Rates Scenario

April 05, 2021 | 17:01

Rates Scenario for April 5, 2021

Economist

Deputy Chief Economist, Head of U.S. Economics and Managing Director
Economics

Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the tea... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

Jennifer has been with BMO Capital Markets Economics for over two decades and is perhaps best known for her high... (Read more)

Michael Gregory , CFA

Deputy Chief Economist, Head of U.S. Economics and Managing Director
Economics

Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the tea... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

Jennifer has been with BMO Capital Markets Economics for over two decades and is perhaps best known for her high... (Read more)

Forecast Summary

Canada-U.S. Rates Outlook

Compared to the previous Rates Scenario (March 4), we are lifting our forecast for longer-term bond yields.

Ten-year Treasury yields are currently trading around 1.70%, up more than 25 bps during March and 75 bps since the start of the year. This is the highest level since January 2020, reflecting market expectations for stronger real GDP growth, faster inflation and bigger budget deficits. These expectations were stoked by a one-two punch of fiscal policy. Between the Consolidated Appropriations Act signed on December 27 and the American Rescue Plan Act signed on March 12, there’s $2.0 trillion more fiscal relief coming this year (ending September), worth 9.3% of GDP, and an additional $538 billion coming next fiscal year (2.5%), along with their commensurate increases in Treasury borrowing requirements.
We look for the upward trend in yields to continue, but at a more gradual pace. With the sea-change in market expectations already past, yields are now going to be driven by how the economic data, particularly those beyond the next couple months, alter the stronger-growth, faster-inflation narrative. The market is probably bracing for eyebrow-raising results among the key growth and inflation metrics through the spring. On the growth side, this reflects the lifting of pandemic-related restrictions, a rebound from February’s extreme weather and the speedy distribution of both vaccines and stimulus cheques. On the inflation side, this reflects unfavourable year-ago comparisons, temporary supply shortages and the ripple effect of higher commodity prices. We look for 10-year Treasury yields to average around 1.75% by the end of this year and 2.00% by the end of next year.
Mimicking a similar market narrative north of the border, 10-year Canada yields are currently trading above 1.50%, up more than 15 bps during March and 85 bps since the start of the year. Part of this year’s net underperformance versus Treasuries reflects dashed market expectations for the Canadian economy to have been hit even harder by the more onerous restrictions and slower rollout of vaccines, along with the realization that Bank of Canada tapering is likely to happen sooner than the Fed’s (if only for technical reasons). We look for 10-year Canada yields to average around 1.60% by the end of this year and 1.85% by the end of next year.
Our base case remains for the Fed to maintain the current monthly pace of asset purchases until the end of this year ($80 billion Treasuries, $40 billion MBS), with a gradual (year-long) tapering process starting early 2022. The Bank of Canada’s timetable should begin earlier with the current clip of $4 billion per week (of Canadas) already absorbing a higher proportion of the government’s borrowing requirements than other central banks’ QE programs. In a March 23 speech, BoC Deputy Governor Gravelle said: “Our GoC bond purchases since last March represent a little over 35 percent of the total amount of GoC bonds that are outstanding—by far the highest among this group of central banks [Fed, BoE, ECB and Riksbank].”
The upcoming federal budget (April 19) should show these requirements falling meaningfully for the year ending March 2022, despite providing additional fiscal stimulus. This will likely compel the Bank to pare its QE pace sometime this spring. However, the Bank’s asset purchases should continue into next year. In the meantime, on both sides of border, we can’t rule out an increase in the weighted average maturity (WAM) of purchases during the tapering process, or even before, if bond market conditions warrant. We also can’t rule out another Operation Twist from the Fed. Meanwhile, we continue to look for both the Federal Reserve and the Bank of Canada to begin rate hikes in 2023.
In the FOMC’s March 17 policy statement there were no changes to the forward guidance. The 0%-to-0.25% target range for the fed funds rate will be maintained “until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time”. In the dot plot, 7 of 18 participants pencilled in at least one rate hike by the end of 2023 (vs. 5 of 17 before), with four in 2022 (vs. only one). It will take two more participants changing their no-move calls to turn the dial on the median rate forecast for 2023.
In the BoC’s March 10 announcement, the key phrase was reiterated: “We remain committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. In the Bank’s January projection, this does not happen until into 2023.”
The broad U.S. dollar index averaged 1.2% stronger in March, following a 0.5% February gain, as investors continued to take note of America’s rising yields and brightening economic prospects. This followed nine consecutive monthly declines (worth 9.6%) from the record high hit in April 2020 at the peak of pandemic panic. Although we expect the key depreciation driver—improving investor-perceived global economic prospects and ebbing risks—to eventually reassert its influence, this should continue being offset by increased net capital inflows for the next few months. On balance, we see the unit just under 1% weaker by the end of this year before weakening more than 2% next year.
The Canadian dollar appreciated an average of 1.0% against the greenback in March, following a 0.2% gain the month before, to above US$0.7950 (under C$1.2575). The loonie’s past dominant driver—the trend in the U.S. dollar—has faded in the light of firming commodity prices and brightening Canadian economic prospects. And, with the assistance of the BoC taking away the QE punch bowl faster than the Fed, we look for the loonie to average C$1.25 (US$0.80) by the end of this year and C$1.23 (above US$0.81) by the end of 2022.

Overseas

Over the past month, the greenback's strength has been surprising but understandable as the U.S. economy powered ahead, supported by reopenings and speedy vaccinations. We remain of the view that stronger U.S. demand will have positive effects globally, lifting risk appetite. However, other parts of the world are struggling with the pace of immunizations (actually getting enough doses) and that will weigh on their economies, rates and currencies in the near-term.
This is particularly the case in the European Union, home of the exceedingly slow vaccine rollout (slower to negotiate contracts followed by production issues). This has been made worse by the argument between Brussels and the U.K., with Brussels at one point considering banning vaccine exports to Britain (it did not) while Britain accused the EU of "vaccine nationalism". Now, with the variants spreading, parts of Europe have been forced back into lockdown; most recently, Germany and France. This puts the fledgling recovery at risk. With the ECB in the midst of buying bonds under the Pandemic Emergency Purchase Programme (PEPP) at a "significantly higher pace", there is a risk that this faster pace could be extended beyond June. There's more. The highly anticipated EU Recovery Fund may be delayed from distributing funds by June. A couple of far-right parties in Germany are questioning the legality of Berlin's participation in the Fund, and have brought their complaint to Germany's constitutional court. Needless to say, the ECB may need to step up its support and that will weigh on the EUR over the next few months.
Meantime, the U.K. has one of the highest rates of vaccination in the world (over half of the population) and that has been a great source of support for the economy. PM Johnson has allowed the country to emerge from its lockdown and though the pace is very gradual, there is hope that all restrictions will be removed by June 21. Although this doesn't give the BoE the green light to tighten, it all but rules out the possibility of negative rates. Interesting how that policy tool was given plenty of attention at the February BoE meeting, then was almost completely absent during the March meeting (according to the Minutes). But there is at least one policymaker who still speaks openly about a number of scenarios that would call for "looser policy" later this year. Meantime, the GBP now has some decent tailwinds behind it.
The BoJ is expected to maintain its highly accommodative policy for a long, long time but some measures were tweaked in March in an ever-so-slightly less stimulative fashion. Although the Bank now permits the 10-year JGB yield to move around in a band (specifically, +/-0.25% around zero), it will only buy ETFs and J-REITs "as necessary", instead of an annual target. However, the JPY has been weakening considerably, with USDJPY recently weakening to ¥110 for the first time in a year. Our Greg Anderson, Global Head of FX Strategy, notes that the JPY's depreciation has been broadbased and has shown up in many different crosses (such as EURJPY, CNYJPY and JPYKRW); it is not simply due to the USD's rally.

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