$CAD a wake up call for slumbering AUD
CAD continues to confound with a further sharp rally after an essentially anticipated rate hike. There was nothing too surprising in the Bank of Canada’s presentation. The outlook has improved as heralded by recent speeches, and the Bank brought forward the closing of its output gap from the first half of 2018 to around the end of this year. However, the market may be taking a fresh look at the Bank of Canada view. If the output gap is closed by year end and inflation back on target by mid-2018, then the Bank will still have a lot of wood to chop next year to get rates back to neutral (around 3%). Unlike the Fed, the BoC is not talking much about headwinds and lower current neutral rates or a need for prolonged accommodation. Its models raise the prospect of more hikes in 2018, something the market is only just starting to wake up to. The Fed has lifted rates to a point where it is now shifting focus to balance sheet reduction. It is skirting around the issue, but there are voices inside the Fed that see this as a reason to hit the pause button on further rate rises. The BoC, of course, has no need for reducing its balance sheet and may be on a clearer path to higher rates in 2018. The CAD has already strengthened sharply this year, and some may baulk at buying at this stage, but the wake-up call from the BoC applies to other low rate countries that may need to normalize rates before too long. This is generating risks that recent strength in CAD continues to spill over to AUD and NZD.
Market starts to think beyond two BoC hikes this year
Following the Bank of Canada policy announcement today, CAD has strengthened significantly further and 2yr Canadian swap rates are up 7.5bp, against a fall in the US of 2.5bp.
There was nothing too surprising in the policy statement. The Bank had set the stage for a rate hike and one was 93% priced into the money markets. And by year end 45bp of hikes were priced-in, suggesting that the market was pricing in a high probability of a second hike by year end.
The market reaction to this policy meeting is none-the-less quite significant. The market has moved to fully price a second hike by year end, and even a small risk that there might be a third.
The market is not fully pricing a second hike at the next MPR date on 25-Oct (it has 18.4bp priced for this date), but it has 26.4bp priced in by the 6-Dec policy meeting (which is not an MPR date).
The market is starting to think beyond the next two hikes towards further hikes in 2018, accounting for the further rise in 2-year yields today.
The Bank dressed up its rate hike delivered today as removing the accommodation put in place in 2015 to deal with the oil prices shock. It cut twice in 2015, and thus the market has in mind there are two hikes in planning (the first delivered today).
However, the broader analysis and output gap framework of the Bank of Canada points to the risk of ongoing policy hikes beyond these two hikes as the economy normalizes.
Since the April MPR, the BoC has brought forward the closing of the output gap from “the first half of 2018” to “around the end of 2017”.
This should not be surprising, but at face value, if the output gap is estimated to be closed by the end of the year, the BoC could then argue it needs to continue normalizing policy.
The Bank estimates that growth will continue above trend through the three-year horizon, so this suggests that it will be moving into a positive output gap (inflationary) in 2018 and beyond.
If it delivers a second hike this later this year, rates will be 1.0%, still well below the Bank’s estimate of neutral (2.5 to 3.5%)
The inflation rate is forecast to still be below target at the end of the year, but the Bank sees most of the recent fall in CPI as due to factors that it believes are temporary and will wash out by mid-2018
The MPR said, “Consumer price index (CPI) inflation has been soft recently, for the most part as a result of food, electricity and automobile prices. Excess supply in the economy has also been a factor. Inflation is forecast to pick up and return close to 2 per cent in the middle of 2018 as relative price movements dissipate and excess capacity is absorbed.”
“The Bank assesses that the risks to the projected path for inflation are roughly balanced.”
So with inflation forecasts to be on target and the output gap positive by mid-2018, there is an argument that rates normalization will be well behind schedule (if normal rates are 3%)
The Bank acknowledges that there may be global trends towards low inflation outcomes, such as the sluggish response in wages growth to tightening labor markets. However, it said the risks to their inflation outlook are balanced.
The shift in forecasts by the Bank of Canada are not so dramatic from April to July, but the market may be taking a fresh look and seeing more risk of rate rises than previously thought.
As it stands, Canadian rates markets are not pricing all that much for additional rate hikes in 2018. My rough calculation from IOS is only 18bp more hikes by mid-2018 (presuming a second hike to 1.0% is delivered by end-2017), and 35bp by end-2018. Rates below 1.5% by end-2018 would be still well below neutral (3%).
If the Fed is at risk of moving more slowly on rate rises while its inflation remains subdued and it assesses the impact of the balance sheet reduction expected to begin (probably in September), then there is scope for higher rates in Canada to place significant upward pressure on the CAD.
There is not a lot of discussion in the Bank of Canada MPR about long run headwinds that might keep rates below neutral for a long time. Unlike the Fed that continues to provide an alternative narrative that the current neutral policy rate (around zero in real terms) is below the long-run neutral, and its view of the long run neutral rates is also low by historical standards (3.0% in nominal terms).
Presumably, the Bank of Canada could not diverge too far from Fed rates policy, or else the CAD could rise significantly, but its current policy outlook and output gap model suggest that rates continue to rise next year, much more than currently priced-in by the market.
Fed switching focus to balance sheet reduction
The Fed has risen rates to a point where it is shifting focus to balance sheet reduction. Yellen has argued that the aim is for balance sheet reduction to be conducted in the background, and the fed-funds rate will be the main policy instrument. Nevertheless, balance sheet reduction is a form of removing policy accommodation, and it will tend to delay and slow rate hikes. This is a point made by several FOMC members in the Fed minutes and very explicitly by Fed member Lael Brainard in a speech on Tuesday.
The minutes said:
“Several participants indicated that the reduction in policy accommodation arising from the commencement of balance sheet normalization was one basis for believing that, if economic conditions evolved broadly as anticipated, the target range for the federal funds rate would follow a less steep path than it otherwise would. However, some other participants suggested that they did not see the balance sheet normalization program as a factor likely to figure heavily in decisions about the target range for the federal funds rate. A few of these participants judged that the degree of additional policy firming that would result from the balance sheet normalization program was modest.”
A “few participants” that supported the rate hike in June, “were less comfortable with the degree of additional policy tightening through the end of 2018 implied by the June SEP median federal funds rate projections.” This suggests that they were biased towards delaying hikes as the QE wind-down proceeded.
Cross-Border Spillovers of Balance Sheet Normalization – Governor Lael Brainard, 11 July – federalreserve.gov
Canada, of course, has no need for balance sheet reduction and is more focused on rates policy. It is now in the mode of normalizing rates, and if the Fed hits pause on rates as its balance sheet reduction gets moving, the CAD may strengthen further.
The CAD has already risen significantly, and the market will be reluctant to keep buying for the time being, but the focus must turn to other countries that may also need to normalize policy via conventional rate hikes. Australia and New Zealand are possible candidates.
Slumbering AUD rates outlook
The market may be dismissing recent evidence of recovery in Australia. The narrative from local commentators is still negative – headwinds from household debt and savings, political leadership lacking, risks from Chinese financial stability. Most do not see hikes coming into view. However, recent business surveys and labour market indicators have picked up. Even the labour costs indicator in the NAB business survey rose to a recent high this week. No one thought a hike was coming into view for Canada less than two months ago, the market is too complacent about the risk in Australia.