Canada-U.S. Rates Outlook
Compared to the previous Rates Scenario (April 5), Bank of Canada and Federal Reserve inaugural rate hikes in 2023 have been pulled forward to earlier in the year. And, the risks of these being pulled further into 2022 have risen.
Background: Both the Canadian and U.S. economies grew around 6½% annualized in 2021Q1, but growth should diverge sharply in Q2 as Canada grinds to a halt because of increased pandemic-related restrictions across the country. In the U.S., many state and local governments continue to ease constraints, joining the lengthening list of restriction-free jurisdictions. Also driving the divergence is America’s faster-deployed vaccinations and fiscal stimulus. However, the Canadian economy should rebound strongly during the summer months, playing catch-up with the U.S. on vaccinations and reopenings. For 2021, we expect growth to average 6.0% in Canada and 6.5% in the U.S., and for both economies to average 4% to 4½% in 2022.
Meanwhile, even accounting for Canada’s spring setback and aside from technical ‘base effects’, inflation risks are rising on both sides of the border. Supply shortages and other capacity constraints (along with higher food, oil and other commodity prices) are posing pressures, particularly as pent-up demand is being unleashed. Both the Fed and Bank of Canada argue that these inflation pressures will be transitory, but we assume some will be more stubborn.
Labour markets are not tight enough—yet—to be concerned about these price pressures being propagated by compensating wage gains. However, the massive amounts of accumulated excess savings suggest that consumers might be willing and able to keep paying higher prices for longer than they otherwise would, affording businesses a window to keep passing on higher costs. The window would remain open until earmarked savings are sufficiently exhausted or pent-up demand is sufficiently satisfied, likely lifting inflation expectations along the way. It could also end up coinciding with when labour markets are tight enough to start generating moderately stronger wage gains. We look for employment levels to fully recover by mid-2022 and jobless rates to return to pre-pandemic levels by the end of next year.
Given the above backdrop, once the dust settles after the bout of acute price pressures this spring, we expect a moderately-above-2% pace to persist through the end of 2022. As we head into 2023 (if not sooner), we suspect both central banks will deem the recovery is sufficiently inclusive and inflation warrant a rate hike.
Federal Reserve: On April 28, as expected, the FOMC didn’t change the fed funds target range, the pace of asset purchases, or the forward guidance. The 0%-to-0.25% fed funds target range will be maintained until maximum employment is achieved and inflation has been tracking moderately above 2% “for some time”. Monthly purchases of $80 billion in Treasuries and $40 billion in MBS will continue until “substantial further progress” toward the employment and inflation goals has been made. However, the Fed’s assessment of the (net downside) risks to the economic outlook were no longer deemed to be “considerable”. This is perhaps a sign that the Fed is growing more confident in the economy’s ability to continue making progress toward the employment and inflation goals. Our base case calls for a March 2023 rate hike, with follow-up moves every half year.
Our tapering call is guided by two considerations. First, the Fed will likely ensure a reasonable amount of time elapses between the end of quantitative easing (QE)—the end of adding accommodation—and March 2023—the start of removing accommodation; we’re giving it six months. Second, following 2013-14’s playbook, the FOMC’s purchases will probably be pared gradually. Our working assumption is by $10 billion and $5 billion, respectively, for Treasuries and MBS each meeting cycle, which results in a year-long tapering process and the consequent start of tapering during the fourth quarter of this year (and, yes, the Fed will conclude that “substantial further progress” has been made).
Bank of Canada: The tone of the Bank’s April 21 policy statement took a hawkish turn. While still committing to hold the policy rate at the effective lower bound “until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved”, this is now projected to happen “some time in the second half of 2022” instead of “into 2023” before. Our base case calls for a January 2023 rate hike, with follow-up moves every half year.
The Bank also reduced its QE bond buying to $3 billion per week from $4 billion, but the weighted average maturity (WAM) of purchases wasn’t changed unlike last October when QE was clipped by a similar amount. This was more of a ‘true’ taper. Moreover, there was a major technical reason to pare purchases. The Bank was already buying a higher proportion of the government’s borrowing requirements than other central banks’ QE programs, and these requirements are now forecast to fall. Although the Bank itself had mentioned the technical issue before, the reason given for the taper was the “progress made in the economic recovery”. We’re expecting another QE pullback within the next six months (to $2 billion) and the program to end by early next year.
Bond yields: Ten-year Treasury yields have been trading in the 1.55%-to-1.65% range since April 13. Despite the recent stability, we still look for yields to drift modestly higher by year-end, to around 1.75% (which they already flirted with at March-end). This reflects the mostly-priced-in trifecta of stronger growth, faster inflation and big budget deficits. In 2022, tapering and tightening speculation should augment the moderate upward pressure on yields, ending around 2.00%. During the above-mentioned interval, 10-year Canadas have been trading in the 1.45%-to-1.55% range, but Canada-U.S. spreads have bounced between -15 bps and -5 bps. We look for 10-year Canadas to follow Treasuries higher, with spreads running in the range of -15 bps to -10 bps. While relatively earlier tapering could contribute to Canadas underperforming, this should be offset by a strengthening Canadian dollar.
U.S. dollar: The broad U.S. dollar index bottomed in early January, down more than 12% from the record high hit late March 2020 at the height of pandemic panic. It then turned up, as the prospects for stronger U.S. economic growth (partly owing to fiscal stimulus) and rising bond yields became a beacon for capital inflows. The unit appreciated more than 3% by March-end but subsequently turned down again. Perhaps the consequences of stimulus-stoked growth—record-sized budget and trade deficits—are starting to take a toll. However, we judge the greenback will ultimately continue to trend weaker owing to improving investor-perceived global economic prospects and ebbing risks. From current levels, we see the unit averaging less than 1% lower by the end of this year, and a further 2% by the end of next year.
Canadian dollar: The loonie is the best-performing major currency so far this year, despite the U.S. dollar’s firming trend through the first three months. This reflects rising commodity prices (to record highs for Canada’s non-energy prices), an improving balance of payments situation (best since 2008), along with the Bank of Canada’s less dovish shift in forward guidance and QE. We look for the Canadian dollar’s strengthening momentum to continue, particularly with the greenback likely back on a weakening trend, averaging C$1.20 (above US$0.83) by the end of this year and C$1.175 (above US$0.851) by the end of 2022.