Canada-U.S. Rates Outlook
Since our last Rates Scenario (February 4), we have made changes to our forecasts. Policy rate hikes are now starting in 2023, compared to 2024. Longer-term bond yields are higher, and the Canadian dollar is stronger.
Both the Federal Reserve and the Bank of Canada are putting larger weights on labour market outcomes in their reaction functions. For both countries, a full and complete labour market recovery is expected to take much longer than that of real GDP. We reckon real output will surpass pre-pandemic levels by Q2 in the U.S. and by Q3 in Canada, owing to tighter second-wave restrictions and slower vaccine rollout. And, by the spring of 2023, we should have surpassed the pre-pandemic levels of household-surveyed employment and then establishment-surveyed jobs (payrolls), with unemployment rates hitting the February 2020 marks of 3.5% in the U.S. and 5.7% in Canada by about mid-2023. Meanwhile, the various core inflation metrics on both sides of the border should be running in the 2.0%-to-2.5% range.
With the Fed’s watch for a “broad and inclusive” labour market recovery and the BoC’s eye on a “shared recovery”, we previously judged the central banks would throw some policy caution to the wind and delay liftoff until early 2024. This was consistent with FOMC’s December ‘dot plot’, in which only 5 of 17 participants pencilled in a rate hike by the end of 2023. Admittedly, it appeared farther than the “until into 2023” signalled in the Bank of Canada’s January policy statement.
However, we now judge the risks to price and financial stability, already beginning to drift up, should compel the central banks to act more quickly, by mid-2023, once adequate labour market outcomes have been attained. But, in recognition of the fact that even further improvement will likely be desired, our base case is for only a gradual (semi-annual) rate hike cadence on the road to ‘neutral’ policy rates (2.00% in the U.S., 1.75% in Canada).
The risks to the forecast are skewed to the upside on both sides of the border, should labour market improvements occur more quickly or core inflation rates appear on track to persistently exceed 2.5%. But, until labour market outcomes are deemed adequate, we suspect further escalating risks to financial stability will likely elicit macroprudential policy responses and central bank lip service rather than expedited rate hikes. However, the latter could contribute to an earlier and more ardent approach to tapering.
Our base case remains for the Fed to stick to 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 quantitative easing clip of $4 billion per week (of Canadas) already absorbing a higher proportion (than the Fed) of the government’s borrowing requirements. The upcoming federal budget (due within the next month or two) should show these requirements falling meaningfully for the fiscal year ended March 2022, probably compelling the Bank to pare asset purchases sometime this spring. However, QE will still likely end sometime next year. In the meantime, we can’t rule out an increase in the weighted average maturity (WAM) of asset purchases during the tapering process, or even before, if bond market conditions warrant.
Tapering will weigh on both bond markets, compounding increasing inflation expectations and inflation risk premia along with the net upside risks to economic growth posed by further fiscal stimulus. The Biden Administration is poised to get most, if not all, of its $1.9 trillion American Rescue Plan passed. In Canada, the Trudeau government has mentioned a potential $70-to-$100 billion stimulus plan over the next three years (likely to be detailed in the upcoming budget).
In consequence, we expect most of the recent bond market selloff will stick. As yields spiked, mid- and long-term Canadas underperformed Treasuries, reflecting heavy provincial bond issuance, fading expectations for a ‘micro’ BoC rate cut, and speculation that the Bank could eventually hike rates before the Fed given that tapering will begin earlier. Yields should continue to trend higher, but probably in a more ratcheting pattern. For example, we see 10-year Treasury yields averaging around 1.70% by the end of this year (vs. 1.47% on March 3), with comparable Canadas at 1.55% (vs. 1.40%). Canadas are expected to outperform slightly as the previous technical and expectational pressures ebb. Once the expected “burst of spending” (Powell’s phrase) doesn’t trigger a torrent of persistent inflation, bond market conditions could stabilize for a while. But, ultimately, yields are headed even higher. The good news is that even higher yields will still be low by historical standards: sub-3% as far as our eyes can see.
The broad U.S. dollar index averaged 0.5% stronger in February, as investors took 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 reassert its influence, this will now probably be partly offset by increased net capital inflows. We see the unit 2.8% weaker by the end of this year and a further 1% weaker by the end of 2022.
The Canadian dollar appreciated an average of 0.2% against the greenback in February to under C$1.270 (above US$0.787). It’s not that the loonie’s past dominant driver—the trend in the U.S. dollar—has dissipated; rather, the currency appreciated 10.5% in the April 2020-January 2021 interval. It is now that the currency is also garnering support from firming commodity prices and brightening Canadian economic prospects. 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.