Market Wire - Bank of Canada's Hawkish Hold Surprises Currency Markets

Karl Schamotta - Chief Market Strategist

In a shock decision, the Bank of Canada executed a “hawkish hold” this morning, stepping back from a widely-anticipated rate hike while removing forward guidance and acknowledging “a broad set of measures are now indicating that economic slack is absorbed” - policy shifts that indicate a March move has become a near-certainty.

This came after inflation hit a three-decade high: The accompanying Monetary Policy Report noted that “close to 55 percent of CPI (Consumer Price Inflation) components are now growing at more than 3 percent”, meaning that there was “an elevated risk that Canadians will start to believe that inflation will stay high over the long term” - something that could “lead to more pervasive labor costs and inflationary pressures and could become embedded in ongoing inflation”.

But the Bank stayed in Camp Transitory: Updated projections show officials now expect year-over-year price increases to hold around 5 percent through the first half of 2022, falling back toward 3 percent later in the year and closer to target thereafter. After a Bank survey showed businesses and consumers also expect prices to go higher in the near term before fading, the statement noted similar views in markets, saying, “Near-term inflation expectations have moved up, but longer-run expectations remain anchored on the 2 percent target”.

The economy is running hot: Employment is rapidly converging with pre-pandemic levels, and record job vacancy numbers are beginning to put upward pressure on wages. With US demand soaring, Canada’s trade surplus topped pre-global financial crisis levels in October, and currency-adjusted oil prices are nearing highs last reached in 2014. Composite benchmark real estate prices are up more than 25 percent over last year’s - already superheated - levels.

Policymakers hinted they would take a passive approach to quantitative tightening: The Bank said it would continue reinvesting, “keeping its overall holdings of Government of Canada bonds roughly constant”, until rates began to climb. At that point, it will consider “exiting the reinvestment phase and reducing the size of its balance sheet by allowing roll-off of maturing Government of Canada bonds” - language that suggests a gradual runoff will begin in April or May, with the portfolio gradually brought down toward $300 billion by early 2024. The Bank’s holdings currently amount to $425 billion dollars, or roughly 40 percent of outstanding Government of Canada bonds.

Markets remain braced for an aggressive tightening cycle: Overnight index swaps pricing still suggests six hikes could come by year end, with the Bank’s policy rate hitting 1.75 percent. Several major banks expect the overnight rate to top 2 percent over the same time period. This should keep longer-term yields well-supported.

But signs of economic weakness are multiplying: With the Omicron coronavirus variant continuing to spread, major economic centres across the country remain in lockdown. Winter is exerting its typical first-quarter chilling effect. US retail sales and industrial output indicators - both of which serve as proxies for Canadian exports - fell sharply in December.

And debt burdens are enormous: Canada’s household debt-to-gross domestic product ratio - and its debt service ratio - are the highest in the G7. A sharp rise in long-term rates could have a devastating impact on consumer spending.

The loonie tumbled on the announcement: The Canadian dollar - which has failed to keep up with oil price gains in recent months - dropped almost a hundred basis points immediately after the release as yields dropped and short-term interest differentials turned less favourable. Traders are now shifting focus back toward this afternoon’s Federal Reserve decision, where officials are also expected to put the foundation in place for a March rate increase.