We look for Federal Reserve and Bank of Canada policy rates to remain at their effective (zero) lower bounds past the end of 2023. This pushes back our previous projection by about half a year, contributing to slightly lower forecasted bond yields.
At the end of August, the FOMC announced changes to its policy framework. For the goal of maximum employment, policy will now be informed by an assessment of the “shortfall” of employment from its maximum level, no longer the “deviation” from its maximum level. The latter meant that, as the unemployment rate approached its longer-run, or natural, rate (4.1%), the Fed would be inclined to tighten policy. However, seeing what the pre-pandemic run of sub-natural jobless rates resulted in (social broadening of employment and wage gains) and didn’t result in (generalized inflation), preemptive tightening will no longer transpire. For the goal of price stability, the FOMC is now targeting inflation that averages 2% over time. This means that, after a period of sub-2% prints, for a while, the Fed will aim for inflation to overshoot a bit.
Reflecting these changes, along with the U.S. economy’s still-uncertain recuperation from the pandemic, the Fed altered its forward guidance on September 16th. The policy statement said that “it will be appropriate to maintain this target range [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.” The Summary of Economic Projections’ median calls and ‘dot plot’ corroborated this messaging. Headline and core PCE inflation are not expected to run above 2% before 2023; they only manage to hit 2% by that year. In turn, the fed funds rate remains at 0.125% through 2023, with a high degree of conviction among policymakers. After unanimity over this call for this year and next, only one participant has a rate hike in 2022 and only four have them in 2023.
On September 9th, the Bank of Canada reiterated its forward guidance, first introduced in the previous (July 15th) policy statement, that “the Governing Council 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.” And, that “as the economy moves from reopening to recuperation, it will continue to require extraordinary monetary policy support.” Although the guidance remained the same, the next day, Governor Macklem’s speech revealed elevated concern over the “slow and choppy” recuperation phase “as the economy copes with ongoing uncertainty and structural challenges.” This should make the Bank more cautious about rate hikes, particularly with the Fed mapping out a longer road with low rates.
Longer-term bond yields hit their post-pandemic (and record) lows at the start of August (10-year Treasuries under 55 bps, Canadas under 45 bps). They have since backed up around 15 bps. Stateside, as the new COVID-19 case rate dropped from a July peak of over 65k/day on average to around 40k currently, deflation risks ebbed in the market’s mind. For the TIPS segment, 5-year expected inflation (5 years forward) has now returned to pre-pandemic levels. Despite the urging of Fed Chair Powell, agreement on another fiscal stimulus package has proved difficult in this politically-charged environment. There’s a growing chance it might only arrive after the election.
On both sides of the border, markets have taken massive budget deficits and escalating debt levels in stride, but we still judge bond supply will become an increasing concern once domestic and global demand for Treasuries and Canadas starts waning owing to rising investor risk appetites, reflecting, in turn, domestic and global business conditions getting sturdier and less uncertain. This will also become a bigger issue once central bank purchases end, but that’s likely a 2022 story at the earliest. In the meantime, we look for only a mild uptrend in yields; e.g., 10-year tenors should only move firmly above 1% in 2022.
The (trade-weighted) U.S. dollar index continues to drift weaker, now at January levels after spiking to a record high on March 23. The greenback is garnering little support from the current pandemic high in the global new case rate, as the dollar’s medium-term prospects appear to be weighing. The Fed has been very aggressive on the QE front and this dollar-unfriendly (other things equal) policy looks to continue (at least) through next year as part of a now more accommodative course past 2023. Meanwhile, a massive Treasury budget deficit combined with a U.S. trade deficit no longer flattered by an improving energy trade balance indicate some eventual investor concern over the “twin deficits” and current account pressures. Add to this some near-term domestic political uncertainty along with the potential for more “risk on” than “risk off” days as pandemic fears finally recede, and you have the makings of a persistent weakening trend for the U.S. dollar. The latter should be the major force pushing the loonie firmer.