Source: Flickr

By Michael O’Neill

Financial markets appear to have an optimistic view of the future.

The evidence is undeniable. The US dollar index is 2.8% lower than where it started the year, the Nasdaq has soared 19.9% and the S&P 500 index (the favourite risk-sentiment barometer) has gained 8.3%. Fears of higher US interest rates have faded with the US 10-year Treasury yield dropping from 3.87% January 2 to 3.60% on April 19.

But the world isn’t pretty, even if traders think differently. 

Chinese President Xi Jinping may not aspire to world dominance (yet), but he is aggressively trying to usurp and neutralize the influence of the United States in world events. He has weaponized the South China Sea, supported Russia in its war on Ukraine, befriended US arch-enemy Iran, and cozied up to Opec. He is also spreading billions of dollars in financial aid and trade deals in South America, an area the American’s used to believe, was in its sphere of influence.

China does not fear a military conflict with the US.  Just a week ago, they demonstrated as much by using “military and naval exercises” to encircle Taiwan. Then to top it off, Chinese officials couldn’t be bothered to take a call from US Defense Secretary Lloyd Austin to discuss Chinese spy balloons.

The Group of 7 nations ended a meeting in Japan on April 18 with a statement proclaiming their unity.  It said, “We reaffirm our intention to promote human security and continue building a global community that leaves no one behind. We call on all partners to join us in addressing these pressing global challenges and to work together to build a better, more prosperous, and more secure future.

The French Minister for Europe and Foreign Affairs probably signed with her fingers crossed. Her boss, Emmanuel Macron, doesn’t necessarily agree.  He said that Europe should avoid being drawn into a conflict over Taiwan, which is like the appeasement tone adopted by Vichy-France Marshal Philippe Petain, who collaborated with Nazi German occupiers in WW ll.

Opec, led by Saudi Arabia, is another cabal of countries shunning US influence.  Saudi Arabia ignored US President Biden’s request to increase production to help prevent an inflation spiral from higher oil prices. 

 Instead Opec announced production cuts of 1.665 million barrels/day effective June 1.  Even worse for America, the Saudis are reportedly close to joining the Shanghai Cooperation Organization, which is led by China and includes Russia, India, and Pakistan.

China is a big destination for discounted Russian crude, bypassing Western sanctions. Many European countries ignore the breach because they do not want to jeopardize Chinese investments or trade..

Traders can’t see the forest through the trees.

Source: Pixabay

The Bank of Canada is one of them.

“Hark” the herald angels sing.  Glory to the inflation fighting king.”

On April 18, Bank of Canada Governor Tiff Macklem addressed the House of Commons Standing Committee on Finance, against a backdrop of media headlines shouting, “Canada’s annual inflation rate cools,” “inflation falls for fifth straight month”, and “CPI drops below 5% for the first time in more than a year.” Cue the applause.

Mr Macklem told the MP’s that inflation is coming down quickly, noting it fell to 4.3% in March and predicted it would be around 3.0% this summer.  Keep in mind, when Macklem says summer, he isn’t necessarily pointing to July or August.  It could be near the end of September.

He also said inflation would drop to the 2.0% target by the end of 2024. That is still close to 2 years from today, and the BoC does not have a great forecasting record.

Sceptics will also point out that Mr Macklem failed to comment on what he often refers to as, “the bank’s preferred measures of core-inflation.” Why not?

Perhaps the magnitude of the Core-inflation decline was not viewed as “headline worthy,” as prices only fell 0.3% in March, from 4.8% to 4.5% y/y.

Another reason is because of the BoC’s preferred inflation indicators.  Two of the three measures of seasonally adjusted core inflation measures rose, according to Scotiabank.

The BoC believes that the risks to its inflation forecasts are balanced but they remain more concerned about the upside risks.

They should be.

USDCAD could retest its 2023 peak if the BoC leaves rates unchanged and the Fed continues to hike. The interest rate differential in favour of the US would boost the greenback.  A weaker Canadian dollar is inflationary as it raises prices for imports, and it would make the BoC’s inflation fighting task a tad more difficult.

Geopolitical rebalancing and the risk of sharply higher oil prices would certainly tarnish the current optimistic economic outlook.

It won’t be pretty, and it won’t look that way.