ECONOMIC & FIXED INCOME COMMENT - Onwards and Upwards
2022 began with a lot of promise. After two years dominated by COVID-19, the global economy looked set for normality. Yes, inflation was becoming a nuisance for central banks, and growth was set to slow from 2021’s rapid pace but, markets appeared to have digested these developments. Then came Russia’s unprovoked invasion into Ukraine on February 24th, 2022. The consequences of the invasion are slower global growth, with Europe taking the largest hit, and higher inflation. The Organization for Economic Co-operation and Development (OECD) have recently revised down their outlook for global GDP in 2022 by 1% to 3.4%. At the time of this writing, even with the downward revision, global growth should still remain above trend, provided hostilities ease and global energy prices stabilize.
Both Canada and the United States will see GDP impacted, but not to the same degree as other countries. The United States GDP has been revised down 0.8% to 3.2% and Canada 0.5% to 3.5% for 2022. Specifically looking at Canada, the economy continued to show resilience during additional COVID-19 restrictions and lockdowns. Canada grew by 0.2% in January and the preliminary estimate for February is 0.8%. Going forward, Canada stands to benefit as a net exporting nation of several commodities, such as oil, wheat and potash, which the war on Ukraine has impacted. Additionally, the Canadian labour market has fully recovered with the unemployment rate back below pre-pandemic levels at 5.5% as of February.
Even with all this uncertainty surrounding the war in Ukraine and the continued implications of COVID-19, central banks will continue their normalization path to combat inflation. Both the Bank of Canada (BoC) and the U.S Federal Reserve (Fed) increased interest rates by 25 basis points in March; the first time since 2018. However, both central banks accelerated the pace towards normalization from previous forecasts as a result of a commodity shock sparked by Russia’s invasion of Ukraine and the mischaracterization of inflation as “transitory” (See chart).
As mentioned, the BoC raised its policy interest rate to 0.5%, from the emergency low 0.25% set after COVID-19 hit North America. This was fully anticipated and priced into the bond market. Furthermore, the BoC has signalled additional rate hikes are warranted and expected due to high inflation pressures (5.7% as of February) and a strong labour market. Not only are inflation pressures high, it is broadening with roughly 65% of the CPI basket growing above the BoC’s target of 2%. Furthermore, medium-term inflation expectations are creeping up and there is concern they might become unanchored. The BoC will need to move monetary policy toward a neutral stance (neither stimulative nor restrictive) faster than previously anticipated. Currently, markets are pricing in six additional rate hikes in 2022 bringing the banks overnight rate to 2% by yearend. The magnitude of rate increases will be largely influenced by the level of business investment, the rate consumers deplete savings accumulatedduring the pandemic and the degree the Russia/Ukraine conflict impacts the Canadian economy.
The Fed is expected to be more aggressive with interest rate hikes. The Fed Funds Rate is forecast to be 2.50% by yearend. The Fed Funds Rate is projected to be higher than Canada due to inflation being more prominent, hitting 7.9% in February and wage growth pressures running high, 5.6% as of March.
During January and February, bond yields were in a tug-of-war between escalating downside risks to economic growth in the wake of Russia’s invasion of Ukraine and upside risks due to high inflation levels. However, there was a sharp increase in yields during March with Government of Canada 10-years ending the quarter at 2.40%. The move in bond yields has been a result of the market adjusting to the new monetary policy regime. Specifically, the BoC and Fed have made it clear they will “do whatever it takes” to tame inflation.
For the remainder of 2022, both the BoC and Fed will continue to increase interest rates and initiate quantitative tightening (reduce their balance sheet). The goal for both central banks is to engineer a soft landing: a situation where they can slow growth down to a maintainable level without derailing the economy and causing a recession. Bond yields will continue to move moderately higher over the course of the year. 10-year Government of Canada bonds should trade within a range of 2.75%-3.25% by yearend.