Canada-U.S. Rates Outlook
Fed… In the January 27 policy statement, the FOMC repeated that it would keep the fed funds target at 0%-to-0.25% “until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time”. This likely means a return to at least pre-pandemic employment levels. As of December, jobs were still down 8.9 million (9.8 mln by the payrolls count) from February, when the unemployment rate was 3.5%. Although December’s jobless reading of 6.7% was relatively closer to the mark compared to the reported peak of 14.8%, in the press conference, Chair Powell said, “the real unemployment rate is close to 10 percent if you include people that have left the labor force”.
Reaching ‘maximum employment’ could easily take until past 2023, and unless there are indications of unacceptably high inflation pressures, there will be no preemptive tightening moves along the way. On the inflation front, the Fed expects the March and April increase in annual rates owing to unfavourable year-ago comparisons to be “transient”, and the same for any later increase owing to “a burst of spending because people will be enthusiastic that the pandemic is over”. Powell said the Fed is going to be “patient” in assessing whether a moderately-exceeding-2% trend is in place. Reflecting the above, and with a nod to persistent labour market slack and the still-powerful secular forces of disinflation (aging population, technological change), we continue to look for no Fed rate hikes until 2024 but with net risk of earlier action.
Meanwhile, the Fed’s appetite to provide additional monetary stimulus will likely wane as the year unfolds, reflecting the lifting of restrictions, a rising vaccinated population share and another large dose of fiscal stimulus. We look for the Fed to announce this December that tapering of asset purchases will start in January 2022 but, again, with net risk of earlier action. Boosting both net risks, the FOMC dropped the prior reference to the COVID-19 crisis posing considerable risks to the economic outlook “over the medium term”.
BoC… In the January 20 policy statement, the Bank of Canada repeated that it “will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. In our projection, this does not happen until into 2023” and “will continue its QE program until the recovery is well underway”. However, the statement freshly added that, “as the Governing Council gains confidence in the strength of the recovery”, QE will be adjusted as required. Meanwhile, the Bank said, “beyond the near term, the outlook for Canada is now stronger and more secure than [before]… thanks to earlier-than-expected availability of vaccines and significant ongoing policy stimulus”. Sounds like some confidence is being gained.
Indeed, once the FY21/22 federal budget is released this spring, along with its probable projection for materially lower borrowing requirements than in FY20/21, we reckon the Bank will announce the start of tapering (perhaps at the April 21 meeting). Note that the BoC’s buying of Canadas (~$20 bln/mo) is proportionately much larger than the Fed’s buying of Treasuries ($80 bln/mo), and the Bank is closer to the point of having to pare purchases to prevent buying an increasing share of decreasing issuance. As the Bank buys less, it could skew remaining purchases to longer maturities, like when the weekly clip was reduced from $5 billion in October.
It seems that the BoC might also start raising rates before the Fed. However, currency concerns could make the Bank more cautious when it comes to these decisions. In the presser, Governor Macklem said, “if we see further appreciation, that will become more of a headwind. That does present some downward risk to our projections”. Furthermore, later this year, the Bank and the Government will renew their five-year agreement on the inflation-control target. This time, there appears to be a greater chance than in previous renewals for a change in the monetary policy framework reflecting recent (persistent) inflation underperformance and the Fed’s shift to average inflation targeting. An example could be to emphasize the 1%-to-3% target range over the 2% midpoint, which would permit extended runs of above-2% (but below-3%) prints. We also continue to look for no BoC rate hikes until 2024 but with higher net risk than the Fed of earlier action.
Bond yields… The monthly average of 10-year Treasury yields has been steadily drifting up since hitting record lows of 0.62% in August (when the Fed modified its policy framework). Last month, the average rose 15 bps to 1.08%, the most so far, as the incoming Biden Administration proposed a $1.9 trillion fiscal stimulus package on top of the roughly $900 billion relief bill that was signed on December 27. This emphasized a factor fuelling an expected (moderate) upward trend in longer-term yields: the mix of waning investor demand for Treasuries (as attention shifts to riskier assets amid brightening post-pandemic economic prospects) and a still relatively large supply of Treasuries (the Fed starting tapering will only exacerbate this imbalance).
Another factor fuelling this trend is rising inflation expectations. In January, the implied 5-year forward inflation rate (from TIPS) averaged above 2% for the first time in 21 months. And, the risks surrounding priced-in inflation compensation are probably also on the rise in the market’s mind should the Fed’s “transient” pressures prove to be more persistent against a background of increasing global commodity prices. We see the trend continuing with the 10-year Treasury yield averaging 1.35% by the end of this year and 1.50% by the end of 2022, with net upside risks.
Ten-year Canada yields have followed the same pattern albeit less dramatically… a record low monthly average of 0.52% in August (Canada-US spread -10 bps) rising to 0.81% last month (-27 bps). Although Canada’s fiscal deterioration owing to the COVID-19 crisis was more dramatic than America’s, it’s expected to start stabilizing sooner (particularly borrowing requirements), amid better-anchored inflation expectations to begin with. However, the consequent potential for relative outperformance is countered by the Bank of Canada starting to pare its proportionately larger asset purchases as soon as this spring. We see 10-year Canadas at 1.15% by the end of this year and 1.30% by the end of 2022 (both -20 bps versus Treasuries), again with net upside risks.
Greenback & loonie… After averaging record highs in April 2020, at the peak of pandemic panic, the trade-weighted U.S. dollar index has consistently weakened for a cumulative 9.5% by January. Increasingly, this trend has reflected improving investor-perceived global economic prospects and ebbing risks, and it looks to continue, albeit more modestly, since relatively stronger U.S. economic performance and higher longer-term bond yields should attract greenback buyers. We see the unit 2% weaker by the end of 2021, before stabilizing next year. This trend should continue to be the dominant force affecting the Canadian dollar. After averaging above C$1.40 in April (below US$0.714), the loonie appreciated a cumulative 9.9% to below C$1.28 by January (above $0.781). With assistance from firmer oil prices (WTI averaged above US$50 in January) and the BoC taking away the QE punch bowl faster than the Fed, we look for the loonie to average C$1.25 (US$0.80, up 2.3%) by the end of 2021, before also stabilizing next year.