Forecast Summary

Canada-U.S. Rates Outlook

Michael Gregory, CFA, Deputy Chief Economist

• We've changed our forecasts for Federal Reserve and Bank of Canada policy rates since the previous issue of Rates Scenario on November 2. The changes are not with respect to the total amount of rate reductions, but in their distribution. More of them are now occurring next year at the expense of those in 2025, with others pushed into 2026. The Fed is now expected to start one meeting earlier in July for a total of 100 bps, with the Bank also starting one meeting sooner in June, for a similar total. This doubles the amount of 2024 easing we had previously.

• We still judge both central banks will wait to start rate cuts until the evidence of inflation being on a sustainable path to 2% is overwhelming, which is expected by the summer months. And we still expect the Bank to act first, reflecting Canada’s weaker economic performance and greater sensitivity to interest rates. However, we now judge the cadence of cuts will be quicker at the outset, as real rates are reduced rapidly to avoid a harder economic landing, minimize the risk of overshooting the inflation targets, and sow the seeds of stronger growth down the road. We expect both central banks to adopt a more gradual easing pace as 2025 unfolds, as the final few tenths down to 2% inflation prove to be stubborn.

• Federal Reserve: The FOMC kept policy rates unchanged on December 13, for the third consecutive meeting and fourth time among the past five confabs. And it kept a tightening bias, although the language was tweaked to make it milder. In the Statement, the forward guidance now says: “In determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” The tweak was the addition of the word ‘any’ (underlined), which indicates a shift farther away from more rate hikes. In the presser, Chair Powell said this was to signal that a rate hike was still “possible”, but not probable.

• As we’ve argued before (for both the Fed and the BoC), keeping the door open for another rate hike, even if the threshold is unlikely to be crossed, is another way to say the rate cut door is closed for the time being. But that door is going to open by around mid-year on both sides of the border. Specifically, Powell said the timing of rate cuts was discussed at the meeting (so we now can’t wait for the Minutes!).

• In the Summary of Economic Projections (SEP) and the ‘dot plot’, the 25 bp lower starting point for the fed funds target range (owing to no further rate hikes this year after September’s SEP had signalled one more), rippled into next year and 2025. On top of this, there’s an additional 25 bp rate cut in 2024, pulling down the midpoint of the range to 4.625% by year-end (down 75 bps). The extra rate cut mostly mirrors the 20 bp reduction in the median core PCE projection to 2.4% next year (Q4/Q4) as well as a further softening of real GDP growth (by a tenth to 1.4%).

• The fed funds rate falls further to 3.625% by 2025-end, representing the same projected easing as in the prior SEP adjusting for the lower starting point. By the end of 2026, the policy rate is 2.875%, the same as before and still above the longer-run level (2.50%). This tells us it’s only a matter of time before the FOMC lifts its forecast for the longer-run level.

• With the FOMC now discussing the timing of rate cuts, the market has moved to price in nearly 75% odds of the first action in March and between five and six quarter-point cuts by the end of the year. However, with the Fed keeping rate hikes on the table (admittedly collecting dust) and the median projection for total and core PCE inflation just barely dipping below the critical 2½% mark by the end of next year, we judge rate cuts will commence after the mid-year mark instead of before it.

• Bank of Canada: The Bank kept its policy rate unchanged at 5.00% on December 6, also for the third consecutive meeting. The statement noted monetary policy was “moderating spending and relieving price pressures” as reflected in the fact the economy “stalled” during the middle quarters of the year and is “no longer in excess demand”. Meanwhile, October’s core inflation results were “towards the lower end” of the recent range. However, the Bank said it’s “still concerned about risks to the outlook for inflation and remains prepared to raise the policy rate further if needed”. Notably, October’s reference to these risks as having increased was dropped, making this tightening bias also milder.

• In the next-day speech, Deputy Governor Gravelle said, with the economy “now roughly in balance”, “we are closely watching inflation expectations, wage growth and corporate pricing behaviour” to assess inflation’s trajectory. And although October’s inflation figures were a “welcome improvement”, they were still just one month’s data and “we need to see further progress”. This further progress, along with favourable developments among the items on the Bank’s ‘watch list’, should be evident as the spring unfolds. This points to the start of policy rate cuts by mid-year (in June and July). Reflecting a cautious approach to easing (with a constant eye on the housing sector), we look for the Bank to briefly pause after this back-to-back action before resuming reductions; a pattern that should be repeated into 2025.

• Bond yields: Treasury yields rallied last month and are continuing to do so in December, after selling off for six consecutive months, as the market is increasingly pricing in aggressive Fed easing in 2024. For example, 10-year Treasury yields averaged 4.50% in November, down from October’s 4.80% which was the highest since July 2007. December is on track to average under 4.05% (the latest daily quote is around 3.90%). However, from current levels, we reckon there’s not a lot of sustainable rally room left, reflecting the combination of higher neutral policy rates (a.k.a. the root of the yield curve which we judge lies in the 2.75%-to-3.00% range) and more normal-looking term premiums.

• Since the FOMC began targeting the fed funds rate in the 1980s, the spread between 10-year yields and the effective fed funds rates has generated a median around 150 bps. Our working assumption has an eventual spread in the range of 75-to-100 bps, resulting in a 3.50%-to-4.00% range for 10-year Treasury yields. Meanwhile, we now expect the Fed will continue with quantitative tightening past the start of rate cuts, well into 2025. Other things equal, this should apply upward pressure on yields with the government sporting large deficits as far as the eye can see. At the same time, there’s more credit risk inherent in Treasuries, according to the three major rating agencies.

• Meanwhile, 10-year Government of Canada yields averaged 3.71% in November, down from October’s 16-year high of 4.06%. December is on track to average under 3.25% (the latest daily quote is just over 3.10%). It’s noteworthy that Canada-U.S. yield spreads have been moving more negative as yields have been both rising and falling. Amid October’s yield peaks, the spread averaged -75 bps compared to -40 bps four months prior. Spreads averaged -79 bps in November as yields declined with December on track to average -80 bps (with the latest daily quote around these marks). The outperformance has reflected Canada’s relatively stronger fiscal situation and relatively weaker economic performance, and these themes aren’t going away any time soon. Although longer-term Canada yields should broadly follow Treasuries’ lead, we now expect relatively wide negative yields to linger a lot longer.

• U.S. dollar: After posting three consecutive months of 1.5% gains, the Fed’s trade-weighted dollar index depreciated 1.8% in November and continued to do so in December, weighed by market speculation about aggressive Fed easing. Despite ongoing geopolitical and global economic concerns, we look for expected and realized Fed rate cuts to continue weighing on the currency. We see the greenback about 3% weaker by the end of next year, compared to November’s average.

• Canadian dollar: After averaging US$0.729 (C$1.372) in October, which is the weakest level since the immediate months after the onset of the pandemic and a few months amid 2015’s collapse in oil prices, the currency hardly budged in November despite a noticeably weaker U.S. dollar. However, as aggressive Fed easing speculation has mounted, the greenback’s softening has finally allowed the loonie to firm. In December, the Canadian dollar is on track to average US$0.743 (C$1.345) with the latest daily quote around US$0.748 (C$1.337). With the Bank of Canada likely to start easing before the Fed, squeezing in two quarter-point cuts before the FOMC’s first one, this could crimp further appreciation a bit. But the broadly weaker greenback should still push the loonie stronger by nearly 4% by the end of 2024 (compared to November’s average).

Overseas

Jennifer Lee, Senior Economist

• After a second year of tightening monetary policy, most central banks have more or less decided to wrap up those rate hikes with a bow and shove them under the inflation tree. They are finished. Of course, they will see how 2024 plays out; but, it appears that the urgency to tighten has passed, with inflation rates tumbling from the peaks, and as economic activity has cooled. However, easing is another story altogether. A couple of central banks are still cautious, and are reluctant to introduce the concept of cutting rates.

• The ECB is one. It kept rates unchanged in December (refi rate at a 22-year high of 4.50%, deposit facility at a record 4%, and the marginal lending facility at a 15-year high of 4.75%). And, it trimmed its GDP forecast and slashed its CPI call for 2024, which are good signs that rate hikes are over. However, the Governing Council still retains a hawkish hue. It kept the line that rates will need to stay at these levels for a "sufficiently long duration" to make a "substantial contribution" to the goal of getting back to the inflation target. The ECB also continues to be concerned about persistent domestic inflation due to high wage growth. President Lagarde even pointed out that if businesses absorbed higher wages and reduced their markups, it would be "really good news for inflation purposes". That is a big assumption. But, the announcement that the PEPP's (the Pandemic Emergency Purchase Programme) time is coming to an end had the hawks' wing prints all over it, as they've brought it up in the past. Reinvestments of maturing securities from the €1.7 trln portfolio will continue in full until June. Then, from July until December, they will be halved to €7.5 bln/month, on average. It stops at the end of 2024. The pandemic is over, as President Lagarde pointed out, so the time is right for balance sheet normalization. We look for rate cuts to start mid-year, with three moves in the second half of 2024. The ECB will not be as aggressive as the market expects.

• The BoE is the other bank. It kept its Bank Rate at a 15-year high of 5.25% in December but it was, again, a "finely balanced" decision. It speaks volumes that the six less-hawkish types on the MPC (only one is truly a dove) failed to bring any of the three hawks over to their side, despite GDP contracting in October and inflation hitting a 2-year low. But services inflation is a concern and it was interesting that "for most members" of that majority, "it was too early to conclude that services price inflation and pay growth were on a firmly downward path." Governor Bailey remarked that it was "really too early to start speculating about cutting interest rates ... we've got to see more progress", which was a good indication of where the majority stands. The tone of the Minutes was not dovish, either. For example, restrictive policy is likely needed for an extended period; more tightening would be needed if inflation persists; and, indicators of inflation persistence remain elevated. Uncertainty continues to play out; and, though the majority of the MPC is not comfortable hiking rates again, it is also far from ready to start easing. We look for the first rate cut to come in mid-2024, with three moves in total.

• Monetary policymakers have learned the importance of data-dependency: when things change, policy changes too. The RBA follows that line of thinking, with a series of hikes, a pause, a couple of more hikes, then four pauses. Philip Lowe's time at the helm came to an end this year, and the reins were passed to Deputy Governor Michele Bullock, who sounded hawkish from the onset. At her first meeting as Governor, a pause and a hike were debated (the pause won), but an upturn in inflation prompted a 25 bp hike in November to 4.35%. That move likely marked the end of this rate-hiking cycle, as economic activity has slowed, October's inflation rate "showed continued moderation", and wages were not expected to rise much more. The Bank is likely being very cautious, however, as the Statement continued to warn about the dangers of entrenched high inflation expectations and how it is determined to do what is needed to return inflation back to the 2%-to-3% target. Clearly, uncertainty is always a part of this world, but the need to tighten further has passed.

• The BoJ has the final meeting for 2023 among the G7 central banks and the decision could go in either direction. The central bank is still very dovish, and retains its Quantitative and Qualitative Monetary Easing with Yield Curve Control. But over the past twelve months, there have been tweaks. Under former Governor Kuroda, the trading band around 10-year JGBs was first widened by 25 bps in December 2022 to +/-50 bps; then, under now-Governor Ueda's watch, the band became more flexible (to as much as 1%). In October, it was axed completely and 1% was regarded as an upper limit, and a "reference". Ahead of the December 18-19 meeting, Deputy Governor Ryozo and Governor Ueda made seemingly hawkish comments, which were interpreted as hints that the BoJ was going to lift rates out of the negative zone (NIRP), and sparked a rally in the yen. The timing of such a move is a little eyebrow-raising, as other central banks are now pausing and some are thinking rate cuts. And, Japan's inflation rate is slowing. But if the market is expecting it, why not take the opportunity to finally lift rates back above zero, and save the bullets for the next downturn? Unfortunately, chatter from other BoJ officials, suggesting that there is no rush, is muddying the waters. Given the Bank's history, it should surprise no one if it opted to stay the course.

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