Will the Bank follow the Fed?

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After a substantial hiking cycle by the Bank of Canada - the Bank wants to be on hold, but is faced with pressure from better than expected domestic data and the Fed who will likely just keep on hiking rates for quite a while longer. Data is hard to predict in the short term, as the long and variable time-lags play out. Hiking more if/when data is significantly better than expected was the 'out' for Maklem in his statement and is absolutely fair. Following the Fed however, just for the sake of keeping interest-rate differentials low, would be as nonsensical as birds migrating south at the end of the winter.

Potential Problems with Pausing?

With Macklem’s potentially premature proclamation of a policy pause, questions arise surrounding what this means for Canadian Fixed Income, when contrasting the Fed’s “Final Push”. As US policy rates look primed to meaningfully expand past Canada for the first time since the COVID 19 pandemic. How will markets react to the Fed out-hawking the BoC??

The “Strong Dollar” trade which rocked 2022, with [most] global commodities priced in US Dollars, was deadly for supply-side/cost-push inflation. With most G10 peer currencies depreciating by five to fifteen percent, with CAD settling just shy of ten percent; even as several commodities saw price declines, the local cost was buoyed by a ten percent currency conversion. This push continued to exacerbate existing inflationary pressures on net-importing countries. While the dollar weakened in the closing months of the year, we have seen a resurgence in recent months as the market is resetting expectations for a more hawkish Fed and higher terminal rate.?

Data Driven Divergence??

While Canada’s inflation appears to be taking a turn for the better, the United States has battled dual challenges of lower but still resilient inflation and a tighter-than-expected labour market. As a result of recent exceptionally strong data, US markets have begun to legitimately price a base-case of higher interest rates throughout 2023.?

The primary question at hand is whether the market is (or should be) pricing in a higher for longer scenario rather than a higher for shorter scenario. Much of this depends on the direction of inflation, and markets have begun to recognize the likelihood that the Fed will indeed hike rates to a terminal level well in excess of 5% – as markets price an increase in 1 Year forward rates by nearly 100 bps.?The US terminal rate has rapidly approached 5.5%.

When policy is (rightfully) being directed by economic data, one can think of the relationship as a call-and-response. Economic data conveys the health and direction of the country’s economy, however many lagging indicators such as inflation and unemployment often take a period of time, often estimated at 9 – 24 months, to reflect changing monetary policy.?

The same idea can be applied to central bank policy, with the two neighbours facing structural differences, we can expect some degree of variance in policy. As we discussed in our 2022 Canadian Crystal Ball series, the Canadian economy has three structural variations which increase Canada’s sensitivity to interest rates; High household debt levels, shorter duration mortgages, and an increased percentage of the economy linked to rate-sensitive sectors. With Canadian consumers exposed to excessive leverage, shorter duration mortgage periods, and variable rate arrangements, while the US housing market is reflecting a sharp decline in sales and refinancing, Canadian homeowners are feeling an immediate increase in both existing and refinanced mortgage agreements.?

To this extent, it appears that Canada’s pause, while perhaps premature, is not incorrect, nor is the Fed’s likely decision to raise rates a further 50-75 basis points. However, with such interconnected economies, how much can BoC afford to deviate from the Fed’s hiking path without creating a significant impact on the CADUSD pair? When looking back, we can see that while the BoC and the Fed have largely danced to the same tune, there have been multiple instances in which one has out-hawked the other. With current projections suggesting a ~75bp spread, this remains firmly in precedented territory, with these levels reflecting the state of the economy prior to the COVID 19 pandemic. Likewise, the same levels were maintained for a sustained period prior to the Great Financial Crisis in 2007-2008 and the dot-com bubble in 2000. ?

From these periods, we can see that despite challenges, a marginal spread of central bank policy rates is ?expected and, in many cases, reflects a natural development of the respective economies. The Bank of Canada is not “obligated” to follow the Fed, if the best interests of the Canadian economy indicate otherwise. Likewise, if these conditions should shift, so too will policy in “response” to the “call” of emerging economic developments.?

CAD, Curves, and Choppy Conditions?

While monetary policy is enabled to diverge, markets may react differently. Historically, when we look at the spreads between US and Canadian monetary policy and the reactionary 2-year yields, barring short-term inter-meeting volatility, the two have moved in tandem. At this point, while markets have priced some degree of future hikes, short term US bonds may widen further from their Canadian counterparts.?

However not all that glitters is gold, currency strength often follows rates, and as Canadian rates fall below their southern counterparts, one could expect some degree of softening of the Canadian Dollar. For currency-hedged investors, this means little from a local performance perspective, however the economy may tell a different story. Should a weakening currency re-spark inflationary pressures (has to be close to 10% to really matter), we would expect central banks to respond accordingly.?A few percentage points here or there do not make a difference.

However, from an economic tail risk case, what if the Bank of Canada breaks their word on principle, electing to pre-emptively follow the Fed? In this scenario, we return to our initial economic comparison.

The resilience of the Canadian economy has been impressive, given the country’s sensitivity to interest rates. Facing over 400 bps of cumulative tightening in under a year would threaten most countries, let alone Canada. Any further tightening for the sake of tightening (following the Fed) would risk the delicate “soft landing” of the economy, likely triggering a recessionary “hard landing”. In this environment, we would expect a significant risk-off shift, leading to significant outperformance of long-duration Canadian Fixed Income.?And crucially also a weaker Canadian Dollar. Interest rate differentials matter until they don't. I will have a hard time believing that hiking rates in this environment on the basis of following the big neighbour will end up being a positive for the currency. Deliberately increasing the risk of a hard crash sounds more like Canadian Dollar weakness than strength.

While we may never be certain of the path ahead, one thing looks to be clear - it is rarely a good idea to do something just because someone else is doing it to. Canada needs to focus on its own unique circumstances and not migrate south just because other birds are doing it.

Congratulations on making it to the end - I hope that you found this piece enticing and educational... As even neighbouring markets such as Canada and the United States highlight divergent momentum, fixed income offers many buying opportunities given yields and carry. As “Hike-First, Hike-Fast" fades away, pockets of Fixed Income appear increasingly attractive from data-dependence and the resulting market volatility. While Canadian snowstorms may require more layers the sunny shores of Florida, Canadian Fixed Income investors may be in for a treat...?

I hope that this piece provides yourselves and your clients with insight and confidence towards the direction of fixed income markets.??

If you have any thoughts, comments, or questions - please reach out.??

All the best,??

Konstantin?