ECONOMIC & FIXED INCOME COMMENT - End of Tightening Cycle in Sight
Since the onset of the synchronized global monetary tightening cycle, major central banks have sought to orchestrate a “soft-landing”; a scenario where labour markets and economic growth settle to sustainable levels without causing a recession or elevated unemployment. In order to achieve this desired outcome, “Front-loading” became the motto of policymakers. During the third quarter, central banks continued to aggressively remove policy support to fight against soaring food and energy prices that continue to erode real incomes, creating a global cost-of-living crisis, particularly for the most vulnerable groups. Specifically, 10 of the most developed economies have raised interest rates by a combined 2,000 basis points as of September 21st, in an effort to tame inflation (Chart 1). The single holdout is Japan, which is still facing only moderate inflation of under 3%. Against this backdrop, the global economy is projected to expand 2.4% in 2022. However, significant downside risks continue to weigh on the global economy and may cause further downward revisions to global growth in the fourth quarter.
In Canada, the BoC raised the overnight bank rate 175 basis points during the third quarter. At 3.25% the overnight rate is now slightly above the 2-3% range that the BoC considers neutral. With monetary policy now in “restrictive” territory, the final terminal rate will hinge on the path of inflation. Although there are signs that headline inflation has peaked (7% in August vs 7.6% in July and 8.1% in June), it has not declined meaningfully for the BoC to pause and take stock of the impact (Chart 2). We anticipate the BoC to raise the overnight rate 50 basis points at the October meeting and 25 basis points in December, bringing the overnight rate to 4%. Although the BoC has raised interest rates 300 basis points in 2022, the Canadian economy has remained resilient. Second quarter GDP grew by 3.3% (annualized), led by higher commodity exports and strong consumer spending. However, growth is expected to weaken in the third and fourth quarter. Nonetheless, the Canadian economy is forecast to grow by 2.6% in 2022.
Similar to the BoC, the Federal Reserve (Fed) raised the Feds Funds rate 75 basis points to 3.25%. While it was fully anticipated by the market, revised Fed comments (dot plot estimates) took markets by surprise. The Feds dot plot is a chart that records each Fed official’s projection for the central bank’s key short-term interest rate. Specifically, the Fed foresees its policy rate rising at a faster pace and to a higher level than earlier forecast. Two factors contributed to the increasingly hawkish tone by the Fed; further strength in the labour force, and August’s surprise increase in core CPI. As a result, the Fed’s target policy is now projected at 4.5% by yearend and 4.75% in 2023. Policymakers are aware these revisions will significantly reduce economic growth and increase unemployment. However, the Fed will continue to raise the Fed Funds Rate until inflation is unmistakably on its way to 2%. The U.S. economy is forecast to expand 0.2% in 2022.
During the third quarter, bond yields in North America moved in lock step with inflation data. In July, there were promising signs both economies were reaching peak inflation and as a result, 10-year yields declined to April levels (2.5% in Canada and 2.6% in U.S.). However, in August, yields reversed course due to a surprise in the U.S core inflation data, Jerome Powell’s hawkish speech at Jackson Hole and the BoC’s unwavering commitment to fight inflation. Finally, in September, the bond market recalibrated the aggressive monetary policy shift which moved 10-year yields higher (chart 3).With shorter-term interest rates rising faster than longer-term interest rates the inverse yield curve steepened further, resulting in a downward shift in economic growth expectations.
In Canada, yields have not risen as sharply in recent weeks as have U.S. Treasuries. This can be attributed to Canada’s weaker labour market, with 3 negative months of job growth and unemployment reaching 5.3%. Furthermore, August’s inflation reading came in below expectations. As a result, this supports the case for the BoC to enact smaller rate hikes ahead, unlike the U.S. The 10-year Government of Canada bond yield is expected to reach 3.5-3.75% by year-end. This is positive as monetary policy takes 12-18 months to work its way through the economy, so we have not seen the full impact of the rate increases already in place.