Compared to our last Rates Scenario (June 9), we’ve lifted our year-end forecasts for Federal Reserve and Bank of Canada policy rates by 25 bps to the 3.25%-to-3.50% range. This was in response to stubbornly high CPI inflation readings on both sides of the border and the FOMC’s more hawkish-toned policy pronouncements on June 15. As before, we expect both central banks to trim their incremental increases as year-end approaches amid some expected improvements on core inflation. And, we look for them to hold rates at their 2022-end levels through next year to ensure that inflation does indeed recede.
However, compared to being skewed to the upside before, we now judge that the risks surrounding our forecasts are more balanced. Apart from slightly higher rates, the risk shift reflects a weaker economic scenario through the turn of the year. Both U.S. and Canadian real GDP growth are now expected to grind to a near-halt compared to running in the low/mid-1% range before. In eliciting extra central bank tightening and eroding even more purchasing power, stubborn inflation is causing additional growth headwinds against a background of sagging markets and consumer confidence. The risks of the Fed and BoC having to hike rates to even higher levels because inflation fails to fall sufficiently are now roughly balanced against the risks of both central banks cutting rates next year. (The latter would pull forward our forecast for 100 bps worth of easing in 2024.)
Federal Reserve: The FOMC meets on July 26-27, and we expect a second consecutive 75 bp rate hike, lifting the fed funds target range to 2.25%-to-2.50% (2.375% midpoint). This is a critical range that incorporates the Committee’s 2.50% median of its 2%-to-3% range of projections for the neutral level and matches the peak in policy rates from last cycle (which proved to be a bit onerous). In last month’s post-meeting presser, Chair Powell said that “either a 50 basis point or a 75 basis point increase seems most likely at our next meeting”. This suggested to us that it was going to be a 75 bp move unless there were major disinflationary surprises, and there haven’t been. After back-to-back 75 bp actions, we’re forecasting a 50 bp move in September, followed by back-to-back 25s in November and December (range midpoint at 3.375%).
Bank of Canada: The next policy announcement is July 13. After two consecutive 50 bp rate hikes, we’re expecting a 75 bp increase, lifting the policy rate to 2.25%, or just above the bottom of the BoC’s 2%-to-3% range of estimates for the neutral rate. In a June 9 press conference, Governor Macklem said: “We may need to take more interest rate steps to get inflation back to target. Or we may need to move more quickly, we may need to take a larger step”. This reinforced the (June 1) policy statement’s assertion that “the Governing Council is prepared to act more forcefully if needed.” Afterwards, we’re forecasting a 50 bp hike followed by 25 bp moves in the final two meetings of the year, which will leave the policy rate at 3.25%, a bit above the neutral range. That is consistent with Deputy Governor Beaudry’s June 2 speech, when he said there was a “likelihood that we may need to raise the policy rate to the top end or above the neutral range to bring demand and supply into balance and keep inflation expectations well anchored.”
Bond yields: After nearing 3.50% ahead of last month’s FOMC meeting (3.49% on June 14) and hitting the highest level in more than 11 years, 10-year (constant maturity) yields have since dropped sharply to around 2.80%. Stoking the 70 bp rally was the post-meeting realization that the Fed was putting fighting inflation well ahead of avoiding recession. The market is betting that inflation can be brought under control without having policy rates stray above 3.5%; that inflation, both on the ground and in expectations, has probably peaked; and, that policy rates can start being cut next year.
We suspect that all aspects of this scenario will be questioned in the weeks and months ahead as the market grapples with what we reckon will be some still-stubborn inflation readings. With recession now on the market’s mind, revisiting 3.50% yields could be more of a stretch, but this doesn’t preclude another noticeable run higher. Partly pushed by the planned doubling of the Fed’s quantitative tightening (QT) effort in September, we see 10-year yields re-peaking around 3.40% by year-end, around the time Fed rates peak. Meanwhile, we look for Canada-U.S. yield spreads to remain in their recent range.
U.S. dollar: After the Fed signalled a more aggressive monetary policy approach during March, in stark contrast to some other major central banks, the trade-weighted unit has been stronger. In the four months ending June, it’s up a cumulative 4.4%, also supported by the war in Ukraine and lockdowns in China. Although other central banks have been jumping on the tightening bandwagon, some surprisingly so, the greenback has continued to rise on heightened concerns about global recession. This theme looks to continue playing for the remainder of the year, with the U.S. dollar gaining a further 2%. However, we look for some retracement next year.
Canadian dollar: Amid the U.S. dollar’s recent strengthening, the Canadian dollar has been trading in a choppy but weakening pattern. The loonie was unable to garner any lasting support from the Bank of Canada’s Fed-like aggressiveness or from stronger commodity prices. After averaging C$1.2814 in June, we look for the loonie to continue drifting weaker (to around $1.30) before ending this year back around the $1.28 mark. Next year’s turn in the greenback should provide some further lift for the loonie.