Investors Fears and the Fall of Bond Yields Seem Exaggerated

DECEMBER, THE YIELD CURVE Investors Fears and the Fall of Bond Yields Seem Exaggerated HIGHLIGHTS ff Growing doubts about the health of the global economy have caused bond rates to fall sharply in recent weeks. ff Confidence indexes and leading indicators in the United States are completely at odds with the prospect of a sharp slowdown. We therefore expect the (Fed) to order another rate hike on December 9, and to keep its tone positive, signalling that monetary tightening will continue. While the federal funds rate is starting to move closer to the neutral zone, the Fed could nonetheless confirm that future rate hikes will be less automatic and more reliant on the economic backdrop. ff is likely to end amid a host of concerns, but we expect the markets to acknowledge the health of the U.S. economy and the abundant supply of bonds. Longer term yields should thus resume their uptrend. ff In Canada, headwinds are forcing the Bank of Canada (BoC) to slow the pace of monetary normalization. The BoC should nevertheless be able to order two rate increases next year, once the dust settles. CONTENTS Highlights and Editorial... Monetary Policies... Bank of Canada... 4 Overseas Central Bank... Bond Market United States... 6 # BEST OVERALL FORECASTER - CANADA The stock market correction in the last few months was largely triggered by surging bond yields, as the U.S. year yield reached.% at the start of October. Initially, this correction thus had a limited effect on bonds yields, especially since a number of central banks seemed to see the return of volatility as a predictable and even desirable consequence of monetary policy normalization. Things have changed in recent weeks, however, with fears about higher interest rates gradually giving way to growing doubts about the health of the global economy. Worrisome economic data, including disappointing third quarter growth in Japan and the euro zone and weak housing data in the United States, are fuelling fears of a sharp global economic downturn. Plunging oil prices, with price of WTI (West Texas Intermediate) falling from more than US$7 a barrel in early fall to about US$ recently, also fed into investors concerns while suggesting weaker inflation. In this environment, bond yields plummeted, with U.S. and Canadian year yields declining about 4 and basis points, respectively, compared to their levels in early November. This resulted in a significant flattening of the yield curve, and even a slight inversion among some maturities (graph on page ), which some view as further proof that a recession is imminent. A vicious cycle seems to have settled on the financial markets, with falling stock markets, interest rates and oil prices feeding investor pessimism, leading to further declines for these market variables. Canada... 7 Tables Key Rates... Fixed Income Market... Schedule of Central Bank Meetings... 9 François Dupuis, Vice-President and Chief Economist Mathieu D Anjou, Deputy Chief Economist Benoit P. Durocher, Senior Economist Francis Généreux, Senior Economist Jimmy Jean, Macro Strategist Hendrix Vachon, Senior Economist Desjardins, Economic Studies: 4 6 or 66 66 7, ext. 6 desjardins.economics@desjardins.com desjardins.com/economics NOTE TO READERS: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively. IMPORTANT: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright, Desjardins Group. All rights reserved.

GRAPH Long-term yields down sharply in recent weeks U.S. federal rate curves In %... November 6, End of 7 -year -year -year -year Current curve -month We therefore expect the Fed to order another rate hike on December 9, and to keep its tone positive, signalling that monetary tightening will continue. While the federal funds rate is starting to move closer to the neutral zone, the Fed could nonetheless confirm that future rate hikes will be less automatic and more reliant on the economic backdrop. We will have to keep a close eye on the number of rate increases signaled for 9, given the possibility of a decrease in the median forecast to just two % increases. This could be viewed by some investors as a first sign that the Fed is backtracking. For the time being, however, we are still comfortable calling for three key rate hikes in the United States in 9. That said, betting on a quarterly break a little earlier, likely in the second quarter, seems more prudent. The Should Stay the Course Already at low levels, investor expectations on rate hikes in the United States have fallen sharply in recent weeks (graph on page 6). The likelihood of further monetary tightening at the December 9 meeting is still pegged at over 6%, but key rates expected to barely budge thereafter. Futures on federal funds thus suggest that this rate could settle at about %, while the latest estimates of (Fed) leaders point to a rate edging closer to % some time in. Has the U.S. economy deteriorated enough to convince the Fed to stop its monetary tightening any time soon? Clearly not, in our opinion. Unlike what we have seen elsewhere, U.S. growth was strong in the third quarter, and another increase above potential is expected at the end of. The job market is still humming, despite some volatility this fall in terms of job creation, and annual wage growth rose to just over %. Confidence indexes and leading indicators in the United States are completely at odds with the prospect of a sharp slowdown (graph ). Clearer Change of Tone in Canada There have been more changes to our forecasts for Canadian yields in the last few weeks. The Bank of Canada s (BoC) highly optimistic tone in October had led us to expect another key rate hike in January 9. The BoC completely shifted its message in December, focusing on the many risks weighing on Canadian growth instead of monetary normalization. Domestic demand was much weaker than expected in the third quarter, and plunging oil prices, which pushed the government of Alberta to cut its oil output, suggest that Canadian growth will come in below potential at the end of and early next year. Canadian key rates should thus stay were they are in the first quarter of 9. The BoC s objective is still to reach a neutral rate, however, leading us to believe that monetary tightening will continue as soon as the economic data are more favourable. Two key rate increases of % thus remains the most likely scenario for 9. François Dupuis, Vice-President and Chief Economist Mathieu D Anjou, CFA, Deputy Chief Economist GRAPH Leading indicator still sending very positive signal on U.S. economy Quarterly annualized variation in % 6 4 - -4-6 - 4 Quarterly annualized variation in % Leading indicator (left) 6 7 6 4 - - Real GDP (right) Sources: Conference Board and Desjardins, Economic Studies DECEMBER

(Fed) Key Rate Hikes to Continue in 9 FORECASTS After the four key rate hikes ordered by the Fed in, economic conditions may call for the pace of increases to slow in 9. Three rate increases are therefore expected next year, in March, September and December. At the end of his first year as Fed leader, Jerome Powell can pat himself on the back for accomplishing his mission. The most recent data point to a very low unemployment rate (.7% in November) and inflation that remains under control (.% in November, based on the total consumer price index) (graph ). While not an easy job, the Fed managed to stay the course despite the return of volatility on the stock markets, mounting trade tensions and President Donald Trump s criticisms. With the hike expected on December 9, the Fed s leaders will have raised key rates by basis points four times in, as they had signalled since the meeting in June. Further key rate hikes are to be expected in the new year. In September, the Fed s leaders expected to order three key rate hikes of basis points in 9, and they will probably stick to this forecast at their December meeting. However, there is a sense that the markets doubt this will occur. Yet, the U.S. economy should keep humming along nicely in 9. Household confidence is still high, and households will continue to benefit from the tax cuts ordered at the very end of 7, especially after the returns have been processed. We expect annual consumption growth to reach.% next year, which would make it the strongest year since. The ISM indexes are also close to their recent historical peaks, and the unemployment rate is lower than the level considered noninflationary. These factors argue in favour of ongoing rate hikes. Some obstacles could slow the pace of monetary tightening, however. The Trump administration s escalating protectionism with China is already destabilizing the markets. Another increase in tariffs could only be damaging to the U.S. economy and could have bigger effects on consumer prices further. The housing market s weakness is another thing to consider. Home sales are already suffering from rising mortgage rates (graph 4) and new increases could further weaken this sector. Lastly, the volatility on the financial markets and the palpable negative sentiment could eventually have an impact on confidence and the real economy. The Fed s leaders will have to keep gauging the situation accurately. As rates move closer or even exceed what is considered a neutral position, the Fed will have to be vigilant, and perhaps more responsive to the economic environment. The situation will remain favourable in 9, but a break, probably at the June meeting, could be appropriate. The economy could be more fragile in, at which time the Fed will have to be even more cautious. GRAPH GRAPH 4 Unemployment rate and inflation in the United States should remain relatively stable Rising mortgage rates in the United States already curbing home sales In % University of Michigan confidence index Favourable conditions for a home purchase Index Annual variation in % 6. Desjardins forecasts.. 4. 4... 6 7 Unemployment rate (left) 9 Consumer price index (right) Sources: Bureau of Labor Statistics and Desjardins, Economic Studies........ -. 7 6 4 99 997 999 7 9 7 Sources: University of Michigan and Desjardins, Economic Studies DECEMBER

Bank of Canada (BoC) Uncertainties Are Intensifying: The Break Will Last a Few Months FORECASTS After a fifth key rate hike in October, the BoC opted for the status quo in December by keeping the target for the overnight rate at %. Even if the monetary authorities indicate that future rate hikes could be ordered, current uncertainties may prompt the BoC to extend the break by a few months. If economic conditions develop the way we expect them to, the door could open up again to further monetary tightening next April. A second rate hike could then be ordered in summer 9, followed by one final increase in to reach the bottom of the forecast range for the neutral rate (between % and % according to the BoC). Domestic demand in the third quarter was very disappointing, with a.% decline (annualized). Not only has growth in consumer spending slowed significantly, but residential and non-residential investment both lost ground. This suggests that the gradual rate hikes in recent months are starting to be felt in Canada s economy. However, the extent and the speed of the adjustments remain unknown, which fuels the uncertainties. Declining oil prices and transportation constraints for crude oil are also being felt in Canada s economy. Moreover, the Alberta government recently announced a cut to crude oil production as of January st, 9, curbing Canada s economic growth in the first quarter. In such conditions, we have downgraded our growth forecast for Canada s economy for 9 from.% to.%. This will have an impact on the output gap, which will remain virtually nil in the next few quarters instead of the gradual expansion we previously expected (graph ). suffering from a labour shortage that limits their ability to meet demand. The unemployment rate also fell to.6% in November the lowest level since the labour force survey started in 976. The job vacancy rate, i.e., the number of filled versus vacant positions, is quite high, at.%. With a few one-time factors off the table, and with falling gas prices (graph 6), the annual inflation rate decreased over the last few months, from.% in July to.4% in October. This decline should continue in the next few months, as our estimates point to a total inflation rate of about.% by next winter. However, we have to look beyond this volatility, by spotting the trends in the benchmark indexes. The average of these benchmarks has hovered between.9% and.% for the past nine months, reflecting some stability. However, some indexes continue to point to a Canadian economy that is nearing full capacity. According to a BoC survey, just over % of businesses would have trouble meeting an unexpected spike in demand, and almost 7% of them are GRAPH GRAPH 6 Canadian growth should remain close to potential Canadian gasoline prices have fallen sharply in recent weeks Output gap Canada Price of regular gas In % - - - -4 - /liter Desjardins forecasts 4 Average 6 Integrated framework 4 6 Extended multivariate filter Sources: Statistics Canada, Bank of Canada and Desjardins, Economic Studies 4 9 6 7 4 JAN. Monthly average -.9% -9.9% Two weeks later: -6.% FEB. MAR. APR. MAY. JUN. JUL. AUG. SEP. OCT. NOV. DEC. Sources: Industry Canada and Desjardins, Economic Studies DECEMBER 4

Overseas Central Bank The ECB May Have Trouble Raising Its Rates Next Year EUROPEAN CENTRAL BANK (ECB) Once securities purchases wind down in a couple of weeks, the next step will be to raise key rates. For now, the ECB is signalling that it could start to raise rates by the end of summer 9. The rate on deposits is currently at -.4%, keeping a number of other market interest rates in negative territory. The end of negative interest rates next year looks increasingly uncertain, however, due to the growth slowdown in a number of countries in the euro zone. Weak consumer confidence does not point to a brisk rebound in growth in the short term (graph 7). Our scenario calls for only one rate increase before the end of next year. The rate on deposits could be fixed at -.%, and the rate for refinancing transactions could rise slightly to.%. This would restore the spread between these two key rates to basis points. BANK OF ENGLAND (BoE) The risks of a no-deal Brexit with the European Union remain high, but at the same time, some believe that a deal is still possible or that a new referendum could even be called to cancel Brexit. For the moment, the economic and financial climate is not conducive to a new interest rate hike mandated by the BoE. The last rate increase was in August. Total inflation is down, but it is still above the % target. Inflation, excluding energy and food, is just below this level. The pound remains very volatile, and any changes in this currency could interfere with the BoE s future decisions (graph ). Any significant depreciation due to a hard Brexit would be inflationary, whereas a surging pound in the event Brexit is cancelled would have the opposite effect. For the time being, we expect a single interest rate increase next year. GRAPH 7 Confidence down almost across the euro zone Consumer expectations Index - - - 6 7 Euro zone Germany France Italy Spain Netherlands Belgium Sources: European Commission and Desjardins, Economic Studies GRAPH The pound is still volatile because of Brexit uncertainty Pound exchange rate US$/ / (inverted scale).7.6.6..4.4... 4 Against the U.S. dollar (left) Against the euro (right, inverted scale).6.7...9 6 7.9 BANK OF JAPAN (BoJ) The size of the BoJ s balance sheet reached % of GDP (graph 9). With an inflation rate that is still struggling to rise, the BoJ does not seem to be close to starting to normalize its monetary policy. That said, it could prove to be more tolerant about keeping Japan s year yield at %. The tolerance range was widened by ± basis points last summer, reducing the need for securities purchases to curb upward pressures on this interest rate. Weak bond yields around the world right now are making the BoJ s job easier, but this weakness should only be temporary. GRAPH 9 assets reach % of GDP Size of central bank balance sheets In % of GDP 9 7 6 4 4 6 4 6 DECEMBER

Bond Market Caution Will Be the Overriding Theme for Central Bankers in 9 FORECASTS With an increasingly less expansionist monetary policy, the (Fed) will moderate the pace of its rate hikes in 9. is likely to end amid a host of concerns, but we expect the markets to acknowledge the health of the U.S. economy and the abundant supply of bonds. Longer term yields should thus resume their uptrend. In Canada, headwinds are forcing the Bank of Canada (BoC) to slow the pace of monetary normalization. The BoC should nevertheless be able to order two rate increases next year, once the dust settles. Bond yields will rise as well, but we do not expect yields to catch up with their U.S. counterparts, given the vulnerabilities that Canada s economy still shows. U.S. FEDERAL BONDS The Fed is about to announce a fourth increase for this year at its next meeting, achieving its normalization ambitions for two years in a row. is likely to be the year in which the Fed s normalization program had the fewest hurdles to clear. The U.S. economy and job market remained robust, and core inflation has converged toward the % objective. While was punctuated by several periods of instability in financial markets and concerns about trade frictions, the real economy was able to weather these tensions, supported by generous fiscal stimulus measures ordered last winter. Although the effects of these measures will gradually fade in 9, our short-term outlook for the U.S. economy remains strong enough to predict that the Fed will stay committed to bringing the federal funds rate closer to its neutral point. That said, it is becoming increasingly clear that future rate hikes will be far less systematic than what we have seen in the last two years. Entry into neutral territory will mark the official end of the low for long accommodating monetary policy regime. Continuing rate hikes at the current pace would make monetary policy more likely to shift into a restrictive setting during the year. This does not mean that a restrictive monetary policy is never suitable, but in general such policies are appropriate when signs of an overheated economy crop up. At this point, despite a historically low unemployment rate, good momentum and even tariffs, there are few signs to suggest that the Fed should be as proactive about the upside risk to inflation as it has been during previous cycles. This implies that the pace of rate hikes will slow down in 9. After the rate hike this month and another next March, we expect the Fed to take a pause. Fed officials have already started to prepare the markets for a less systematic, more neutral approach, with a greater focus on monitoring the data. The Fed will endeavour to take stock of how the economy adjusts to the diminishing effects of the stimulus measures by mid-year, and to the cumulative rate hikes ordered since the start of normalization. Our scenario calls for growth to slow gradually to a pace just below full capacity in the second half of the year. This soft landing for U.S. growth should give FOMC officials the confidence needed to perform two further rate increases in the second half of 9. We expect that the unemployment rate will hit.% by year-end and that underlying inflationary pressures will be tangible enough to justify this new adjustment. All told, 9 will see a more cautious approach to rate increases, mainly because we are edging closer to a more neutral policy and not due to growing concerns about U.S. outlook. Markets have nonetheless significantly lowered their expectations, in part due to the growing recession chatter (graph ). We believe that a downturn in the cycle is more likely in than in 9, as the impact of the expansionist tax policy will continue in full force early into next year. If this view is proven valid, the markets could upgrade their expectations somewhat for Fed rate hikes in 9. GRAPH Markets expect the Fed to be more cautious in 9 United States Expected rate hikes* in 9 In basis points 7 6 6 4 4 JAN. FEB. MAR. APR. MAY. JUN. JUL. AUG. SEP. OCT. NOV. DEC. * Based on federal fund futures. Sources: Bloomberg and Desjardins, Economic Studies In fact, we believe that the term premium could still climb, although this will require a reduction in risk aversion, which DECEMBER 6

has been sustained at high levels since October. Recent market events have not changed the fact that the U.S. Treasury will be issuing a large amount of debt, which may have a greater impact on longer term maturities compared to what was seen this year. On the demand side, signs of decreased appetite among foreign investors were noted in (graph ); the market will have to keep counting on U.S. investors (individuals in particular) to stay heavily invested. In our opinion, these conditions support an increase in longer term bond yields. Along with a slowdown in the pace of Fed rate hikes, we believe these factors will help stave off a serious inversion of the yield curve, one of the strongest signs of an upcoming recession over the last years. GRAPH Waning international interest in U.S. bonds Treasury securities held by foreigners Annual variation in % - 9 4 6 7 As a result, the BoC s sense of urgency regarding the need to bring monetary policy back into neutral territory is hard to explain. While the unemployment rate is at a low not seen in several decades, there are no signs that an overheated economy is around the corner. Real wage growth is barely positive, and tighter regulations have considerably slowed household debt growth. In western Canada, a deficient supply infrastructure has created glut in the oil sector and a drastic drop in prices, forcing the Alberta government to respond by mandating production cuts next year. This decision helped reset prices, but it means a contraction in economic activity in an industry that is still one of the heavyweights within Canada s economy. All in all, the rush to reach a neutral rate is quite misplaced, especially since the impact of the five rate hikes performed since July 7 will continue to be felt over time, and also given higher-than-ever sensitivity to rate hikes. Our economic scenario still calls for Canada to perform relatively close to potential, but recent events have led us to downgrade our projections somewhat. This forecast, coupled with the dampening effect of gasoline prices, suggests that inflation will not be much of a concern in 9. The BoC will thus have the latitude to normalize rates at a very gradual pace, allowing the economy to adjust to the multiple shocks it has to contend with. Markets view things in a relatively similar way, with only one increase expected in 9 (graph ). GRAPH Rate hike expectations cooled rapidly in Canada Bank of Canada rate increases expected* in 9 CANADIAN FEDERAL BONDS The headwinds that rose up in Canada last fall were strong enough that the BoC had to fall back to using more prudent language in December, after its optimism created a surprise at the BoC meeting in October. While markets had flirted with the idea that the BoC would perform up to three rate increases in 9, a mere single increase is now expected. This sudden reversal prompted a significant decline in shorter term bond yields, and the question remains: was this an adequate response or was it too strong, or too weak? Given the recent tangent that Canada s economy has taken, we believe the BoC will wait until next spring before it pursues monetary normalization. National accounts for the third quarter threw cold water on any hopes that business investment would accelerate. While the uncertainty surrounding the trade agreement was expected to curb capital spending somewhat, the magnitude of the contraction suggests that other factors came into play. Investment in commodity sectors were particularly weak as pessimism in the energy sector gained traction. Meanwhile, consumer spending and the housing market are moderating, and generally speaking, Canada s economy will have to deal with a smaller number of growth levers. In basis points 7 6 4 October November December * Based on futures on bankers acceptances. Sources: Bloomberg and Desjardins, Economic Studies One question relevant to the Canadian bond market in 9 is: will longer term Canadian bond yields converge with U.S. yields? This seems unlikely in our view. Markets expect the terminal rate in Canada to be lower than the U.S. rate, an assumption that seems justified to us given the imbalances in the Canadian economy. From a medium-term risk perspective, if a global recession were to eventually occur, it is not inconceivable that the negative impacts in Canada would be worse than in the United States. The incorporation of this risk is likely to be one factor that keeps longer term yields in Canada at significantly lower levels than in the United States. DECEMBER 7

TABLE Key interest rates 9 Q Q Q Qf Qf Qf Qf Qf Qf United States Federal funds...7.7... Canada Overnight funds.... Zone euro Refinancing rate. United Kingdom Base rate.. END OF PERIOD IN % Japan Main key rate f: forecasts TABLE Fixed income market END OF PERIOD IN % UNITED STATES Treasury bills -month Federal bonds -year -year -year -year Yield curve slopes -year - -month -year - -year -year - -month 9 Q Q Q Qf Qf Qf Qf Qf Qf.7.9.9.4.6.7.9.....9.7..7.97..7.6.99..9.6..9.9......4.......7.4.6.7.6.7..6.7....4.6......47.4...6.76.4........4..........4...4.9.7.....4....4.4.......4..4.6.7.6..9.6..9...9....9...6.6..9....7.74...4..6...4.7.4..4.6.4.6.... -.6 -.6 -.6 -.64 - -. -.9 -.9 - - - -.9 - - - -.6 -.6 CANADA Treasury bills -month..6 Federal bonds -year.77.9 -year.96.6 -year.9.7 -year.. Yield curve slopes -year - -month.6. -year - -year..6 -year - -month..94 Yield spreads (Canada United States) -month -.6 -.67 -year - -.6 -year -.9 -.67 -year -.66 -.69 -year -.74 -.79 f: forecasts DECEMBER

Schedule of Central Bank Meetings Date January 7 7 Central banks Decision Rate February 7 Reserve Bank of New Zealand 7 Bank of England 4 Bank of Sweden 6 - b.p. 6.7 7. - March 7 - b.p. - Bank of Canada* Bank of Sweden 7. - Reserve Bank of New Zealand Bank of England Bank of Canada 7. Bank of England Swiss National Bank Reserve Bank of New Zealand. 7.7 - Bank of Canada* Bank of Canada Swiss National Bank Reserve Bank of New Zealand Bank of England April May 9 6 7 June 4 4 7 EMPTY Central banks Decision Rate Bank of Sweden Bank of Canada* - Bank of England Reserve Bank of New Zealand. 7.7 September 4 Bank of Canada 6 Bank of Sweden Bank of England 9 Swiss National Bank 6 Reserve Bank of New Zealand 6 - -. October 4 7 4 4 7.7 -.. - July 6 6 6 Date 6 August 7 6 Bank of Sweden Bank of Canada* November Bank of England 7 Reserve Bank of New Zealand 9 December Bank of Canada Swiss National Bank 9 9- Bank of England Bank of Sweden NOTE: Certain banks may decide to change rates in-between the scheduled meetings. The abbreviations and b.p. correspond to status quo and basis points respectively. * Monetary Policy Report published. DECEMBER 9