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Heading into today’s Bank of Canada meeting, the risks for the loonie were heavily tilted towards the Bank under delivering relative to money market expectations given overnight index swaps had 25bps fully priced in by April’s meeting. The BoC didn’t disappoint, however.
The Bank of Canada today announced that it would taper its QE programme by a further C$1bn a week, therefore entering the reinvestment stage, while it also brought forward its forecast for the output gap closing from H2 2022 to “the middle quarters” of next year.
While the final QE taper was largely expected, the adjustment to the output gap assessment wasn’t a given and delivered the hawkish punch as the closing of the output gap is largely attributed with the Bank’s timing for rate lift-off. This resulted in a sharp repricing in USDCAD as Canadian front-end rates soared on the prospect of even higher rates next year.
USDCAD drives towards recent lows as front-end yields shoot higher on hawkish BoC messaging
The Bank’s reassessment of when the output gap is set to close came as somewhat of a surprise, largely because it was accompanied by a downgrade to 2021 and 2022 GDP forecasts. The Bank now expects the economy to grow 5% this year and 4.3% in 2022, down from 6% and 4.6% previously, and means the driving force behind the latest output gap assessment comes from the supply side. The Bank accompanied its GDP downgrades with a lower forecast for potential growth, at an average rate of 1.6% (0.2 percentage points lower than previously). With a robust recovery in the labour market, and an upwards revision to the inflation forecast, the Bank has now laid its cards on the table and shown the market that it is sensitive to current inflationary conditions.
An interest rate increase in Q2 is now the likeliest scenario, with the BoC most likely to deliver the rate increase at its April 13th meeting as all communication channels will be open then, barring any substantial undershooting in 2022 growth conditions.
Even so, slower than expected growth next year is unlikely to deter the BoC from raising rates initially, especially if the inflation profile remains robust and signs of wage pressures appear. The question for markets will be how high rates can go in 2022 under the Bank’s current economic projections and in the scenario of lower growth and entrenched inflation. Our initial view is that the Bank will raise rates by a cumulative 75bps next year under its current economic base case, while a slower growth profile will likely result in a more gradual normalisation process as opposed to delayed lift-off. However, our conviction on this view is limited, not only due to the uncertainty surrounding economic forecasts at present, but also because the Bank hasn’t provided markets with a sequencing timeline – that is, at what point within its tightening the Governing Council will look to reduce its stock of assets. In today’s press conference, Governor Macklem stated that “how long the reinvestment stage lasts is a future monetary policy decision”.
Author: Simon Harvey, Senior FX Market Analyst