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.