Bank of Canada hikes, but Loonie gains could prove temporary
In a widely anticipated January 17 announcement, the Bank of Canada (“BoC”) opted to increase its overnight lending rate to 1.25 per cent. The rhetoric behind the increase was dovish as the BoC highlighted concerns surrounding the future of NAFTA and its potentially negative influence on future business investment and trade. The BoC caveated that despite the outlook warranting higher interest rates over time, the economy would likely continue to require a degree of continued monetary policy accommodation. As at the date of publication, the currency pair was trading at 80.3 US¢/CAD.
In a review of the bank publications this month, we observe a divergent view as to the outlook for the currency pair. Scotiabank is expecting the Loonie to retreat in the next few weeks, but highlights that higher commodity prices will give the CAD some protection against risks surrounding the future of NAFTA and the housing market. On the other hand, National adjusted its near-term forecasts to reflect the Loonie’s strength through to Q2 of 2018, but is less optimistic thereafter anticipating headwinds generated by a resurgent Greenback. National is expecting the USD to rebound in Q3 of 2018 and continue its rise throughout the year, stating the recent tax reform - which provided a significant tax reduction to U.S. corporations repatriating foreign profits - could temporary boost the currency. Overall, surveyed banks lack consensus as to the future of the value of the CAD, forecasting between 76.0 and 80.65 US¢/CAD by end of 2018, and between 78.74 and 82.0 US¢/CAD by end of 2019.
ECB communication suggests hawkish tilt
On January 11th, 2018, the European Central Bank (“ECB”) announced that it could revisit its communication stance in early 2018, suggesting the ECB may be preparing to reduce its Quantitative Easing (“QE”) program. As a result, the EUR soared, and as at the date of publication, the pair traded at 65.7 EUR¢/CAD. The EUR outperformed major currencies in 2017, but National expects a reversal of fortune this year highlighting Italy’s general elections in early March, which could rattle a European Union already reeling from Brexit, and persistently low inflation in the Eurozone which would likely delay any tightening of monetary policy.
BMO shares National’s concerns, adding that the Catalan independence movement in Spain is another factor which could undermine confidence in the European Union. Scotiabank on the other hand is more optimistic, highlighting that economic momentum has picked up to its strongest levels since 2011 and expects the EUR to benefit from more capital being redeployed to Europe as political risks subside. Overall, the theme remains that the surveyed banks are still divergent as to the future of the EUR/CAD currency pair, forecasting it to trade anywhere between 60.8 and 72.0 EUR¢/CAD through the end of 2018.
Monetary policy tightening a theme for 2018
The BoC increased its overnight rate by 0.25 per cent citing “recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity”. However, the BoC remained dovish in its rhetoric as it expressed growing concern regarding NAFTA which may negatively affect the Canadian economy. Despite the words of caution, certain reporting banks anticipate further hikes, with BMO in particular anticipating three additional rate hikes in 2018. In the United States, at the December FOMC meeting, most participants anticipated further policy normalization in 2018, with the consensus amongst surveyed banks for three or more rate hikes in the next 12 months. Overall, going forward, there is a growing consensus of more monetary policy tightening to come in both Canada and the United States.
Upward adjustments made to the Canadian and the U.S. 2-year government yields
Since last months’ publication, upward adjustments were predominantly made to both Canadian and the US yield forecasts by the reporting banks to reflect the expectations for further rate hikes by the FOMC and the BoC. Overall, the reporting banks are in consensus that 2 year bond yields shall steadily rise over the forecast horizon in both Canada and the US. The exception to this is RBC, who is forecasting the Canadian 2 year bond yield to peak in Q2 of 2019 at 2.60%, but end the year at 2.30%. Irrespective of this outlier, the reporting banks all anticipate the 2-year yield to continue to rise from current levels (Canada: 1.81%, United States: 2.05%) over the forecast horizon.
Yields rise, but disproportionately so
The 10-year government bond yields continue to rise in Canada and the U.S., but this month the surveyed banks made minor upward and downward adjustments to their forecasts. Notably, in its December meeting, the FOMC addressed the inverted yield curve (the spread between the 2 and 10 year), highlighting that although the current flatness was not unusual by historical standards, it is important to continue to monitor in the coming quarters. Historically, inverted yield curves have often preceded economic recessions and as such have become focal points of analysis of many economists. Overall, the reporting banks are forecasting the 10 year government bond to range between 2.85% and 3.05% in Canada, and 3.20% to 3.75% in the United through 2019.
Resurging inflation expectations to drive rise in long bond yields through 2019
We observe an increase in the actual Canadian and the U.S. long bond yields to 2.35% and 2.90%, respectively. There is consensus amongst the forecasting banks that the long bond yields will steadily rise into December 2019. Desjardins highlights that a favourable global economic outlook, with central banks increasingly confident that inflation will return near target levels, confirms its expectations of a clearer upswing in long-term bond yields in the coming quarters. RBC remains on the high end of the forecasts of the surveyed banks, expecting Canadian and U.S. long bond yields to rise to 3.15% and 3.60% by 2018 year-end, and to continue to rise to 3.30% and 3.85% by 2019 year-end, respectively.