Compared to our last Rates Scenario (September 8), we’ve raised our year-end policy rate projections, by 75 bps to the 4.50%-to-4.75% range for the Federal Reserve and by 25 bps to 4.00% for the Bank of Canada. Reflecting these higher rate profiles and a probable end to inflation relief from oil prices (owing to OPEC+), we also lifted our forecast for longer-term bond yields through the turn of the year, against a background of still stubbornly high core inflation and wage growth. The emerging policy divergence also contributed to a weaker Canadian dollar forecast.
Having hiked policy rates since March by a cumulative 300 bps and into restrictive territory (>3%), including by 75 bps at last month’s meetings, both central banks showed no signs of stopping. Repeated was the Fed’s forward guidance that “ongoing increases in the target range will be appropriate” and the Bank’s that “the policy interest rate will need to rise further”.
However, there were clear indications that the previous comparable rate hike paths were primed to depart. Chair Powell reiterated: “At some point, as the stance of monetary policy tightens further, it will become appropriate to slow the pace of increases, while we assess how our cumulative policy adjustments are affecting the economy and inflation.” But with the FOMC’s median projection for the 2023-end fed funds rate rising 87.5 bps to a 4.625% range midpoint and Powell saying “there's a ways to go” before any holding pattern, the takeaway was that the Fed was not at that “point” yet (at least it wasn’t on September 21). However, back on September 7, the Bank said, “as the effects of tighter monetary policy work through the economy, we will be assessing how much higher interest rates need to go to return inflation to target”, sounding much more in the present tense. Besides, with Canadian households flirting with record-high debt-to-income ratios (well above their U.S. counterparts) and many of their mortgages readily impacted by higher interest rates (unlike America’s 30-year fixed rate loans), we had already reckoned the Bank would start hiking more cautiously once crossing into restrictive territory.
As cumulative policy tightening increases further, we look for real GDP growth to grind to a halt next year in both countries (0% average growth for each), with net contractions in the first half of the year amounting to around ½% (not annualized). These would be considered short and very shallow recessions. Nevertheless, we still expect the Fed and BoC to remain on hold next year, assessing the impacts of their rate hike campaigns on inflation. We judge there’ll be enough progress made to forestall further rate hikes but not enough to encourage rate cuts until early 2024. In both economies, we see the key inflation metrics still running above 3.00% by the end of next year (but on a clear track to 2%). In other words, the expected mild recessions are just offsetting more persistent inflation pressures on the ground now. The net risk is that the economies succumb further to these rate hikes, or even more tightening ensures they do, thus triggering rate cuts next year.
Federal Reserve: At the November 2 meeting, we look for a fourth consecutive 75 bp rate hike, lifting the fed funds target range to 3.75%-to-4.00%. Supporting a quartet, core PCE inflation increased 0.2 ppts to 4.9% y/y in August. Although still down from the 5.4% peak earlier in the year, the annual changes in the median and mean versions of the PCE were both hitting new highs in the month. Not so supportive was the JOLTS showing a near-record drop in job openings in August and, apart from the pandemic, the largest drop in labour demand (payrolls + openings) since the Great Recession. The next inflation reports (CPI on October 17th, PCE on the 28th) could be critical for the Fed in determining when to start shrinking the increments. However, short of significant downside inflation surprises, with the median FOMC projection for December at a 4.375% range midpoint, 75 bps followed by 50 bps on December 14 appears to be the baseline (and a final 25 bps at the next meeting on February 1).
Bank of Canada: At the October 26 meeting, we look for a 50 bp action, lifting the policy rate to 3.75%. In August, all three of the Bank’s core inflation metrics decreased, with the average slipping 0.2 ppts to 5.2% y/y (July was the peak). Although still high, this was the first slip for the average in 20 months. Governor Macklem's October 6 speech made it clear that another aggressive rate hike is coming, consistent with our call. However, if the data surprise on the high-side (strong growth/inflation), that could prompt another 75 bp hike. The next Business Outlook Survey on October 17 and CPI report on October 19 will be critical for the 50 vs 75 decision, as will what happens to the Canadian dollar (recent weakness is already stoking inflation) and coming wage settlements. Meanwhile, (household) employment dropped in each of the three months ending August, and if the next Labour Force Survey (October 7) keeps this weakening trend intact, that would put the BoC in an increasingly difficult spot.
Bond yields: Ten-year Treasury yields (constant maturity) peaked at just under 4% on September 27, which was the highest in more than a dozen years, after selling off a net 46 bps in the wake of the Fed’s ‘hawkish hike’ on the 21st (including two almost +20 bp days). This was on top of the 35 bp selloff since the start of the month. They subsequently rallied a net 35 bps (including a -25 bp day) by early this week, only to give back about 20 bps over the past couple days (sitting above 3.80%). The volatility emphasizes the intense struggle between two market narratives. One is that the Fed’s more aggressive tightening will lead to slower economic growth, perhaps even a recession; and, consequently, quicker disinflation along with earlier and more aggressive policy rate cuts (and QT ending sooner to boot).
The other is that this means higher policy rates will last longer with their influence rippling along the yield curve, as stubborn core inflation and wage growth on the ground offset any additional GDP-driven disinflation. Our view is that, through the turn of the year, the second narrative will dominate, and we look for another (temporary) test of 4% with December averaging a cycle high 4.00%. The latter will be the highest since the ‘4-handles’ of the Great Recession era.
In the wake of the BoC’s ‘dovish hike’ and before the Fed meeting, 10-year Canada yields trended mostly lower causing negative Canada-U.S. spreads to more than triple from around -15 bps to almost -50 bps. Much of the subsequent post-Fed volatility was absorbed in spreads, first to -68 bps then back to about -50 bps. We expect a range around -50 bps to hold through the turn of the year, with the net risk it could move even more negative. Once we turn the corner on cross-border rate hikes, we see spreads trending less negative by an average annual 10-to-15 bps.
U.S. dollar: The trade-weighted greenback averaged its highest level on record in September (series started in 1973), surpassing the previous peak at the onset of the pandemic in April 2020. The real exchange rate also hit its highest level since October 1985 (the month after the Plaza Accord was signed among the G5 countries to deliberately depreciate the USD). Net capital inflows are being driven by the Fed’s relatively aggressive policy approach, along with escalating global economic and geopolitical risks (Europe’s energy crisis, the Ukraine war, China’s lockdowns). These risks aside, we reckon as soon as Fed rate hikes are reduced and then stopped, the greenback will lose much of its lustre. We look for the big dollar to depreciate nearly 5% by the end of next year.
Canadian dollar: Amid the U.S. dollar’s strengthening trend, the loonie has been weakening, averaging C$1.332 (US$0.751) in September. This is the weakest since July 2020 when the loonie was rebounding from its pandemic-pummelling. With the Bank of Canada likely no longer keeping pace with Fed rate hikes (75 bps vs 150 bps) and stopping sooner (December vs February), we look for the loonie to weaken further despite brighter prospects for oil prices (thanks to OPEC+). Favourable oil prices simply don’t fuel the investment flows (and capital inflows) they once did. After averaging around C$1.40 (US$0.714) in December, we look for the loonie to appreciate more than 7½% against the greenback (to C$1.30 or US$0.769) by the end of next year.