Bank likely to talk rate expectations back down - Capital Economics
Canada Economics

Bank likely to talk rate expectations back down

Canada Economics Weekly
Written by Stephen Brown
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The surge in yields this week occurred despite another signal from the Bank of Canada that it plans to keep interest rates at rock-bottom levels for a long time. This has led to suggestions that the Bank could engage in yield curve control, but we think it will first try to talk interest rate expectations back down.

The surge in yields this week occurred despite another signal from the Bank of Canada that it plans to keep interest rates at rock-bottom levels for a long time. This has led to suggestions that the Bank could engage in yield curve control, but we think it will first try to talk interest rate expectations back down.

While the jump in bond yields was a global phenomenon, they rose by more in Canada than in most places. The 10-year yield is now within touching distance of its US counterpart at 1.5%, and the even more startling move was the near-doubling of the 5-year yield toward 1%. (See Chart 1.)

Chart 1: Government Bond Yields (%)

Source: Refinitiv

That move in the 10-year yield is line with our forecast for the end of 2021, but the crucial difference is that, rather than the rise being driven by higher inflation compensation as we expected (see here), the jump has been due to a surge in real yields. That in turn reflects a repricing of the expected path for policy rates. Overnight index swaps (OIS) now imply that the Bank will raise interest rates in early 2022, with a total of 110 bp of hikes by the end of 2023. (See Chart 2.)

Chart 2: Policy Rate Implied by OIS (%)

Source: Bloomberg

While there are admittedly upside risks to the outlook from the recent jump in oil prices, the path of interest rates now implied by OIS seems improbable. For a start, we already know that Canada’s vaccine progress will lag far behind some other countries. Even with Health Canada approving the AstraZeneca vaccine on Friday, the risks seem to lie toward the coronavirus restrictions being lifted later than the second quarter, which is the timing of our current assumption.

Above all, we think market participants are not fully appreciating the extent to which the Bank’s reaction function has changed. With the Bank reiterating just a month ago that it wants to keep “rates low across the yield curve”, and Governor Tiff Macklem this week emphasising the need for the Bank to support employment across all parts of society (see here), we think it is unlikely that the Bank will turn hawkish any time soon.

This raises the question of how the Bank will respond to the surge in yields. We think the most likely outcome is that it will try to talk them back down with a communications blitz at the next policy meeting on the 10th of March. We will address that in more detail next week in our Bank of Canada Watch.

Future move above $0.80 to be sustained

The other noteworthy development in markets this week was that the Canadian dollar moved above $0.80 for the first time in years, although that move was swiftly reversed as global equity markets dropped back. Despite our view that market pricing is now overstating how soon the Bank will raise interest rates, we still see scope for the loonie to move above $0.80 this year and ultimately hit $0.84 as oil prices rise further and the global economy recovers. (See here.)

The week ahead

The fourth-quarter GDP data will take the headlines next week, but the more important news will be the preliminary GDP estimate and the trade data for January. We expect to learn that the economy coped better with the latest lockdowns than most expected.


Data Preview – GDP (Dec. & Q4) 08.30 2nd Mar.

Forecasts

Previous

Median

Capital Economics

GDP (%m/m)

0.7

0.4

GDP (%q/q annualised)

40.5

8.0

Focus on preliminary estimate for January

GDP appears to have risen by 0.4% m/m in December, which should have driven an annualised gain of 8.0% in the fourth quarter.

Stats Can said in the press release for the November data that quarterly growth appeared to be 7.7%. Since then, the December retail sales data have come in worse than first indicated, but the estimate of output in the oil sector has been revised up significantly. The effect of the latter should slightly outweigh the former, so we are going with a slightly higher pace of fourth-quarter growth of 8%.

The bigger news will be the preliminary estimate for January. Bank of Canada Governor Tiff Macklem said this week that the economy appears to have performed worse in the first quarter than the Bank anticipated. As the Bank already expected a modest contraction, that makes us a bit nervous about our recent decision to revise up our forecast for first-quarter GDP growth to 1% annualised. It could be that the Bank knows something we do not, but for now we are sticking to our view that the unexpected rise in hours worked in January (see Chart 3) and the surge in oil exports are signs that the economy outperformed most expectations.

Chart 3: Hours Worked & GDP (% m/m)

Sources: Refinitiv, Capital Economics

Data Preview – International Trade (Jan.) 08.30 Fri. 5th Mar.

Forecasts

Previous

Median

Capital Economics

Merchandise Trade Balance (C$bn)

-1.7

-1.4

Trade deficit to improve as imports fall

We estimate that the trade deficit narrowed slightly in January, as exports edged up and imports fell.

The deficit narrowed sharply in December to a six-month low of $1.7bn, as exports rose by 1.5% m/m and imports declined by 2.3%. December’s improvement in energy exports appears to have been repeated in January, given that oil prices rose further and export volumes to the US jumped to a record high. But offsetting that, the US advance trade data confirmed that auto trade dropped sharply amid supply-chain disruptions, which have forced some plants to temporarily close. (See Chart 4.) As a result, we suspect exports only edged up by 0.3% m/m.

Auto imports also appear to have fallen sharply, but this was probably mostly offset by a rebound in consumer goods imports following the sharp fall in December. We are therefore pencilling in a modest decline of 0.2% m/m. The net result should be that the trade deficit narrowed to $1.4bn.

Chart 4: US Vehicle Assembly & Canada Exports (% y/y)

Source: Refinitiv


Economic Diary & Forecasts

Upcoming Events and Data Releases

Date

Release/Indicator/Event

Time EST (GMT-5)

Previous*

Median*

CE Forecasts*

Mon 1st

Current Account Balance (Q4)

(08.30)

-7.5bn

Manufacturing PMI (Feb)

(09.30)

54.4

53.0

Tue 2nd

GDP by Expenditure (Q4)

(08.30)

40.5%

8.0%

GDP (Dec)

(08.30)

+0.7%(-2.8%)

+0.4%(-2.7%)

Wed 3rd

Building Permits (Jan)

(08.30)

-4.1%

+7.0%

Labour Productivity (Q4)

(08.30)

-10.3%

Ivey Purchasing Managers Index (Feb)

(10.00)

48.4

52.0

Thu 4th

No Significant Data Released

Fri 5th

No Significant Data Released

Selected future data releases and events

Wed 10th

Bank of Canada Policy Announcement

(10.00)

0.25%

Fri 12th

Capacity Utilisation (Q4)

(08.30)

76.5%

Unemployment Rate (Feb)

(08.30)

9.4%

Wholesale Sales (Jan)

(08.30)

-1.3%

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts

%q/q ann. (%y/y) unless stated

Q4 2020

Q1 2021

Q2 2020

Q3 2021

Q4 2021

Q1 2022

2020

2021

2022

GDP

8.0

1.0

5.8

8.0

5.2

4.4

-5.4

5.2

5.0

CPI Inflation

0.8

1.4

2.7

2.4

2.2

1.8

0.7

2.2

1.8

Unemployment Rate (%)

8.9

8.8

7.5

7.1

6.9

6.4

9.5

7.6

6.0

Overnight Rate, End Peri’d (%)

0.25

0.25

0.25

0.25

0.25

0.25

0.25

0.25

0.25

10 Yr GoC., End Period (%)

0.60

1.20

1.30

1.40

1.50

1.55

0.85

1.50

1.75

USD/CAD, End Period

0.75

0.79

0.81

0.82

0.84

0.84

0.77

0.84

0.82

Sources: Refinitiv, Capital Economics


Stephen Brown, Senior Canada Economist, +1 416 874 0514, stephen.brown@capitaleconomics.com