Rates Scenario
May 15, 2025 | 17:24
Rates Scenario for May 15, 2025
Economics
Economics
Economics
Economics
Canada-U.S. Rates Outlook | Michael Gregory, CFA, Deputy Chief Economist |
As the Tariff Turns And, yes, a soap opera metaphor is appropriate given the dramatic developments since our last episode of Rates Scenario (April 17). Unexpectedly, the U.S. and China dialed back their tit-for-tat trade war that had left both U.S. ‘reciprocal’ tariffs on China and Chinese retaliatory tariffs on the U.S. at an eye-watering 125%. They both now stand at 10%. (The 20% fentanyl tariffs on China and related Chinese retaliatory measures, along with the tariffs and counter-tariffs dating back to Trump 1.0, remain in place.) With the likes of Walmart and Home Depot (big importers from China) warning of looming product shortages and price hikes, some rollback was expected, particularly given the quick exemption of certain consumer electronics. But not a complete capitulation. By our calculation, in one fell swoop, this chopped America’s (trade-weighted) average tariff rate from its century-plus high topping 26% to a bit above 14%. There’s still a significant stagflation impulse poised to impact the U.S. economy. Tariffs will push up import costs and, potentially, the prices of import-competing (domestically produced) products. The consequent erosion of purchasing power will dampen real spending, with overall economic growth pared further by how U.S. exports fare amid retaliatory measures. However, this impulse will now be less than before, but probably not enough to alter the Fed’s prospective policy path given the still heightened uncertainty surrounding the economic outlook. Federal Reserve policy: The FOMC kept policy rates unchanged on May 7 for the third consecutive confab, but the risks surrounding the outlook were altered profoundly. Not only had uncertainty “increased further” (the adverb was newly added) but it was now judged that “the risks of higher unemployment and higher inflation have risen”. The stagflation risk alarm was officially rung. In citing the source of increasing uncertainty, Chair Powell repeated that “the new Administration is in the process of implementing substantial policy changes” and that these policies are still “evolving” with their economic effects remaining “highly uncertain”. But it’s the “significantly larger than anticipated” increases in tariffs announced so far that are ringing the Fed’s stagflation alarm. Obviously since the meeting, the alarm is no longer ringing as loudly as it did, but it’s still ringing. With stagflation risks on his mind, Powell reiterated that “we may find ourselves in the challenging scenario in which our dual-mandate goals are in tension”. But the Fed has a published game plan here. In setting policy: “We would consider how far the economy is from each goal [maximum employment and price stability], and the potentially different time horizons over which those respective gaps would be anticipated to close.” Although tariffs are expected to boost the price level and measured inflation on a year-over-year basis, as long as the incremental monthly moves show little in the way of ‘second round’ or ‘feedback’ influences, we reckon the Fed will look past the temporary boost to the annual rate. And, instead, focus on a rising jobless rate that should be knocking on 5%’s door by the end of the year. We’re forecasting a resumption of rate reductions in July and reflecting continued policy caution, we look for the rate cuts to come in back-to-back pairs, separated by a pause. This results in three rate cuts by the end of this year and another three by June 2026, leaving the range for the fed funds rate at 2.75%-to-3.00%. This is just a shade below the FOMC’s median projection of the neutral level (3.00%). Bank of Canada policy: The BoC paused last month (April 16), after reducing the policy rate by 225 bps over seven consecutive meetings. And, going forward, the Bank said it “will proceed carefully, with particular attention to the risks and uncertainties facing the Canadian economy. These include: the extent to which higher tariffs reduce demand for Canadian exports; how much this spills over into business investment, employment, and household spending; how much and how quickly cost increases are passed on to consumer prices; and how inflation expectations evolve.” Note that the first two inclusions deal with the risks to growth and the last two deal with the risks to inflation. Reflecting the “pervasive” uncertainty surrounding the outlook, we judge the Bank is putting much more policy weight on the economic evidence at hand. The latest data reveal weakness in employment (beyond election-related hiring), housing, and manufacturing. We reckon this sets the stage for a June 4 rate cut, if the April core inflation readings (due May 20) don’t show worrisome signs. Of course, the headline figure is going to benefit hugely from the end of the consumer carbon tax. As before, we look for 75 bps worth of rate cuts by the end of this year to 2.00%... a bit below the Bank's 2.25%-to-3.25% estimate of the neutral range. After June, we’ve pencilled in September and December for the next steps. Bond yields: Ten-year Treasury yields are on track to average above 4.40% in May (based on the latest mark), testing the highest monthly average since January (4.63%). The latter marked the apex of the so-called ‘Trump Trade’, investors betting on higher yields in anticipation of net pro-growth policies and higher inflation. During January, the daily closes peaked at 4.79% (on the 13th), selling off from the election eve close of 4.26%. However, yields began to trend down as tariffs, government cutbacks and ramped up deportations, all growth dampers, were being implemented much more quickly than deregulation and tax cuts. In the wake of the (April 2) introduction of ‘reciprocal’ tariffs, the daily close rallied down to 4.01%, a six-month low. As the reciprocal tariffs were eventually postponed and, more recently, as the U.S.-China tariff war de-escalated, yields have been drifting up again. We reckon yields will average close to current levels (within a 5-to-10 bp range) until the Fed resumes rate cuts or is widely speculated to do so. As before, we see yields averaging in the 3.75%-to-4.00% range past the turn of the year as Fed easing unfolds. Of course, if reciprocal tariffs (all or some) are reintroduced after the postponement period ends in early July, we’ll likely get to this range a lot sooner, at least for a little while. Meanwhile, Canada-U.S. yield spreads are on track to average around -125 bps this month (based on the latest mark) compared to -117 bps in April, with the latest (yield lifting) tariff news bypassing Canada. We judge that this month’s outperformance is not indicative of a trend shift, which has been one of underperformance since record negative spreads (-139 bps) were averaged in February. As before, we judge that the Fed is poised to cut rates more aggressively than the Bank of Canada, prodding a trend of less negative yield spreads, and look for the -100 bp line to hold well past the turn of the year. U.S. dollar: The Fed’s broad trade-weighted dollar index is on track to average 1.2% lower in May (based on the latest close). This marks the fourth consecutive monthly decline (for a cumulative 4.7%) since the greenback averaged a record high in January. With tariffs having been expected to net boost the big dollar, the net depreciation since their introduction (on February 1) reflects the fact that this driver is being dominated by more hesitant inflows of net foreign investment. Elevated economic policy uncertainty and ‘quiet’ retaliation could be reasons for the hesitancy. Now, with ‘peak’ tariff worries behind us (for the time being) and Fed rate cuts lined up for this summer, we reckon the dollar’s depreciating trend will continue, albeit mildly. By year-end, we look for the currency to decrease more than 5% from January’s peak, with additional depreciation of 2% next year. Canadian dollar: The loonie is on track to average around |
Overseas | Jennifer Lee, Senior Economist |
Hawks are now doves? That seems to be the case these days. Discuss amongst yourselves. Yes, the 90-day pause between the U.S. and China is good news, but there are still plenty of questions that trade delegates from both countries need to address. Perhaps equally important for the region with which the U.S. has the second-largest trade deficit: how does this deal/pause translate for the EU? Already, Scott Bessent has warned that it won't be an easy one to deal with. That means Europe should continue with previous plans to boost spending on defence and infrastructure (i.e., not rely on the U.S.) and diversify its energy suppliers (Brussels plans to stop all imports of Russian energy by 2027). Plus, look at other trade deals to get involved with, including the CPTPP. And keep the list of €100 bln worth of U.S. imports to target if talks fail. Meantime, the ECB will remain on high alert as it watches the fallout on the economy and inflation while it goes through what appears to be a slower process to arrive at a deal. After cutting rates 25 bps in April to 2.25%, citing exceptional uncertainty, there is still a good case for a follow-up cut in June. After all, as the Netherlands' Klaas Knot—a hawk during normal times—said, trade tensions, "unresolved or not", will cause businesses and consumers to postpone spending, which will slow GDP and weigh on inflation. It won't be an easy decision. Another hawk, Isabel Schnabel, cautioned that the planned increase in fiscal spending suggests that rates should stay "close to where they are today". We believe another 50 bps of cuts this year is reasonable, leaving the deposit rate at 1.75% by year-end. The U.K. garnered lots of headlines as it was the first to land a "deal" with the U.S., but the country is still facing tariffs that did not exist at the start of the year. And some of these new arrangements are not going over well with, for example, British farmers and ranchers as their American counterparts were given more access to the U.K. market and standards are different. So growth is still expected to struggle, although the country boasted the strongest GDP result among the G7 in Q1, thanks to a surge in exports. The latest jobs data also show that labour demand is cooling, as evidenced by three monthly declines in payrolls, a 4-year low for job vacancies, and slower wage growth. But, like the ECB, the decision on rates will not be clear-cut. Within the BoE, the nine policymakers are not of the same ilk. At the most recent meeting in May, 5 members voted to cut rates 25 bps to 4.25% and of those 5, the majority called the decision "finely balanced" between cutting in May or waiting. Meantime, 2 members voted to cut rates 50 bps, while the remaining 2 (including the influential Chief Economist Huw Pill) wanted to leave rates unchanged. But, as Laurence Mutkin, Head of EMEA Rates Strategy, put it, the Bank "did the U.K. economy a great service" by not delivering a "panicky response to global trade developments". We continue to look for two more rate cuts, 50 bps in total, leaving the Bank Rate at 3.75% by year-end. The RBA is meeting in mid-May and a 25 bp cut is expected, bringing the cash rate to 3.85%. We got the hint after the Board stated at its most recent meeting in April that May would be an "opportune time" to revisit policy. Policymakers also agreed that a significant increase in tariffs or other trade restrictions could “materially disrupt” trade and cause businesses and households to reduce spending. And they have. Consumer confidence may have risen over 2% in May, but that is coming off 6-month lows, and business confidence is still negative. Less pressure on inflation is also helping the cause... the trimmed mean CPI slowed to a 3-year low of 2.9% in Q1. It is a relief that China now has a 90-day pause on tariffs; but until we are comfortable that the trade war will not flare up again, we continue to look for another 50 bps in rate cuts, (after May's move) by year-end, which will leave official rates at 3.35%. Finally, there is the BoJ. Earlier this year, it was the one major central bank that was expected to continue raising rates, with inflation remaining above target and the weak JPY lifting energy costs. The trade war put an end to all of that and so far, there has been little progress made during the talks. Japan is clearly unhappy with the 25% tariff on its auto sector and its proposed reciprocal tariff of 24%. It has offered to increase its imports of U.S. corn, rice and soybeans, but only time will tell if that is enough. And now, declining real cash earnings will weigh on consumer spending, and that is giving the Bank less incentive to tighten monetary policy. At the most recent meeting in early May, the BoJ was surprisingly more dovish as it pushed back the timing of when it will reach the 2% inflation target and slashed its growth outlook. On the FX front, until there is more certainty that calmer heads are prevailing, the greenback will remain soft. We look for the likes of the EUR, the JPY and the CNY to test stronger levels by year-end but, much like the trade talks, expect more volatility. |
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