Photo: BingAI

By Michael O’Neill

“Hot enough for ya?” It has been a popular question for the past few weeks all over North American and in many parts of Europe. And its not just the heat; it’s the humidity.  It’s also forest fires, typhoons and tornados that are wreaking havoc around the globe. The weather news is so bad that if ET had dropped-in on Elliot, he would be calling home urgently, convinced the world was ending.

But it’s nothing new, it happens all the time.  

Historians in Texas, Kansas, and Oklahoma can recount tales of the Dust Bowl heat wave in the early 1930s, which had a devastating impact on the US Midwest and Great Plains. This catastrophic event killed thousands and severely affected agriculture. Around the same time, Australia faced a similar problem with its own severe drought,

Heatwaves occurred in 1972 and in 1976 in Russia and Europe respectively. These events resulted in widespread droughts and water shortages, causing significant challenges for the affected regions.

Hurricanes are another natural phenomenon that regularly wreaks havoc. In 1780, a devastating storm struck the Caribbean, resulting in the tragic loss of approximately 22,000 lives. The Galveston Hurricane of 1900 and the Great New England Hurricane of 1938 caused widespread death and destruction as well.

Back in the day, the heat and the storms were just “bad weather.” Now, they are seen as compelling evidence of climate change.  That is just like  financial market analysts comparing historical data with today and asserting “but this time it’s different.”

It isn’t.

The Bank of Canada’s April Monetary policy complained that inflation in Canada remains too high and that “even though it continues to decline from recent peaks, ongoing excess demand in the economy and a still tight labour market will exert upward pressure on prices.”  Those concerns  forced them off the bench and with a 25 bp interest rate hike, put them back on the tightening path. The BoC has hiked rates by 450 bps since March 2022 and they aren’t done yet.

Those concerns and the likelihood that another rate hike will be needed to drive inflation to its 2.0% target has many economists convinced Canada will experience a recession before year end. Bond traders agree.  The Canada 10-year/2-year yield curve is inverted to the tune of 131 bps (as of July 5), a traditional harbinger of a recession. Falling commodity prices are another indicator.  The BoC Commodity Price Index (BCPI) fell from 881.17 in May 2022 to 587.55, or 33%, a year later.

Recession naysayers need a history lesson.

Source: Bing AI

Canada experienced a nasty recession in the early 1990’s. It was the culmination of an inflation-fighting policy by then BoC Governor John Crow who had hiked the benchmark rate to 21% in 1981, because inflation had hit 12.5%.  Rates declined slowly but these measures led to high unemployment rates, wage freezes, and even wage reductions in some cases. The BCPI index fell by 19% within a year. While there were various other factors contributing to the recession, inflation was at its core.

During that time, Canada faced another challenge—an exacerbated recession due to a significant debt problem arising from large provincial and federal budget deficits. Former Bank of Canada Governor Gordon Thiessen acknowledged this issue in a 2001 speech, stating, “By 1994, it had become clear that Canada could be facing a potentially very serious debt problem. If there was any doubt about that, it disappeared in early 1995 when Canada was sideswiped by the Mexican peso crisis. The Canadian dollar came under strong downward pressure, and interest rates rose sharply across all maturities as investors demanded even larger risk premiums.”

At the time the overall government deficit was close to $45.0 billion. In the period between 1995 and 2000, governments made a concerted effort to rein in spending and balance the budget. The net public debt to GDP ration dropped from around 104% to 80% by the new millennium and the budget deficit turned to a surplus by 2000.

That is not going to happen in Canada any time soon.  How could it? Prime Minister Trudeau famously proclaimed, “I don’t think about monetary policy,” when campaigning in the 2021 election.  He won, but fiscal responsibility suffered as a result.

The Fraser Institute estimates that the total government debt-to-GDP ratio in Canada is 111.6%. However, there is a silver lining: Canada is comparatively better off than other fiscal basket cases such as Greece, Italy, Japan, Portugal, and Spain, which have larger government deficits relative to their economies.

Yet, the haunting melody of the piper can already be heard, and he will want to be paid. This scenario is unfolding in the UK, despite its better financial position than Canada. The aftermath of the pandemic and the energy crisis resulting from the war in Ukraine is expected to drive the UK’s public debt from 103% of GDP in 2022 to 113% by 2028. GBPUSD has declined by 11% since July 2021 and remains in a long-term downtrend.

Canada is not immune to these challenges. Even if USDCAD appears attractive at the moment, the uptrend channel from June 2021 remains intact as long as prices stay above 1.2910.

If you are going to run with the big dogs, history tells you to wear padded pants.