BoC sees economy growing above potential in 2018 but remains dovish
To no surprise, the Bank of Canada (“BoC”) maintained its dovish stance by keeping the overnight rate unchanged on December 6. The BoC cited slack in the labour market, and suggested its intent to remain cautious on further rate hikes, despite the 5.9 per cent jobless rate. Thereafter, on December 14th, BoC Governor Poloz retreated slightly by stating that the economy will need less monetary stimulus over time. Poloz was cautious to caveat that the economy will need to be guided by the sensitivity to higher interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. Following the speech that brought an interest rate hike on the table for Q1 of 2018, the CAD appreciated to 77.9 US¢/CAD.
As noted by BMO, reasons for the BoC’s caution are in the more onerous home-mortgage rules that take effect on January 1st, and the fate of NAFTA talks which look to be leaning towards a less favorable outcome than initially anticipated. RBC shares the NAFTA concerns but remains more optimistic than BMO, expecting the Loonie’s underperformance against the Greenback to be short-lived with the BoC returning to rate hike mode in Q2 of 2018. Overall, the surveyed banks lack consensus as to the future value of the CAD, with National, BMO and CIBC forecasting between 76.0 and 76.8, US¢/CAD by the end of 2018, while RBC, TD, Scotiabank, Desjardins and Laurentian see 80.0 to 82.0 US¢/CAD for the same period.
The ECB ending 2017 on an optimistic note
The European Central Bank (“ECB”) announced on December 14 that it will keep its monetary policy unchanged, and reiterated that policy rates would remain at current levels well past the ECB’s net asset purchases. The ECB revised upwards its inflation forecast for 2018 to 1.4 per cent and raised the GDP forecast to 2.3 per cent in 2018 and to 1.9 per cent in 2019. ECB President Mario Draghi highlighted the expectation for continued economic growth in the Euro area in Q3 of 2017. As at the date of publication, the pair traded at 66.2 EUR¢/CAD.
BMO suggests that President Draghi will set the stage, possibly by September, for the Quantitative Easing (“QE”) program to finish by end of 2018. RBC adds its concerns about Brexit as negotiations progress to hammering out the details of the future trade arrangement growth is likely to slow modestly. National highlights that despite a good November for the Euro, which saw its biggest jump in four months, a major tightening of monetary policy is unlikely anytime soon due to the persistence of low inflation. Overall, the surveyed banks remain divergent as to the future of the EUR by the end of 2018, with CIBC forecasting 61.1 EUR¢/CAD and RBC expecting 72.0 EUR¢/CAD.
Bank of Canada dovish (for now); Fed continues to hike
As reported in last month’s publication, the anticipation was that the BoC will keep the overnight rate steady at 1 per cent. RBC expects that with the economy maintaining its strong momentum and the labour market at full employment, inflation will gravitate to the BoC’s target in 2018 and be supportive of more rate hikes. Given the recent drift by Governor Poloz to a more hawkish tone, the surveyed banks are watching for further supportive data.
In the United States, the Fed, as widely anticipated, decided to raise the Federal Funds Rate by 0.25 per cent, marking its third increase of that magnitude since March 2016. The Federal Open Market Committee’s (“FOMCs”) median projection for 2018 is for three more hikes of this magnitude.
2-year government yields upwardly adjusted in the U.S., while again downwardly adjusted in Canada
During September there was a shift towards a hawkish tone by Chair Yellen resulting in the rise of the U.S. 2 year bond yields. As highlighted by Desjardins, the expectations for tighter monetary policy are causing the 2 year bonds yields in the U.S. to rise significantly. In Canada, CIBC states that Canada’s yields should outperform in the latter half of 2018, given that there’s no rising federal deficit to fund. Overall, given the Fed’s hawkish tone, and BoC’s recent dovish language, the forecasts by the surveyed banks saw a downward adjustment to the expected 2 year Canadian bond yields and an upward adjustment to the U.S. 2 year rate.
Narrowing 2 and 10 year spread raises concerns amongst economists
The 10 year yields edged lower despite the Fed’s rate hike, narrowing its spread over the 2 year rate. As highlighted by TD and National, the 10 year yield is now at nearly the equivalent yield as at the end of 2016. This trend is a notable phenomenon, as historically, an inverted yield curve (where a 2 year yield is higher than the 10 year) has preceded every economic downturn in the last half-century. As such, it will be worth monitoring whether this flattening and possible of inversion of the yield curve continues to persist. As reported by the surveyed banks, the 10 year Canadian government bond is expected to yield between 2.25 per cent and 2.85 per cent, while the U.S. 10 year Treasuries are expected to yield between 2.70 per cent and 3.30 per cent by the end of 2018.
Long bond yields downwardly adjusted in Canada and the U.S.
Desjardins notes that the long bond yields in the U.S. do not adequately reflect the state of the U.S. economy and the potential for monetary tightening. BMO adds that the long government yields in the U.S. will continue to face upward pressure from upwardly-drifting inflation expectations, prodded by fiscal stimulus. Overall, the surveyed banks are in consensus as to the upward direction of the long bond yields in Canada and the U.S. through to end of 2018. RBC is on the high end of forecasts for long bond yields, expecting them to reach 3.6 per cent in the U.S. and 3.1 per cent in Canada by 2018 year end.