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The Weekly Bottom Line: Optimism on Trade Deal Lifts Markets

U.S. Highlights

  • There was good news in the trade negotiations between the U.S. and China this week as the President announced a postponement of tariffs and China exempted key agricultural goods (pork and soybeans) from existing tariffs.
  • The European Central Bank lowered its key policy rate further into negative territory this week and announced a plan to restart asset purchases that will continue “for as long as necessary” to bring inflation back to target.
  • U.S. core inflation picked up in August and retail sales beat expectations. Even so, the Fed is likely to cut rates by 25 basis points when it meets next week, likely citing global growth and trade headwinds.

Canadian Highlights

  • Housing starts surpassed expectations in August, driven higher by an advance in both single and multifamily units. The uptick in new construction since spring has coincided with an improvement in underlying fundamentals.
  • Household balance sheets strengthened in the second quarter, as both financial and non-financial assets increased. The household debt-to-disposable income ratio fell for a third straight quarter as income growth outpaced debt.
  • Higher interest rates are taking a good bite out of household disposable incomes. However, some relief is likely in the quarters ahead as the recent fall in mortgage rates translates into lower mortgage interest payments.

Financial markets turned optimistic this week on signs of progress in trade talks between China and the U.S. On Wednesday, President Trump tweeted that “as a gesture of goodwill” the tariff hike scheduled for October 1st (moving the rate from 25% to 30% on over $200 billion in Chinese imports) would be postponed until October 15th. China responded by exempting U.S. pork and soybean exports from its 25% agricultural tariffs.

In other Presidential tweets, Trump once again advised the Fed to cut rates, this time adding “to zero or less”. The president cited “no inflation” as justification. Only a day later, the consumer price index (CPI) data for August showed a pick-up in the core rate of inflation (excluding food and energy) to 2.4% year-on-year (y/y), its highest level since the recovery began (Chart 1). On a three-month moving average basis, core prices are up 3.4% (annualized), a noticeable breakout from the past several years. As much as it is a sign that a hot economy, rising prices also reflect the impact of tariffs. Core goods prices were up 0.8% (y/y) in August, the fastest gain in over seven years.

Trump’s admonishment of the Fed came prior to the ECB’s decision on Wednesday to lower its deposit rate by 10 basis points to a new low of negative 0.5%. The ECB’s decision, however, is a reflection not of economic strength, but of weakness. Right on cue, data showed Euro area industrial production pulled back by 0.4% in July. Inflation in Europe is also lower than in the U.S., hovering close to the 1% mark. The serial disappointment on inflation led the ECB to announce a plan to leave rates unchanged “until it has seen the inflation outlook robustly converge” to its target. President Draghi, in his press conference, said that the ball is now in fiscal policy’s court and expressed hope that governments would respond with additional spending to support the economy and return inflation to target.

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Turning back to the U.S., the President won’t have to wait long for the next interest rate decision. The Federal Open Market Committee (FOMC) meets next week and will likely deliver a 25-basis point cut. The FOMC is likely to look through the tariff-related increase in consumer prices, but with an unemployment rate at 3.7% there is little at present to motivate a full-blown cutting cycle. The meeting will come with updated economic projections. Perhaps even more than its near-term forecasts, we’re looking for the migration in the Fed’s long-term projections for the fed funds rate and the unemployment rate, which may validate at least some of the decline we’ve seen this year in bond yields and provide a sense of where policy may land in the coming months and quarters.

With inflation showing a bit more momentum and signs that an ever-worsening trade war may not be the most likely outcome, bond investors may be starting to reassess just how low the Fed will go. Yields have rebounded through the month of September (Chart 2) and providing the economy can avoid a recession, some further increases may still be ahead.

With the election writ drawn up this week, news headlines over the next five weeks will be increasingly dominated by electoral promises leaving economic indicators likely to play second fiddle. Nevertheless, in an era where a single tweet can shift market sentiment from boom to gloom it’s important to keep track of the pulse of the Canadian economy as suggested by the flow of indicator data.

This week’s data showed a Canadian economy that has rebounded to a healthy pace of expansion in the middle of this year. Booming new residential construction is helping lead the way. About 227k units were started in August, mostly multifamily units. Single-detached home starts continued to stage a rebound after slumping earlier in the year. The advance was generally broad-based, with all regions experiencing an improvement except British Columbia, which saw starts pullback after several months of strength. Overall, it appears that the lull in new residential construction following the B-20 regulations at the start of 2018 is now in the rearview mirror.

Unsurprisingly, the uptick in new construction this spring has coincided with an improvement in the fundamental drivers of housing demand. Employment and income growth have outperformed expectations, population growth has been robust, and borrowing costs have decreased. Looking at the gap between residential housing permits and new construction it appears that the recent uptick in new construction has more room to run (Chart 1). With demand conditions improving, it’s good to see hou