To my clients:

It was an up week for North American stock markets with the Canadian TSX finishing up 0.4%; the U.S. Dow Jones Index finishing up 1.3%; and the U.S. S&P 500 finishing up 2.6%.

Before getting to my commentary let me add that this week also saw a notable decline in the value of the U.S. dollar which lessened the value of U.S. client holdings. Discretionary clients have significant U.S. exposure. Further, our portfolio valuations here at RBC Dominion Securities are typically reported in Canadian dollars so, while there were gains across the board for client accounts this week, these gains were offset materially from the decline in the value of the USD.

The big news this week was that after ten consecutive meetings where rates were raised (by a total of 5.0%), the U.S. Federal Reserve opted NOT to raise rates this time around. That’s the good news. The “bad” news (if indeed it can be considered “bad” – more on that below) was that the average expectation of board members was that two more 0.25% rate increases were expected BEFORE year end which represents an INCREASE vs. prior expectations. Indeed, this is a strange dichotomy where, on the one hand, the Fed chooses to skip a rate increase in the here and now, yet opts to become incrementally more prone to raising rates on the other hand. Stranger still is that the markets had a strong up week (the US dollar notwithstanding) in the face of an incrementally – and supposedly - more aggressive Fed. What’s going on here?

Let me preface my comments by suggesting that the market reaction likely aligns with my own take on matters, namely that market participants don’t believe the Fed will follow-through on this more aggressive guidance. And here it is important to keep in mind that one of the tools at the Fed’s disposal is the power of its own words: “jawboning” so to speak. The words of the Fed can set the tone for market activity, and by suggesting that rates are likely to rise further by year end it is the belief of myself and others that, at the very least, this limits the propensity of market participants to begin pricing in the opposite - rate CUTS. In other words, it is my belief that the Fed is attempting to set the stage for rates to at least remain at current levels for an extended period. But why do I and others believe this to be the case? Let’s look further.

First, economy-wide inflation is undeniable coming down. This week saw the most widely followed inflation measure – the Consumer Price Index – fall all the way from 4.9% year-over-year in May to 4.0% year-over-year in June. Given the way this measure is calculated, the year over year rate is all but assured to fall even further all the way to the low 3’s in July.

Second, the Producer Price Index (i.e. what manufacturers pay for the materials that go into consumer goods), which is considered a leading indicator for economy wide consumer inflation, is actually at 1.1% year-over-year! That’s right now! This is below the Fed’s 2.0% target!

Third, the “yeah but” crowd will point to core inflation (which strips out the volatile up and down effects of food and energy prices) which is still running at 5.3% year-over-year. On the surface this is admittedly concerning. HOWEVER, one must remember that housing costs make up almost half of the core inflation measure and that historically there has been a statistical lag of about 6 to 12 months in the official CPI data! Real time housing cost measures such as the Zillow Observed Rent Index have been showing a sharp deceleration in housing price increases since February 2022. The official CPI data only began turning down in March 2023 (in fact a 13-month lag!). Interestingly, the Fed is well aware of this lag, with Jerome Powell himself saying in a November 30, 2022 speech to the Brookings Institute that:

“Housing inflation tends to lag other prices around inflation turning points… (real -time) measures of 12-month (housing) inflation have been falling sharply since about midyear [2022].”

And fourth, the Fed’s forward rate expectations (as measured by the so-called “dot plots”) are not particularly reliable. For example, at the end of 2021, 16 of 18 Fed Board members saw rates by the end of 2022 at under 1.0%. The two remaining members saw year ahead rates at 1.25%. In fact, rates ended 2022 at over 4%!

Given all of the above, I have a hard time squaring the forward Fed guidance with the facts on the ground. And stock market reaction seems to agree with me. In fact, so do the currency markets. All else being equal, currencies such as the U.S. Dollar should go UP if there are expectations for higher interest rates because the demand for higher risk-free interest on U.S. will likewise go up. But the opposite happened this week.

Of course, I could be wrong in all of the preceding. It won’t be the first time. We will know soon enough because the next Fed meeting is in July. Prior to that meeting, we will have one more set of Consumer Price and Producer Price inflation data also. I suspect that inflation data will be quite instrumental in shaping the Fed decision that would soon follow.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Senior Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
Toll Free: 1.844.665.9900 │Email: nick.scholte@rbc.com

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