Avery Shenfeld
January 24, 2022
Money Economy Commentary Trending Weekly updateFalse precision (The Week Ahead)
There’s near unanimity among economists and market participants that an interest rate cycle will soon be upon us in Canada and the US. Both countries face excessive inflation pressures, both are nearing full employment, and given that the major driver for growth (a diminishing Covid pandemic here and abroad) will be similar, there’s little reason to expect a significant policy divergence.
How far that will take us is a matter of some debate, but there are at least a few principles we can apply to take a stab at that question. If we’re zeroing in on full employment and don’t face any new headwinds, the tightening cycle should take rates into the vicinity of the so-called neutral rate.
Evidence from the prior cycle puts that in the 2½% range stateside, and likely something perhaps just a hair below that in Canada, assuming inflation gets back to its 2% target as growth decelerates and Covid disruptions fade. Past cycles also see occasional pauses along a tightening path, as economies are often buffeted by developments that force a pause or a back step. When inflation cooperates, as we expect it will after 2022, central banks like to see how the economy has digested the first round of hikes before moving rates even higher.
This cycle will also see the use of quantitative tightening, which could help lift longer term rates, and thereby raise term borrowing costs, even during those periods in which short rates are paused. We see no reason why the Bank of Canada should continue to reinvest maturing bonds into fresh government bond purchases once it starts hiking rates, so that QT process will begin very soon here, and likely not very far into a US rate hike cycle that could commence as early as March.
But high frequency traders aren’t typically satisfied with a projection that tells them to brace for 200 basis points or so in rate hikes over the next two and a half years. They want to know exactly which meetings each central bank will use to lift rates, a question we face now as the Bank of Canada prepares to reveal such a decision in the week ahead.
Any such forecasts suffer from a degree of false precision. Put yourself in a meeting room in, say, June 2024, looking back on how the Canadian economy evolved over the prior 10 quarters. Just how much difference would it have made to the outcome on growth or inflation if you moved the timing of each rate hike forward or backward by a couple of months? Not much.
Since the Bank of Canada’s rate decisions are really based on steering the economy over that sort of horizon, so as to attain its inflation objectives, it can follow its own tastes on exactly when to pull the trigger. It could opt to do its first hike now, counting on Omicron’s wrath to fade out, and assuming that it’s not followed closely by an immunity-escaping “pi” or “rho” variant with the same infectiousness but even greater punch.
Or it could, as we’ve assumed, signal that, prior to Omicron, the economy had reached the conditions it previously had laid out for rate hikes to begin. But it has likely slipped back from that status during this wave, and the Bank could clarify that hikes are in the offing once we have more assurance that Omicron has departed and that no serious new wave is replacing it. That would lay the groundwork for a hike in March or no later than April, and still leave ample time to get rates into the 2% range in 2024.
For investors, that makes it unwise to put on trades that will only work if a particular timing is followed. Instead, the opportunities lie in thinking about where the curve is headed under any gradualist path that sees inflation return to the 2% range in 2023, gets both Canadian and US short rates through 2% in 2024, and is combined with a reversal of quantitative easing that pares back the Fed’s and Bank of Canada’s bond holdings. We’ll steer the details on such trades to our FICC strategy team, which has some excellent ideas to consider.
The full document is available here.
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