Rates Scenario
February 13, 2025 | 16:04
Rates Scenario for February 13, 2025
Economics
Economics
Economics
Economics
Canada-U.S. Rates Outlook | Michael Gregory, CFA, Deputy Chief Economist |
The Waiting Game Both the Federal Reserve and Bank of Canada are playing a waiting game. The Fed is waiting for stubborn inflation to break and to see what path inflation takes in the wake of government policies. The BoC is waiting for those same U.S. government policies to launch and then to react to any net impacts on the Canadian economy, particularly with inflation already running at its target. Compared to our last Rates Scenario (January 16), we still see Fed rate cuts commencing later, this time by the autumn, with the next BoC rate cut still to be sprung by the spring. And, as before, given the profound uncertainty surrounding U.S. government policies, particularly about tariffs, the confidence intervals around our base case forecasts for central bank policy rates, bond yields, and currencies have all widened considerably. Federal Reserve: The FOMC is expected to pause at its next policy meeting (March 19) for the second time in a row. The latter followed 100 bps worth of rate cuts over the final three confabs of 2024. This year’s pause reflects, first, still-sticky inflation. The yearly change in the core PCE price index was 2.8% in December, although the three- and six-month annualized changes were running in the low-2% range. But the core services ex-rents metric sported 3%-ranged readings across the tenors. And if January’s CPI is any guide, the shorter-term measures are poised to heat up meaningfully, with no improvement in the yearly changes, as the much-anticipated cooling of start-of-the-year pricing pressures has not happened. Second, the policy pause reflects the fact that still-sturdy economic and labour market performance affords the Fed more time to wait for inflation to improve. The jobless rate was at a 9-month low of 4.0% in January, below the FOMC’s median projection of the natural rate (4.2%). Although payroll employment expanded a tepid 143k in the month, the past three have averaged 237k, the highest in 22 months. Real GDP growth is tracking 2.9% annualized for Q1, according to the Atlanta Fed’s Nowcast, up from Q4’s 2.3% advance result and in line with the 3.0% clip during the middle quarters of last year. Also keeping the Fed a hint more hesitant is the heightened uncertainty surrounding the paths for trade, fiscal, immigration and regulatory policies, along with their respective impacts on the economy, broadly, and inflation, specifically. Given the above, we now see a gradual (quarter-point-per-quarter) rate cut cadence starting in September, assuming again that the “further progress on inflation” precondition will be evident by then. As before, the easing continues up to our estimate of the neutral range, 3.00%-to-3.25%, which is just a bit above the FOMC’s median projection (3.00%). Bank of Canada: After cutting policy rates for six consecutive meetings, including by 25 bps on January 29, and a total of 200 bps, we look for the Bank to pause next month (March 12). But there is a significant net risk this could become meeting #7 of easing. Indicating that a pause was probable (pending what happens on the U.S. tariff front), the latest announcement said: “The cumulative reduction in the policy rate since last June is substantial. Lower interest rates are boosting household spending and, in the outlook published today, the economy is expected to strengthen gradually… However, if broad-based and significant tariffs were imposed, the resilience of Canada’s economy would be tested.” (The underline is ours.) In the presser, signalling the Bank was prepared to act if needed, Governor Macklem said: “Having restored low inflation and reduced interest rates substantially, monetary policy is better positioned to help the economy adjust to new developments.” Note that December’s 50 bp rate cut pulled the policy rate down to the top of the Bank’s estimated 2.25%-to-3.25% range for the neutral rate. At the time, Macklem said: “With inflation back to target, we have cut the policy rate by 50 basis points at each of the last two decisions because monetary policy no longer needs to be clearly in restrictive territory.” It now wasn’t, so a policy pause last month initially looked probable. But then came the (increasingly credible) threat of significant U.S. tariffs on imports from Canada, with dire economic consequences (as modelled by the Bank). Macklem indicated this was a factor in deciding to pull down the policy rate a further 25 bps into the neutral range. Just the uncertainty over U.S. tariffs was having a negative impact on business investment and broader economic confidence. Indeed, the subsequent run of tariff-related news, such as the 25% tariff on all Canadian goods except for 10% on energy and critical minerals being postponed to only March 4, along with ‘stackable’ 25% tariffs on steel and aluminum kicking in March 12, has hoisted uncertainty far beyond what the Bank perceived just over two weeks ago. This is what’s pumping the prospects for a follow-up ‘risk management’ rate cut on March 12. Our base case has two more 25 bp actions pencilled in for April and July. But they could easily occur earlier or there could be much more of them, depending on how the tariff situation unfolds. Bond yields: Ten-year Treasury bond yields averaged 4.63% last month and are on track to average about 5 bps lower for this month. The January outcome was the second-highest level in more than 17 years (October 2023’s 4.80%, the highest, was last surpassed by July 2007’s 5.00%). We reckon yields will remain in a 4%-plus range for the foreseeable future. This is where they’ve spent 17 of the past 19 months. Yields last averaged sub-4% in September (3.72%) amid the Fed’s surprise 50 bp inaugural rate cut. Despite further Fed easing, yields have backed up on market concerns about faster inflation and bigger budget deficits, along with corresponding dimming prospects for further Fed easing. Since September, 10-year real yields (TIPS) are up about 50 bps with implied inflation expectations up about 35 bps. The latter has been prodded by stubborn inflation results (see above) and concerns over a policy-induced pick-up owing mostly to tariffs. Meanwhile, the extension of expiring 2017 tax cuts alone will add $4.0 trillion to the 10-year deficit (according to the CBO) with most years already recording budget shortfalls above 6% of GDP. Even if no other tax measures are put in place, we judge budget offsets from tariffs along with DOGE-led and other spending cuts will have a hard time covering the 'extension tab'. Our base case is that fiscal discipline prevails. And, apart from at least some expiring 2017 tax cuts being extended, we make no explicit assumption about tariffs or other government policies (we’ll factor them in after they’ve been put in place). As Fed rate cuts resume by the autumn, bond yields could be drifting down again but staying above 4%. Meanwhile, 10-year Government of Canada bond yields continue to outperform their U.S. counterparts. Last month, yield spreads averaged a record -134 bps and this month they are on track to better that by more than 10 bps. There are three fundamental factors driving record negative Canada-U.S. yield spreads. First is the Bank of Canada’s larger rate cut tally, at 200 bps compared to the Fed’s 100 bps. And in a Canada-U.S. tariff war, the Bank would be expected to respond much more aggressively than the Fed. Second is Canada’s better fiscal performance. The federal budget deficit is running under 2% of GDP compared to the 6%-plus outcomes south of the border. Third is Canada’s better inflation performance. Canadian CPI inflation was 1.8% y/y in December (below the 2% target, aided by the GST/HST holiday) with the main cores running around 2.4%-to-2.5%. U.S. headline and core CPI inflation (in January) were 3.0% and 3.3%, respectively. We continue to expect that extreme negative yield spreads will linger a while longer before moving slightly less negative as the year unfolds. But they should remain in the triple-digit range, holding the -100 bp line. Finally, we judge the net risk to both our bond yield forecasts rests on the upside. U.S. dollar: The Fed’s broad trade-weighted dollar index averaged a record high in January, for the second consecutive month. Although it’s on track to lose a little ground this month, it remains historically very elevated. The recent strength has been driven by the prospects for U.S. tariffs. Such levies contribute to strength in the greenback by reducing the amount of U.S. dollars being converted into foreign currencies owing to consequent reduced U.S. demand for imports. The strength has also been driven by fading prospects for further Fed easing owing to sticky inflation along with the inflation impacts of potential tariffs themselves. We still judge that market anticipation of the resumption of Fed rate cuts (and their subsequent realization) will be what pushes the big dollar on a modestly depreciating trajectory. But, in the meantime, the trifecta of tariffs, sticky inflation prints, and a steadfast Fed has the potential to propel the greenback to fresh record highs. Canadian dollar: The loonie averaged After the tariff scare at the start of February, one legacy left by the whipsawing of our Canadian economic forecast was a weaker loonie. This reflected the now more tangible risk of tariffs. We see the currency staying above |
Overseas | Jennifer Lee, Senior Economist |
Central bankers have a lot on their plate these days. Besides sustainably guiding inflation to target, a trade war is brewing. The new U.S. tariffs haven't taken effect yet, except for China, but the threats are becoming louder. All of this comes as most policymakers have been lowering rates, some faster than others. In less than one year, the Riksbank (-175 bps), the ECB and RBNZ (-125 bps), and the BoE (-75 bps) have been trimming policy rates, while the BoJ has gone in the other direction (+60 bps). The RBA and Norges Bank haven't budged, but both have signalled that their next moves will be to ease. The ECB was becoming more dovish (considered a 50 bp cut in December) but is now moving ahead with more trepidation ahead of potential U.S. tariffs. At the most recent meeting in January, the 25 bp cut to 2.75% was unanimous, and a larger cut was not even discussed. Since then, President Largarde has continued to emphasize that the Euro Area's disinflation process "is well on track" but warned that the outlook would be in question in the event of a trade war. Her words, specifically, were that "greater friction in global trade" would make the inflation outlook "more uncertain". Given President Trump's comments that the EU is next, European Commission President Ursula von der Leyen fired back with the warning that the EU will take "firm and proportionate countermeasures". More information will come to light by the next meeting on March 6 but already, the most hawkish of the Governing Council has already brought up the possibility that tariffs will create price pressures. The ECB will truly make its decisions on a meeting-by-meeting basis. Meantime, we are comfortable with our call for three more cuts: March, June and September. For now. The BoE has also been easing, but at a far slower pace. Its reluctance stems from sticky inflation (particularly services) and sticky wage growth. But economic activity has been cooling, and that has intensified since Chancellor Reeves tabled the Autumn Budget. The budget measures weighed heavily on consumer and business confidence, as well as spending/hiring plans. At the last meeting in February, the 25 bp cut to its Bank Rate to 4.50% was expected, but there was one shocker: the more hawkish Catherine Mann voted for a 50 bp rate cut. She explained her decision by saying that her "activist" approach was to "cut through the noise". She wanted to reach a lower interest rate faster, then leave it there to anchor inflation expectations. She also favours a rate that is "well above" neutral. For the MPC as a whole, inflation is still a worry, so a "gradual and careful approach” to further rate cuts would be “appropriate”. Those words were chosen “very deliberately”, according to Governor Bailey: "gradual” refers to the disinflation process, and “careful” because of all the “risks and uncertainties”, and we all know there are plenty of those. We continue to look for two more cuts, but let's wait for Chancellor Reeves, who is expected to revise her budget on March 26. Standing out in the crowd is, once again, the BoJ as it tightens policy slowly. It was almost a year ago (March) when the Bank axed the negative interest rate policy, and it has raised rates three times since then, most recently, by 25 bps to a 16½-year high of "around 0.50%". It signaled that there was more to come with surprisingly clear forward guidance: "If the outlook presented in the January Outlook Report will be realized, the Bank will accordingly continue to raise the policy interest rate and adjust the degree of monetary accommodation." Inflation remains above 2%, real cash earnings are higher, and household spending grew at its fastest pace in over two years. We look for the Bank to continue normalizing policy, and raise rates three more times to 1.25% by mid-year. Finally, the time for the RBA to finally cut rates is approaching. Governor Bullock has cited increased comfort in the view that inflation is heading to the 2%-to-3% target in a sustained fashion. We saw it in the latest monthly and quarterly CPI figures. The most notable move was that the trimmed mean CPI slowed from 3.6% y/y in Q3 to a below-expected 3.2% y/y in Q4. And the declines sped up at quarter-end: December's trimmed mean fell to 2.7% y/y from 3.2% in November. That alone should be enough for the RBA to trim the cash rate 25 bps in February, the first rate change since November 2023. |
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