article titled Inflation risk and the inflation risk premium by Geert Bekaert and Xiaozheng Wang

Another interesting paper was Residential Mortgage Securitization in Canada: A Review by Adi Mordel and Nigel Stephens, which showed that the outstanding amount of Canada Mortgage Bonds at the end of 2015 was about $200-billion, whereas slightly under 50-billion of RRBs were outstanding at that time (this consultation paper also had good charts regarding liquidity).

TXPR closed at 580.07, down 0.53% on the day. Volume today was 2.68-million, highest of the past 21 trading days.

CPD closed at 11.53, down 0.60% on the day. Volume was 230,170, second-highest of the past 21 trading days.

ZPR closed at 9.56, down 0.42% on the day. Volume was 188,630, well below the median of the past 21 trading days.

Five-year Canada yields were shot up to 2.94% today.

Equities did well. Pundits sounded a little at loss for words:

The S&P/TSX Composite index rose 161.77 points, or 0.80%, to 20,503.21. The tech sector rose 2.4%, with most sectors higher. After a bumpy week of trading, the Canadian benchmark was nearly unchanged.

Comments from Federal Reserve officials have largely said they expect interest rates to climb to at least 5% this year as the central bank continues to try and tamp down high inflation. On Friday, Fed Governor Christopher Waller said the central bank may be “pretty close” to a point where rates are “sufficiently restrictive” to cool inflation, which gave an additional boost to equities.

The Fed is largely expected to raise rates by 25 basis points (bps) at its Feb. 1 policy announcement.

Still, concerns about corporate earnings persist as the U.S. economy shows signs of a slowdown and a possible recession.

Analysts now expect year-over-year earnings from S&P 500 companies to decline 2.9% for the fourth quarter, according to Refinitiv data, compared with a 1.6% decline in the beginning of the year.

Gains on the Dow were curbed, however, by a 2.54% fall in shares of Goldman Sachs Group Inc after the Wall Street Journal reported the Fed was probing the company’s consumer business.

They should have said “bargain hunting”. When the market goes up after a few down days, it’s always “bargain hunting”.

US retail sales were poor in December:

Retail sales fell in December, highlighting how consumers’ concerns about inflation became the defining factor of the holiday shopping season.

U.S. retail sales fell 1.1 percent from the month before, the Department of Commerce said on Wednesday. While the data is adjusted for seasonal variations, it does not account for price changes, and inflation continued to ease during December, which would have contributed to the decline.

Retail sales in November were also revised to show a fall of 1 percent from October, worse than the 0.6 percent decline originally reported.

Sales were down in December at popular holiday shopping destinations like electronics stores, car dealerships and clothing outlets. Department stores posted a 6.6 percent decline from the previous month.

… and bond yields gapped lower:

Stocks and bond yields fell on Wednesday after weak U.S. economic data rekindled fears about a looming recession, snapping an eight-day winning streak for the TSX. While equity losses were minor in Canada, it was the worst day in more than a month for the S&P 500 and Dow Jones Industrial Average.

Moves were particularly notable in credit markets, where the benchmark U.S. 10-year Treasury yield fell 16 basis points to its lowest level in four months. Canada’s five-year government bond yield – a key indicator for where fixed mortgage rates are heading – fell to its lowest level since last August.

By late afternoon, Canada’s five-year bond was yielding 2.809%, down about 12 basis points. Last October, it was yielding close to 3.9%.
…
U.S. producer prices also fell more than expected in December as the costs of energy products and food declined, offering more evidence that inflation was receding. Canadian producer prices were also lower in December. They fell 1.1% from the previous month, while the annual rate of growth eased to 7.6% from 9.4%. This follows data on Tuesday showing that consumer prices in Canada rose at the slowest annual pace since February last year.
…
A Fed report on Wednesday also showed that there were some encouraging signs U.S. inflation pressures and labour shortages were easing, but economic activity was tepid as the central bank’s actions weigh on growth.

St. Louis Fed President James Bullard and Cleveland Fed President Loretta Mester on Wednesday stressed on the need to raise rates beyond 5% to bring inflation to heel.

And late in the afternoon, Philadelphia Federal Reserve President Patrick Harker said that he expects the Fed to raise rates a few more times this year although he reiterated earlier comments that he’s ready for the U.S. central bank to move to a slower pace of rate hikes due to signs of cooling inflation.

The Fed commentary also highlighted the disparity between the U.S. central bank’s estimate of its terminal rate and market expectations, which were of the rate peaking at 4.88% by June.

Traders are pricing in a lower rate than Fed officials are signaling as they question whether the U.S. central bank will continue to hike or hold rates at restrictive levels if the economy suffers. Traders are now betting on a 25-basis point rate hike in February.

… and UK inflation was off its peak, but still high:

The rate of inflation in Britain slowed for a consecutive second month in December, but was still running in the double digits, maintaining a tight squeeze on household finances.

Consumer prices rose 10.5 percent in December from a year earlier, down from 10.7 percent the previous month, with rising food prices and prices at hotels and restaurants offsetting lower gasoline and clothing prices, the Office for National Statistics said on Wednesday. Food and nonalcoholic drink prices rose 16.8 percent in December from a year earlier, slightly faster than the previous month.

The overall declines come after inflation hit a 41-year high in October, at 11.1 percent.

PerpetualDiscounts now yield 6.00%, equivalent to 7.80% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.11% on 2023-1-6 and since then the closing price has changed from 15.04 to 15.67, an increase of 419bp in price, with a Duration of 12.24 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies a decline in yield of about 34bp since 1/6 to 4.77%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened slightly (and perhaps spuriously) to about 305bp from the 300bp reported January 11.

Canadian inflation was OK:

Canada’s inflation rate eased in December, thanks largely to a plunge in gasoline prices, in what is an encouraging sign for the Bank of Canada as it mulls further increases in interest rates.

The Consumer Price Index (CPI) rose 6.3 per cent in December from a year earlier, down from a 6.8-per-cent pace in the previous month, according to figures published Tuesday by Statistics Canada. Financial analysts were expecting an inflation rate of 6.4 per cent.

Consumer prices fell 0.6 per cent during the month of December, highlighted by a 13-per-cent plunge for gasoline, its largest decline since the early stages of the COVID-19 pandemic.

Excluding food and energy – two of the more volatile components of CPI – prices rose 5.3 per cent on an annual basis, a slight deceleration from 5.4 per cent in November.
…
There were signs of weaker consumption in Tuesday’s report. Price growth for durable goods is slowing quickly. For example, the cost of household appliances fell 4.1 per cent in December, the largest month-over-month decline on record. Furniture price growth is also decelerating.
…
At the same time, there are sticky aspects of inflation. Grocery prices rose 11 per cent in December on an annual basis, down from 11.4 per cent in November. Those prices are still growing near the highest rates in several decades, an ongoing frustration for consumers.

Mortgage interest costs have jumped 18 per cent over the past year, on account of the rapid rise in borrowing rates. (Some costs related to housing are declining.) Statscan also noted that prices for personal care supplies – including soap, cosmetics and other products – have risen by 9.9 per cent on an annual basis, the quickest pace of growth in nearly four decades.

The New York Fed’s SCE Household Spending Survey was consistent with all this:

• The median reported year-over-year increase in monthly household spending declined to 7.7 percent in December, down from its series high of 9.0 percent in August 2022. The decrease was broad-based across age, education, and income groups.
• The share of households that reported making a large purchase over the past four months decreased from 61.7 percent in August to 56.4 percent in December. While the share of those making large purchases on home appliances, electronics, and furniture rose in December, the share spending on vehicles, home repairs, homes, and vacations fell.
• The median expected monthly overall spending growth over the next twelve months declined to 4.0 percent from 4.4 percent in August, its lowest reading since April 2021. The decrease was most pronounced for those with household incomes over $100,000.
• The median expected year-ahead change in everyday essential spending (that is, daily living expenses) dropped from 5.6 percent in August to 5.2 percent in December, its lowest reading since April 2021, but above its pre-COVID levels. The median expected change in non-essential spending also declined from 1.8 percent in August to 1.7 percent in December.
• The average reported likelihood of making a large purchase over the next four months increased for home appliances and electronics, but decreased for furniture, home repairs, vacations, vehicles, and homes.