ACTV - High U.S. Bond Yields: What It May Mean For The Fed And Markets

2023-10-24 14:48:00 ET

Summary

• What growth surprises mean for interest rates.
• Why consumer spending trends are making the Fed's job harder.
• Divergence trends emerging in the bond market.

U.S. Treasury yields have reached highs not seen since 2007. Alexandra Gorewicz, Vice President & Director, Active Fixed Income Portfolio Management at TD Asset Management, speaks with Kim Parlee about the broader implications and what it could mean for interest rates.

Transcript

Kim Parlee: US consumers continue to show their resilience. The latest retail sales numbers for September came in much stronger than expected. The results were a big reason US bond yields climbed all the way back up to their 16-year highs. So what does that mean for the Fed and interest rates? Alexandra Gorewicz is Vice President and Director of Active Fixed Income Management, Portfolio Management at TD Asset Management. She joins me now in the studio. Nice to have you here.

Alexandra Gorewicz: Thank you. That's quite a title, right?

Kim Parlee: It's quite a title. There's a lot to say there. Let's talk a bit about some of these growth surprises that we're seeing in the economy and maybe just explain why we're seeing them and maybe what the ongoing impact is going to be.

Alexandra Gorewicz: Yeah, it's really tough to pinpoint the why. So it'll seem like a bit of a wishy-washy answer, but, actually, there's a behavioral component here. And what I mean by that is, relative to the spending patterns, relative to the budget patterns that we used to expect before the pandemic, we've now seen a bit of a shift.

So households, for example, are happy to spend more and save less despite this high level of interest rates. And, similarly, the US government is running significant budget deficits given the strength of the economy. And so if you think about the high level of consumption that we're seeing in the US economy, companies are saying, okay, well, I'm happy to proactively pass on higher prices to consumers.

And so the entire -- call it -- inflation picture for the future looks a little murky. And bond investors are saying, we don't know how long this is going to last. We don't know where it ends. We should probably be charging borrowers higher interest rates, higher prices toward borrowing.

Kim Parlee: To try and stop that kind of spending. One thing -- just maybe explain it to me. Because traditionally, one would think from a behavior standpoint is if, just to think of myself, if I am paying more in interest on debt, I have less money to spend on other things, but what you're saying is we're seeing consumers and government at that level going further into debt to continue to maintain or even grow some of that spending.

Alexandra Gorewicz: Yeah, that's right. So if you're the central bank, the logic response to raising rates as quickly as you have over the last 12 to 18 months would be that you expect people in the economy, whether it's the private sector or the public sector, to save more, spend less, and perhaps even pay down their debt, delever. And we're not seeing that.

Now, for what it's worth, it's a little bit more of a US phenomenon. It has some sort of unique American characteristics to it because if we look here at home through the retail sales numbers over the last couple of months and just the -- some of the GDP-influencing numbers, we're seeing a lot softer data. We're seeing a lot less spending.

And, actually, if we look at other economies like UK and Europe, their retail sales are negative, and their GDP is even softer. So you're starting to see some divergences here. This is not necessarily a one-size-fits-all analysis about this uber-spending behavior.

Kim Parlee: If we look at the States, though, I mean, one of the things I know we've been talking about with you and others for a long time is that the amount of incredibly stimulative government spending that's coming out as they reshore, bring chips back, all that good stuff -- reshoring in general -- that's so stimulative. And that supports the consumer, I'm sure. You think about more jobs coming back or those types of things. So when -- do we know when, when we think things might slow down? Or what are you going to look for to see that we're starting to see some cracks?

Alexandra Gorewicz: I think it's also important to highlight that the high budget deficits -- call it the eye-popping budget deficits in the US, especially relative to other economies, by the way. We are running budget deficits here in Canada or again in Europe but not to the same degree as the US.

And if we look at what has happened in the US, it's not just all been from spending. It's actually been from higher interest costs because interest rates have risen. And the government hasn't responded by cutting its spending. It's maintained its level of spending but now spending even more money, growing the debt pile just to service its existing debt.

So that part we have to take with a grain of salt in terms of how stimulative it actually is for the economy. And then it's probably more important to pay attention to companies to figure out the durability of the consumer, of the households' ability to continue consuming and spending at the level that they have.

And that's really through the labor market. So if the labor picture turns, if it softens, if some people start losing their jobs, that's where I think there would be some significant headwinds to the spending we've seen to date.

Kim Parlee: We see little headlines here and there of cuts here and a little cut here, but it's interesting, again, do you have a thought in terms of next year when we're going to start to see things really start to get a bit more real, I guess, on the economic standpoint?

Alexandra Gorewicz: Again, it's hard to say. If you had asked me at the beginning of this year, I wouldn't have anticipated that labor strength would have been quite as strong as it has been. And we did see, for example, some layoffs, quite a few layoffs, actually, in the tech sector, but that didn't necessarily spread to other sectors of the economy.

However, what is really going to be interesting about this earnings season -- it's pretty early on in terms of corporate earnings. We're only about 10% to 15% of the way through, whether we're talking about Canada or the US.

But what we saw in the last earnings season is that interest coverage ratios are now starting to deteriorate. In other words, interest is rising a lot faster than, let's say, earnings or profitability and that could in the coming quarters, if that trend is going to increase, that could start to be quite a bit of a headwind for the labor market.

Kim Parlee: Yeah, yeah and especially, I guess, for companies with lots of debt, they're going to really start to look at that the same time, right?

Alexandra Gorewicz: Correct, because we haven't seen that deleveraging en masse the way that one would have expected to based on how much monetary policy has tightened.

Kim Parlee: We have Jay Powell coming, I think, in November, I think is the next time we hear from the Fed, but Bank of Canada next week. And the Bank of Canada has made some comments somewhat about just the inflation they're seeing being passed on to consumers, but what are you expecting to hear from them?

Alexandra Gorewicz: If we look at the inflation print that we got earlier this week, core inflation in particular maybe was a little bit softer than the consensus across economists. However, when we annualize inflation that we've seen throughout the third quarter, it is running above the Bank of Canada's forecast that they had in their July monetary policy report.

That's problematic in the sense of there are headwinds. We talked about soft retail sales, soft GDP in Canada. Bank of Canada's acknowledging that, that could be an issue particularly for the labor market in the coming quarters, but at the same time, companies are still passing on high prices to consumers, again, because consumption is still holding on.

Kim Parlee: It's strong.

Alexandra Gorewicz: It's still strong, again, softer --

Kim Parlee: Weakening, but strong.

Alexandra Gorewicz: Weakening, softer than the US, but still strong. And so Bank of Canada is going to be measured in terms of all of these sorts of competing forces that are suggesting. They don't need to go further in terms of hiking interest rates, but they probably should maintain that optionality just in case.

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