Inflation risks remain stubborn on both sides of the Canada-U.S. border. This is in spite of the downside economic risks posed by rising COVID-19 infections (owing to the Delta variant) along with supply bottlenecks proving to be more long-lasting than initially anticipated. Meanwhile, economic performance has remained solid, despite the occasional disappointment for market expectations, and there are good prospects for continued strength—and corresponding inflation risk—supported by accommodative financial conditions and the massive amount of pent-up savings. In the prior Rates Scenario (July 5), we argued that the risk of policy rate liftoff occurring earlier was rising. And, even with the cloud from Delta’s spread, we’ve since slightly pulled forward our calls, with inaugural rate hikes in October 2022 for the Bank of Canada and February 2023 for the Fed.
Federal Reserve: The July FOMC policy announcement stuck to the transitory narrative for inflation, but Fed Chair Powell acknowledged in the presser that “as the reopening continues, bottlenecks, hiring difficulties, and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than we expect.” We reckon Powell’s “possibility” will translate into some reality, with many supply bottlenecks projected to persist into next year. And, besides, bottlenecks could soon take a backseat to the ripple effect from higher home prices as an inflation worry.
Elsewhere, the statement toned down the phrase: “The path of the economy continues to depend on the course of the virus.” It dropped the reference to the path depending on it “significantly”. Powell said each virus wave seems to have “less in the way of economic implications” as “we’ve kind of learned to live with it.” Amid the Fed-perceived reduced economic risk from the pandemic, the FOMC also took a step closer to tapering its asset purchases.
Citing the forward guidance first proffered in December (QE at the current pace “until substantial further progress” has been made toward the maximum employment and price stability goals), the statement said: “Since then, the economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings.” Powell indicated that more labour market improvement was required to satisfy the tapering prerequisite; perhaps last week’s 943k jump in payroll jobs and half-point drop in the jobless rate to 5.4% meets much of the requirement. As such, we’re sticking with our base case calling for a formal September announcement of an October tapering start… one more employment report away. On August 2, Governor Waller said: “If the jobs reports come in as I think they’re going to…then in my view, with tapering, we should go early and go fast.” This is likely where the net risk lies.
Bank of Canada: On July 14, the Bank announced another tapering of the QE program, to $2 billion per week from $3 billion, stating that: “This adjustment reflects continued progress towards recovery and the Bank’s increased confidence in the strength of the Canadian economic outlook." We expect to see another tapering action in October (to $1 billion), presuming the economy continues performing well, and the QE program to end early next year.
The Bank also repeated the commitment 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” which was still “sometime in the second half of 2022.” In the wake of the second tapering step and, importantly, its rationale, we pulled forward our policy rate liftoff forecast to the last MPR meeting (October) of 2022.
Bond yields: Ten-year Treasury yields (constant maturity) were trading below 1.20% to start August, only to pop back above 1.30% in the wake of the strong employment report. Although tapering is getting closer and inflation risks continue to swirl around America’s solid economic performance, the capital-inflow-prodding global economic risks posed by the surging Delta variant should keep selloffs in check for the time being. Nevertheless, persistent higher inflation readings and a Q4 start to tapering (both of which are not fully priced in) should prompt a modest upward trend for the reminder of this year supplemented by policy rate tightening speculation as 2022 unfolds (presuming the infection surge eventually subsides). We see 10-year yields averaging around 1.5% by the end of this year and 2.0% by the end of next year.
As Treasuries have mostly rallied in recent weeks, Canada-U.S. 10-year spreads have moved less negative, to a 3-bp range on either side of -7 bps (the range midpoint was more like -10 bps to start July). This underperformance also reflects a bit of the view that the Bank of Canada isn’t only going to beat the Fed in tapering timing but also rate hikes. We expect this range to hold for the time being.
U.S. & Canadian dollar: The greenback continues to be guided by market-perceived global economic risks (and associated capital flows), strengthening when they rise but weakening when they fall. And, amid the surging Delta variant, it has been more of the former instead of the latter. It’s currently about 2½% above the pandemic low hit at the beginning of June. However, we judge the greenback will ultimately re-weaken again, once the market gets over the Delta blues, averaging around 1½% lower by 2021-end and a further 1¼% by 2022-end—once again testing the pandemic low.
This should help the loonie change its recent flightpath. It has been weakening in the wake of U.S. dollar strength, dropping under US$0.785 (above C$1.274) mid-last month, from highs above $0.830 (below C$1.205) at the start of June. A relatively more hawkish Bank of Canada (vs. the Fed) should help as well. We see the Canadian dollar eventually appreciating to around US$0.816 (C$1.225) by the end of this year and US$0.833 (C$1.200) by the end of next year.