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The Bank of Canada increased its overnight interest rate by 50 basis points in an effort to tackle surging inflation. Anthony Okolie speaks with Alexandra Gorewicz, Portfolio Manager, Active Fixed Income, TD Asset Management, about the potential impact of rising rates.
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- Well, as expected the Bank of Canada hiked rates 50 basis points. That's the first time in more than 20 years. Alex, what's your take on this move?
- The long and short of it is that they're clearly worried about inflation, inflation coming from multiple sources. Not just continued disruptions in global supply chains, which they highlighted in their release, but also food and energy inflation that has really skyrocketed, especially with the onset of the war in Ukraine. And so the bank's revisions to its inflation forecast both for this year and for next year were revised materially higher.
In addition, given a strong labor recovery after reopenings following the Omicron lockdowns, the labor market recovery was a lot stronger than expected. And the Bank had enough information to be able to revise its GDP forecast higher, at least for this year. So the combination of both of those things made them feel comfortable, that a more assertive rate hike was necessary.
- OK. Now the Bank of Canada also announced the beginning of its balance sheet reduction, or quantitative tightening on April 25. Was this a surprise given the size of the rate hike?
- Perhaps for some, yes. I mean, I would say that, there was some still expecting, for example a 25 basis point rate hike, in combination with quantitative tightening, or QT. So the 50 basis points with the QT could be seen as a hawkish response.
However, a couple of things to note about that. In terms of the balance sheet holdings, they are skewed to shorter maturities. So if you look at the maturity profile of what the Bank of Canada holds, we have about $130 billion maturing or rolling off the balance sheet between this year and next. And in combination with the budget that was announced by the government of Canada, particularly showing a smaller deficit than they previously guided to, it gave the Bank confidence that they could proceed with relatively minimal impact to markets.
- How have the bond markets reacted to all this news? And what are the yield curves currently telling investors about the economy and the potential for, actually, further rate hikes down the road?
- Yeah, that's a great question. So I will say, judging by the reaction following the Bank's announcement, it was a little bit all over the place. But by and large, it looks like the curve wants to flatten. And what I mean by that is, interest rates, longer-dated interest rates, let's say, 10 years, are either not rising, or they're falling a lot faster than shorter-dated interest rates.
And that flattening at the moment-- so if I take the yield differential between the 2-year Canada bond and the 10-year Canada bond, it's a little bit less than 30 basis points or 0.3%. That's relatively flat, given that this was only the second rate hike, albeit a 50 basis point rate hike from the Bank of Canada.
Normally, the kind of flattening that we're seeing today in the yield curve and that we've seen as a general trend over the last couple of months, is something that we'd see after the Bank has delivered a series of rate hikes, not necessarily to. And that flattening is the bond market's way of telling the Bank of Canada, you have room to hike interest rates but up to a point, beyond which-- and I would say that level is around 3%-- beyond which, you will seriously start to impact growth.
And it will be difficult to meet the growth expectations, which continue to be positive, both from the general consensus across the market as well as from the Bank of Canada.
- And of course, we know that they're raising interest rates to curb inflation. And Canadian consumer expectations for inflation rose last month. And the Bank of Canada did acknowledge that the risks to these expectations becoming entrenched are increasing. Do you believe that long-term inflation expectations remain anchored at this point?
- So if we look at the consumer survey, and I think that's what you're referring to from the Bank of Canada, it would suggest that longer term, or at the very least, medium term, if we consider five years to be medium term, they are anchored. But shorter term expectations, looking one year ahead or two years ahead, those expectations are very elevated.
And the question for the Bank right now is, at what point do those shorter term expectations seep into longer term expectations, particularly when we still have so much inflation uncertainty? So if we also look, for example, at the business outlook survey that the Bank also published, a record number of firms are citing capacity challenges because of labor and global supply chain disruptions. And so they are forced, if you will, to continue passing on higher costs, input costs, to consumers.
At what point does that change the consumers or the average household's expectation about longer-term inflation expectations? And then, in turn, at what point does that start affecting discretionary spending today, particularly when the uncertainty around inflation suggests further revisions from here, both from the market as well as Bank of Canada are skewed to the upside?
So that's a very important point that we're watching. And it'll be a key factor into how things continue to develop from here, with respect to the economy.
- OK. So beyond inflation, what are some of the other things that you're watching? What are some of the big risks right now to the Bank of Canada's path on rates?
- So the two big risks that I would highlight-- and in fact, they feed back into inflation. For one, we're still in a pandemic. And although we do have rising case counts here, it's not nearly as worrisome as what is happening in Asia more broadly, but China, specifically.
And China's approach to dealing with COVID cases is a zero-tolerance approach. They take very strict measures, lockdowns. And at the moment, if we tally all the cities and regions that are under lockdown, they represent something like 40% of the Chinese economy.
And so to the extent that those lockdowns are prolonged or last longer than we currently expect, that could feed through additional disruptions in global supply chains as well as, obviously, the war in Ukraine that has created a new source of disruption for global supply chains, as well as sanctions on Russia that have disrupted commodity markets globally. And so both of those risks ultimately feed back into higher inflation, but not necessarily higher growth.
And that will challenge the Bank of Canada in continuing to raise interest rates. On the one hand, that it would need to if inflation continues to be higher. And on the other hand, that it would be very challenging to do it if the growth outlook deteriorates.
- OK. Now what about your outlook on the loonie? How do you expect it to perform going forward?
- So year to date, it has been one of the best performing currencies against major market peers, because commodity prices have risen, and energy prices, in particular, that improve prospects for the Canadian economy.
But on the flip side, against the US dollar, for example, it's been relatively flat because of global risk sentiment, particularly after the onset of the war in Ukraine. And so in a negative risk environment, the US dollar tends to outperform all other currencies.
Looking forward, if risk sentiment doesn't deteriorate further, terms of trade tailwinds, if you will, because of a robust commodity backdrop, should mean that the Canadian dollar appreciates or benefits, at the very least. And so if we've been trading in a relatively tight range year to date of $0.78-$0.80, we could see that range move higher for the balance of the year.
- Alex, thank you very much for your time.
- Thank you very much, Tony.
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- The long and short of it is that they're clearly worried about inflation, inflation coming from multiple sources. Not just continued disruptions in global supply chains, which they highlighted in their release, but also food and energy inflation that has really skyrocketed, especially with the onset of the war in Ukraine. And so the bank's revisions to its inflation forecast both for this year and for next year were revised materially higher.
In addition, given a strong labor recovery after reopenings following the Omicron lockdowns, the labor market recovery was a lot stronger than expected. And the Bank had enough information to be able to revise its GDP forecast higher, at least for this year. So the combination of both of those things made them feel comfortable, that a more assertive rate hike was necessary.
- OK. Now the Bank of Canada also announced the beginning of its balance sheet reduction, or quantitative tightening on April 25. Was this a surprise given the size of the rate hike?
- Perhaps for some, yes. I mean, I would say that, there was some still expecting, for example a 25 basis point rate hike, in combination with quantitative tightening, or QT. So the 50 basis points with the QT could be seen as a hawkish response.
However, a couple of things to note about that. In terms of the balance sheet holdings, they are skewed to shorter maturities. So if you look at the maturity profile of what the Bank of Canada holds, we have about $130 billion maturing or rolling off the balance sheet between this year and next. And in combination with the budget that was announced by the government of Canada, particularly showing a smaller deficit than they previously guided to, it gave the Bank confidence that they could proceed with relatively minimal impact to markets.
- How have the bond markets reacted to all this news? And what are the yield curves currently telling investors about the economy and the potential for, actually, further rate hikes down the road?
- Yeah, that's a great question. So I will say, judging by the reaction following the Bank's announcement, it was a little bit all over the place. But by and large, it looks like the curve wants to flatten. And what I mean by that is, interest rates, longer-dated interest rates, let's say, 10 years, are either not rising, or they're falling a lot faster than shorter-dated interest rates.
And that flattening at the moment-- so if I take the yield differential between the 2-year Canada bond and the 10-year Canada bond, it's a little bit less than 30 basis points or 0.3%. That's relatively flat, given that this was only the second rate hike, albeit a 50 basis point rate hike from the Bank of Canada.
Normally, the kind of flattening that we're seeing today in the yield curve and that we've seen as a general trend over the last couple of months, is something that we'd see after the Bank has delivered a series of rate hikes, not necessarily to. And that flattening is the bond market's way of telling the Bank of Canada, you have room to hike interest rates but up to a point, beyond which-- and I would say that level is around 3%-- beyond which, you will seriously start to impact growth.
And it will be difficult to meet the growth expectations, which continue to be positive, both from the general consensus across the market as well as from the Bank of Canada.
- And of course, we know that they're raising interest rates to curb inflation. And Canadian consumer expectations for inflation rose last month. And the Bank of Canada did acknowledge that the risks to these expectations becoming entrenched are increasing. Do you believe that long-term inflation expectations remain anchored at this point?
- So if we look at the consumer survey, and I think that's what you're referring to from the Bank of Canada, it would suggest that longer term, or at the very least, medium term, if we consider five years to be medium term, they are anchored. But shorter term expectations, looking one year ahead or two years ahead, those expectations are very elevated.
And the question for the Bank right now is, at what point do those shorter term expectations seep into longer term expectations, particularly when we still have so much inflation uncertainty? So if we also look, for example, at the business outlook survey that the Bank also published, a record number of firms are citing capacity challenges because of labor and global supply chain disruptions. And so they are forced, if you will, to continue passing on higher costs, input costs, to consumers.
At what point does that change the consumers or the average household's expectation about longer-term inflation expectations? And then, in turn, at what point does that start affecting discretionary spending today, particularly when the uncertainty around inflation suggests further revisions from here, both from the market as well as Bank of Canada are skewed to the upside?
So that's a very important point that we're watching. And it'll be a key factor into how things continue to develop from here, with respect to the economy.
- OK. So beyond inflation, what are some of the other things that you're watching? What are some of the big risks right now to the Bank of Canada's path on rates?
- So the two big risks that I would highlight-- and in fact, they feed back into inflation. For one, we're still in a pandemic. And although we do have rising case counts here, it's not nearly as worrisome as what is happening in Asia more broadly, but China, specifically.
And China's approach to dealing with COVID cases is a zero-tolerance approach. They take very strict measures, lockdowns. And at the moment, if we tally all the cities and regions that are under lockdown, they represent something like 40% of the Chinese economy.
And so to the extent that those lockdowns are prolonged or last longer than we currently expect, that could feed through additional disruptions in global supply chains as well as, obviously, the war in Ukraine that has created a new source of disruption for global supply chains, as well as sanctions on Russia that have disrupted commodity markets globally. And so both of those risks ultimately feed back into higher inflation, but not necessarily higher growth.
And that will challenge the Bank of Canada in continuing to raise interest rates. On the one hand, that it would need to if inflation continues to be higher. And on the other hand, that it would be very challenging to do it if the growth outlook deteriorates.
- OK. Now what about your outlook on the loonie? How do you expect it to perform going forward?
- So year to date, it has been one of the best performing currencies against major market peers, because commodity prices have risen, and energy prices, in particular, that improve prospects for the Canadian economy.
But on the flip side, against the US dollar, for example, it's been relatively flat because of global risk sentiment, particularly after the onset of the war in Ukraine. And so in a negative risk environment, the US dollar tends to outperform all other currencies.
Looking forward, if risk sentiment doesn't deteriorate further, terms of trade tailwinds, if you will, because of a robust commodity backdrop, should mean that the Canadian dollar appreciates or benefits, at the very least. And so if we've been trading in a relatively tight range year to date of $0.78-$0.80, we could see that range move higher for the balance of the year.
- Alex, thank you very much for your time.
- Thank you very much, Tony.
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