Thoughts

November 05, 2022 | 14:45

Hawkish Fed a Looming Issue for the BoC

Economist

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

This week’s hawkish tone from the Fed came in stark contrast to what we heard from Governor Macklem and the Bank of Canada last week. Growth worries loom large for Canada; while Chair Powell made it clear that though the economy and lagged policy impact are on the radar, inflation remains the #1 priority. The Bank of Canada surprised markets with a 50 bp hike when it was 70% priced for 75 bps, while the Fed disappointed those looking for a clear signal that a downshift in tightening was coming after the fourth straight 75 bp hike. October’s strong employment report and an anticipated big CPI print later this month have prompted us to look for 50 bps from the BoC at the December meeting and a final 25 bps in January. Meantime, we’ve added 25 bps to our Fed rate hike forecast, with a total 100 bps still to come.

The biggest divergence was in the tone of where policy rates are headed. Governor Macklem said that they’re nearing the end of rate hikes, though not quite yet. His language suggested that the Bank could opt for another 50 bps in December, or move in two 25 bp increments; either way, taking it meeting by meeting thereafter. Chair Powell made it clear that a pause isn’t even a thought at the moment and that a 5-handle for policy rates could be in the cards. That divergence has the potential to create a difficult dilemma for the BoC.

Following the IMF meetings, Governor Macklem held a media roundtable (now semi-infamous) in which he noted that a weaker Canadian dollar is something that policymakers need to watch. There was no mention of the loonie’s weakness and potential inflationary impact in October’s policy statement and MPR, but that doesn’t mean his words weren’t true. Rather, the loonie has been firmer of late amid a friendlier environment for risk. That may explain the lack of mention last week, as they don’t want to waste bullets and would have sent a bit more hawkish message.

Post-Fed, the C$ was on the defensive as interest rate spreads moved further in the US$’s favour (until the blowout Canadian employment report). Terminal rates in the U.S. are now about 70 bps above Canada’s. The widest spread in the U.S.'s favour since 2000 was 100 bps in the mid-2000s. At the time the C$ was consistently appreciating as commodity prices were ramping up. Before that, the mid-1990s saw a monster 250 bp spread as the U.S. economy was on fire, and Canada was in the midst of a fiscal consolidation and still recovering from early 1990s weakness. The loonie came under severe pressure in the late 1990s even as that rate spread narrowed, prompting the BoC to hike 100 bps in August 1998 to defend the currency.

Given the higher sensitivity to interest rates in Canada versus the U.S., it’s possible interest rate spreads could revisit the mid-2000s level, and even move beyond it. That’s where the BoC’s dilemma arises. If interest rate spreads continue to run, the Canadian dollar will likely weaken further, adding to already heated inflation. At that point, we’ll probably have policy rates north of 4%, and further hikes have the potential to turn housing-driven weakness into something much nastier.

Key Takeaway: The divergence in Fed and BoC policy has the potential to create a dilemma for the Bank: allow the C$ to weaken and add to inflation, or continue to hike rates to shore up the loonie and risk an even deeper economic downturn. While the huge job gain puts this issue aside for now, it’s looming on the horizon.