The Weekly Bottom Line: Happy-Go-Lucky Fed Presses On With Rate Hikes

U.S. Highlights

• Economic data was a mixed bag this week: retail sales were a bright spot, but housing starts unexpectedly plunged in June.
• Trade developments continued to make headlines, with Donald Trump announcing he was prepared to extend duties on $500bn of imports from China – roughly the value of all China’s imports into the U.S.
• In his testimony to Congress, Fed Chair Powell offered an upbeat view of the U.S. economy, and noted that the risks posed by trade protectionism would not push them off course on further rate hikes.

Canadian Highlights

• It was a good week for Canadian data releases, with positive surprises in retail, manufacturing, and housing, affirming last week’s upbeat tone set by the Bank of Canada.
• Existing home sales were particularly positive, and, taken together with last week’s housing starts, support the view that the housing market is gradually stabilizing following the implementation of B-20 guidelines.
• The U.S. announced that it will probe tariffs on uranium imports, increasing already-heightened global trade uncertainty risks.

Economic data was a mixed bag this week. While May’s retail sales were a bright spot, housing starts unexpectedly plunged in June. Trade policy developments also remained top of investors’ minds: Angela Merkel spoke strongly against tariffs, while Donald Trump ramped up his protectionist rhetoric, saying he was prepared to extend duties on the full $500bn of imports from China. He also criticized the Fed’s interest rate hikes, and the strong U.S. dollar – leading to modest greenback selloff.

While the threat of further trade tariffs continues to pose a substantial downside risk to U.S. and global growth, for the time being the U.S. economy is moving full steam ahead. In June, retail spending rose by a robust 0.5%, on top of a substantial upgrade to May’s data, as consumers continued to hit stores and restaurants in masses. One of the categories that saw strong growth was spending on restaurants and eating out (+1.5% m/m), accelerating to 8% y/y – the fastest pace since August 2015. The pickup in spending in this largely-discretionary category is a testament to strong momentum in consumer spending. Indeed, for the second quarter as a whole, nominal retail sales were up nearly 8% annualized (versus 1.8% in Q1) (Chart 1), suggesting that even adjusting for inflation, second quarter consumer spending is set to come in above 3% (annualized) in next week’s GDP release.

The upbeat view of the domestic economy was further echoed by Fed Chair Powell this week. In his semi-annual testimony to Congress he noted the strong labor market, rising after-tax incomes, and healthy growth in business investment. He also praised progress on the inflation front, and somewhat downplayed the risk stemming from trade protectionism noting that “the risks to the outlook were roughly balanced”. He concluded, that “the FOMC believes that, for now, the best way forward is to keep gradually raising the federal funds rate.” In other words, current trade risks are not enough to derail the Fed from hiking rates on a quarterly basis.

The U.S. economy continues to be red-hot, but this pace of expansion will be hard to sustain going forward as it starts to bump against capacity constraints, particularly on the labor front. Higher material prices, wages and shortages of labor in some sectors featured prominently in the latest Beige Book.

The construction industry is one sector facing these headwinds, with prices of lumber and steel rising precipitously following the tariffs. While homebuilders’ optimism remains quite high, housing starts fell by 12.3% m/m in June – the largest decline since November 2011. (Chart 2). The bulk of the pullback was seen on the multifamily side (-20% m/m), with more moderate decline in single-family starts (- 9.1%). The large decline on the multifamily side could be reflective of the changing housing market dynamics, with demand rotating away from rental units. Next week’s release of both new and existing home sales should shed more light on the health of the housing market, particularly on the demand side.

This was a good week for Canadian data, with releases on manufacturing, retail, and existing home sales, as well as consumer price inflation all surprising on the upside.

Existing home sales kicked off the release schedule, moving up 4.1% in June, with the relatively broad-based increase erasing much of the losses in the previous month. Taken together with last week’s housing starts release, this confirms expectations of a stabilizing housing market following the implementation of B-20 guidelines.

Manufacturing sales also showed a broad-based rebound of 1.4% in May, offsetting April’s disappointing performance. Even more encouraging, retail sales growth came in at 2.0% for May, significantly exceeding expectations and suggesting healthy wage gains are making their way into household spending. With retail and manufacturing sales recently subjected to one-off factors (weather, temporary refinery outages), this paints a reassuringly healthy picture of their underlying trend this quarter.

Finally, CPI came in slightly above expectations as headline inflation accelerated to 2.5% (year-on-year) from 2.3% in May – the fastest pace since early 2012. The average of the Bank of Canada’s core measures, meanwhile, remained at its 2.0% target. The CPI-Common core measure held steady at 1.9%, while the other two core measures edged up to 2.0% (from 1.9% previously).

All told, the data this week paint a positive picture of Canadian economic growth, and support the notion that activity is bouncing back from its soft performance early in the year. Indeed, with the releases this week, we anticipate real GDP growth to advance at a solid 2.9% in the second quarter, in line with the Bank of Canada’s recently-updated forecast.

The case for cautiousness on further rate hikes continues to lie in the risk management framework of Governor Poloz. As long as the threat of a further escalation of trade wars looms on the horizon, we expect the Bank to keep the pace of hikes very gradual.

Accentuating lingering trade uncertainties was an announcement from the United States Commerce Department this week, of a probe into uranium imports using the same national security lens used to justify tariffs on steel and aluminum. With the potentially impacted value of goods at 0.2% of the country’s total merchandise goods exports, its magnitude comes in at less than those already imposed on steel and aluminum, and much less than the more worrying auto tariff investigations. If implemented, however, their effects would be more regionally concentrated.

Looking at OIS-implied probability of rate hikes confirms the absence of a pre-determined path for rate hikes. The odds of an October hike are still divided at the 55% mark (as of 10:30 am this morning), moving up only modestly following the releases this week.