We have made no major changes to our interest and exchange rate forecasts since the last Rates Scenario (June 3). However, the risks of Fed and BoC policy rate liftoff before 2023Q1 have risen.
Federal Reserve: Amid raised dots and taper talk, the Fed took a hawkish turn on June 16. In the Summary of Economic Projections (SEP), the 2023 median forecast for the fed funds rate was raised to now reflect two 25 bp rate hikes by the end of the year, from none in the March SEP. Among the 18 policymakers, 13 penciled in at least one rate rise, up from seven in March. And, although the 2022 median remained unchanged, there were now seven individual forecasts of rate hikes, up from four before. It will now take just two participants changing their call to a rate hike to raise the median for 2022 as well. In the press conference, Chair Powell indicated that the FOMC had started to talk about tapering. We suspect the staff was charged with briefing the Committee on tapering options and consequences for the July meeting, putting us on ‘announcement watch’ for as early as the September meeting.
Meanwhile, real GDP should have completely recovered from the recession in Q2 (data to be released July 29). We look for payroll employment to do the same by the end of next summer, with the unemployment rate returning to its pre-pandemic range (well below the 4.1% natural rate) before the end of next year. By early 2023, labour market performance should convince the Fed that the policy tightening prerequisite of maximum employment, defined in a broad-based and inclusive fashion, is solidly on track to soon be achieved. This should be enough for policy rate liftoff with the Fed’s other tightening prerequisite, inflation running moderately above 2% for some time, likely considered satisfied. We look for core PCE inflation to settle in the 2¼%-to-2½% range after spiking to nearly 4% this year owing to the mix of exuberant demand and constrained supply (both mostly temporary). Our base case calls for a March 2023 rate hike, with follow-up moves every half year.
Our tapering call is based on three factors. First, the Fed will likely ensure a reasonable amount of time elapses between the end of quantitative easing (QE)—the end of adding accommodation—and March 2023—the start of removing accommodation (say, some three to six months). Second, following 2013-14’s playbook, the FOMC’s purchases will probably be pared gradually. Our working assumption is by $10 billion and $5 billion, respectively, for Treasuries and MBS each meeting cycle, which results in a year-long tapering process. Third, from a risk management perspective, the FOMC may want to be able to raise rates by the end of next year if necessary (and seven participants already project it will). These factors point to a September announcement, with tapering starting in October.
Bank of Canada: Despite the pandemic-related restrictions across the country during Q2, the Canadian economy still likely managed to expand. This reflects the strong handoff from Q1 (March alone was +1.3% m/m), a smaller-than-expected drag from the restrictions (April was -0.3% vs. the -0.8% flash), and the likely resumption of growth in June as restrictions started being relaxed. Meanwhile, amid a first-dose vaccination rate that has become one of the best in the world, the economy is finding support from further fiscal stimulus, a strengthening U.S. economy and robust commodity markets. Real GDP should have completely recovered from the recession in Q3 (a quarter behind the U.S.). By the end of this year, jobs should have done the same (outpacing the U.S.), with the unemployment rate returning to its pre-pandemic range (5.6%-to-5.7%) by next autumn and the core inflation metrics also averaging in the 2¼%-to-2½% range.
The Bank already took a hawkish turn on April 21, and it stayed in that direction on June 9. While still committing to hold the policy rate at the effective lower bound “until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved”, this now happens “sometime in the second half of 2022” (it was “into 2023” before April). Our base case calls for a January 2023 rate hike, with follow-up moves every half year. At the April meeting, the Bank also reduced its QE bond buying to $3 billion per week from $4 billion. We’re expecting another QE pullback either this month or in October (to $2 billion), and the program to have ended by early next year.
Bond yields: Ten-year Treasury yields (constant maturity) slipped below 1.45% to start July, after spending most of June in the 1.45%-to-1.55% range, which was, in turn, down from the 1.55%-to-1.70% range that had been in place since April. The bond market is interpreting the Fed’s hawkish turn in a bullish light, scaling back inflation expectations and risks, amid increased growth concerns (owing to the Delta variant) and continued supportive capital inflows (1.45% is still globally attractive, particularly with a more stable U.S. dollar). Despite the recent slide, we look for yields to move modestly higher by year-end, to around 1.75% (which they already flirted with in March). This reflects more persistent inflation and a Q4 start to tapering (both of which are not fully priced in). In 2022, policy rate tightening speculation should augment the moderate upward pressure on yields, ending around 2.00%. Ten-year Canadas began July trading near the bottom of the 1.35%-to-1.45% range in place since early June, with Canada-U.S. spreads running in a 3-bp range on either side of -10 bps, which is where we judge they’ll run for the remainder of this year. While a relatively earlier end to QE could contribute to Canadas underperforming, this should be offset by a strengthening Canadian dollar.
U.S. dollar: The Fed’s hawkish turn helped turn the broad U.S. dollar index around. The index had been drifting weaker since late March (a total 3.2%), reflecting improving investor-perceived global economic prospects and ebbing risks. And, as record-sized budget and trade deficits were likely starting to take a toll. The greenback is currently 1.8% above its pandemic low hit at the beginning of June. However, we judge the greenback will ultimately weaken again reflecting the same factors. From current levels, we see the unit averaging 1½% lower by the end of this year, before starting to stabilize next year.
Canadian dollar: The loonie was the best-performing major currency through the first half of the year, reflecting rising commodity prices (Canada’s non-energy prices averaged record highs in May), an improving balance of payments (Q1 showed the first current account surplus since 2008), and the Bank of Canada’s hawkish turn. We look for the Canadian dollar’s strengthening momentum to continue, averaging C$1.20 (above US$0.833) by the end of this year and C$1.175 (above US$0.851) by the end of 2022.