Rates Scenario

March 08, 2022 | 15:51

Rates Scenario for March 8, 2022

Economist

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

Michael is part of the team responsible for forecasting and analyzing the North American economy and financial m... (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 is part of the team responsible for forecasting and analyzing the North American economy and financial m... (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

Michael Gregory, CFA, Deputy Chief Economist

Compared to our last Rates Scenario (Feb. 8), we have not made any changes to our Federal Reserve and Bank of Canada forecasts. We look for both central banks to raise policy rates by a quarter point at each of their next three consecutive meetings. The March 16 confab will mark policy rate liftoff for the Fed, after the Bank launched its tightening campaign on March 2 with an expected 25-bp move. Following this flurry, we look for them to switch to an every-second-meeting rate hike cadence (all 25-bp moves) until rates have risen to levels tucked under the midpoints of their neutral ranges. That is, 2.375% compared to the 2.00%-to-3.00% range of projections among FOMC participants and 2.00% versus the 1.75%-to-2.75% range for the Bank of Canada’s estimates.
However, while our rate forecasts haven’t changed, the risks surrounding them have heightened materially in the wake of Russia’s invasion of Ukraine, which is stoking both downside risks to economic growth and upside risks to inflation. While the onerous sanctions should push Russia into a recession, some U.S. and Canadian businesses with trade and investment ties to Russia will also feel the impact from public and shareholder pressure to pull back on activities. The Russian recession will have more of a trade impact in Europe, but slower growth there will likely ripple across the Atlantic.
Then there’s the growth-sapping impacts of further disrupted global supply chains that are already impacting European automotive production. Unfortunately, this comes just as domestic supply chains are starting to recover from the production disruptions caused by the Omicron-related surge in absenteeism (new infections on both sides of the Canada-U.S. border peaked during the first half of January). Of course, such disruptions, given sturdy demand, are also sources of inflation pressure.
So, too, is the fact that Russia is a major producer and exporter of oil, natural gas and base metals. Along with Ukraine, they are also major producers and exporters of grains and oilseeds. Commodity markets are concerned about constrained supply owing to spreading sanctions (so far imposed lightly in this sector), Russia threatening to withhold some exports (such as natural gas to Europe), and the impact of the war on local production (will Ukraine plant crops this year?). The consequence has been higher and more volatile commodity prices, which is impacting what consumers pay at the pump and for groceries. This comes as U.S. CPI inflation is already at a 40-year high of 7.5% y/y, with Canada at a 30-year high 5.1%.
The invasion’s growth headwinds are hollering for more rate hike caution or temporary postponement of further moves. Meanwhile, the conflict’s inflation tailwinds are arguing to stick to the current tightening script, if not intensify it further. At this point, the Fed and BoC appear to judge that the latter trumps the former. But, the longer the war in Ukraine lasts, let alone whether the conflict escalates or Russian sanctions are expanded, the downside risks to growth and upside risks to inflation will continue to mount. And, likely increasingly tilting the scale to the growth risk side, particularly if financial conditions continue to deteriorate. Hence Chair Pro Tempore Powell’s assertion about being “nimble”. Amid the post-liftoff flurry of rate hikes, a temporary pause is very much possible. And, at the very least, the events in Eastern Europe are reducing the odds of 50-bp actions this spring.
Federal Reserve: A 25-bp rate hike is expected on March 16. We look for the FOMC to signal follow-up moves in the statement and via the ‘dot plot’. For 2022, that means fewer participants in the under-3-hikes camp (there were 6 in Dec.) and more in the 4-plus group (2 in Dec.), perhaps with the latter mustering enough to lift the current 3-hikes median projection. Powell already mentioned in his recent semi-annual testimony that the quantitative tightening (QT) plan is unlikely to be finalized at this meeting, but we're hoping to get some clues in the presser.
Bank of Canada: The Bank raised rates 25 bps on March 2, and stated that “interest rates will need to rise further”. The statement said it will now “be considering when to end the reinvestment phase and allow its holdings of Government of Canada bonds to begin to shrink”. Since October, the BoC has been buying $4-to-$5 billion per month to keep its holdings unchanged. The purchase pace was calibrated to match the large and unevenly spaced maturities over time. In the next-day speech and presser, Governor Macklem said: “When we initiate QT, we will stop purchasing” and allow “full run-off”. Along with a follow-up rate hike, we’re bracing for the BoC's announcement of QT’s start at the April 13 meeting, which will immediately end reinvestment.
Bond yields: Amid the swings in investor sentiment in the equity market, bond yields are in a tug-of-war between the escalating downside risks to economic growth and upside risks to inflation. The latter, already an issue before the invasion, contributed to 10-year yields hitting 2.05% in mid-February, their highest level since July 2019. However, in the wake of the invasion, yields have pulled back about 20 bps, all owing to real yields. Indeed, since mid-February, 10-year inflation breakevens are up about 30 bps. If the conflict worsens, or the longer it lasts, it seems that the curve is only going to get flatter with the increasing risk of inverting (2s10s is currently under 25 bps). Our base case is that market-perceived risks should eventually ebb, which, along with the upward pressure from QT, should push 10-year yields above their recent highs by the end of the year. The same narrative holds for 10-year Canadas, with Canada-U.S. spreads remaining in their recent range. Spreads at the front end of the curve shed their positive signs last month, with the Bank and Fed now on more comparable (but not identical) rate hike and QT schedules.

U.S. dollar: The greenback is strengthening due to safe-haven flows amid the unfolding conflict in Eastern Europe. The trade-weighted unit is currently trading at an 18-month high, with more gains likely. Although the currency is vulnerable to a stabilization of the situation, with the Fed still expected to tighten more aggressively (via rate hikes and QT) than most other major central banks, the dollar should hold on to its recent gains. We see the greenback averaging more than 1½% stronger by the end of the year.
Canadian dollar: Despite escalating oil prices along with solid trade and current account fundamentals, the loonie has been nothing short of lacklustre. It has remained in the C$1.26-to-C$1.29 range so far this year. The issue is that recent rising oil prices have been reflecting supply constraints and potential disruptions, not risk appetites. Indeed, with risk aversion on the rise and the big dollar being a beneficiary, the best the loonie can do is fly sideways. With the greenback likely to remain firm and the current risk premia embedded in commodity prices likely to ebb over time (presuming the Russia-Ukraine situation at least stabilizes), it will be hard for the CAD to break significantly below the current range even as risk appetites return.

Overseas

Jennifer Lee, Senior Economist

The onset of the war in Ukraine, and the subsequent surge in energy prices and other commodities, will send sky-high inflation even higher while stalling growth. Indeed, the possibility of stagflation in Europe has now been introduced, though joint bond sales by the EU to fund spending on energy and defense could help limit the downside for growth. Still, this complicates plans by the ECB and the BoE to tighten monetary policy. Not tightening runs the risk of boosting inflation even further, while tightening too much runs the risk of stopping the recovery in its tracks.
The ECB’s mandate is to maintain price stability at 2% over the medium term and it must act if that target is derailed. Take a look at the latest inflation reading for February. Euro Area consumer prices jumped 0.9% in the month, or a record 5.8% y/y. Energy was the biggest contributor, but it went beyond that as core CPI rose from 2.3% at the start of the year to 2.7% last month, the highest since October 1995. This was the third surprise in a row for inflation. There is a strong likelihood that this will pressure wages, particularly with labour markets so tight. What does this mean for the ECB on March 10? Based on the data and only the data, it would be an open and shut case for less accommodation and eventually higher rates. The Minutes from the ECB's February meeting revealed increasing worry about inflation and that getting to the 2% target in the medium term was “no longer a distant prospect, thus making the fulfillment of the forward guidance criteria more likely within a shorter time span”. Communication was important: central bankers agreed to stop calling inflation temporary or transitory, and“stress its assessment” that prices will decline over the course of the year. Therefore, “a scaling-back of monetary accommodation should commence, in line with the established forward guidance on sequencing.” But the war in Ukraine has caused some to rethink what appropriate action to take. We expect the central bank to stick to its December plan, but with some tweaks. For starters, the PEPP will, without a doubt, be put to bed. The APP will take over, but the size of the planned monthly buys may be trimmed (example: instead of €40 bln between April-to-June, perhaps €35 bln or €30 bln; then, instead of €30 bln from July-to-September, perhaps €25 bln or €20 bln). But the APP may be left open-ended, with a view to reconsider it at upcoming policy meetings. Prior to the invasion, we expected that the APP would end in September, allowing for a rate hike before year-end. But given the highly unsettling backdrop of the war, the ECB will not want to back itself into a corner and will emphasize “flexibility” and “optionality”. Still, a rate hike before year-end remains in the cards.

Then there is the BoE. At least it already began the process of raising its Bank Rate, by 15 bps in December and by 25 bps in February to 0.50%. Four of the nine members of the Monetary Policy Committee wanted to push up the official rate by 50 bps at the last meeting and, if not for the Russian invasion, would have likely convinced at least one other policymaker to vote with them in March. Now, even the most hawkish member seems to be getting cold feet. But with a three-decade high inflation rate (both headline and core), the Bank is expected to raise rates another 25 bps on March 17. As Governor Bailey said, "We have not raised rates because the economy is roaring away…. a higher Bank Rate is necessary because it is unlikely inflation will return to target without it."
On the other side of the coin, the RBA, despite inflation finally reaching the 2%-to-3% target range, is still not prepared to raise rates just yet and has stressed "patience" in its latest press release. Nonetheless, we remain of the view that a rate hike in the second half of the year is a strong possibility. Finally, the BoJ's stance has not changed at all. Governor Kuroda continues to stress the Bank's resolve to maintain its ultra-easy policy, particularly as the manufacturing sector (autos) remains hobbled by supply shortages. Expect an on-hold announcement and a downgrade to its economic assessment when it meets on March 18.

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