Bank of Canada to Hike 25bp, Value in Long CA-US 2Y Spread, AUD/CAD Could Retrace

Summary

• The labour force has continued to prove resilient with participation climbing, unemployment lower and wage growth remaining positive (vs core).
• Core disinflation progress has stagnated.
• Recent Business and Consumer Outlook Surveys are supportive of persistent inflation with expectations for inflation increasing in both level and duration.
• As a result, we expect the Bank of Canada (BoC) will hike by 25bp to 4.5%.

Market Implications

• There is value in fading priced Federal Reserve (Fed) cuts versus BoC. We favour being short the US two-year versus Canada.
• AUD/CAD may retrace some of its recent run. Anywhere closer to 0.96 likely proves an attractive short.

One Last Hike

At their December meeting, the BoC hiked the policy rate by 50bp to 4.25%, larger than our expectation for a 25bp move. However, we believe it was the change of language that was most important. Notably, they listed necessary conditions that needed to be made for them to pause. At this meeting, we, again, expect a slowdown to a 25bp hike. Here’s why:

Labour Force Proving Resilient

The labour force is proving resilient. Through December, participation climbed 0.2pp (to 65.0% from 64.8%) while unemployment (5.0%) slipped closer to 50-year lows as employment rose +104k – the majority was in full-time work (+84.5k). Meanwhile, wage growth remained above +5.0% YoY for the seventh consecutive month with 75% of 2022 seeing stronger wage growth than historically seen. Looking forward, our model for Canadian employment suggests further upside for the employment rate (note: the spike is induced by one strong data point; Chart 1). We still see a strong jump in employment ahead when taking a relatively conservative outlook.

Core Inflation Failed to Retreat Further

Inflation remains the core target of BoC monetary policy. On this front, three-month annualised core inflation is failing to retreat. It was outlined as a concern in December, noting a desire for the trend lower to sustainably continue. However, this failed to materialise. At best, they have moved sideways. In reality, both median and trim three-month annualised growth measures are higher than they were during the December meeting (Chart 2).

BoC Survey Supportive of Final Hike

The Business and Consumer Outlook Surveys delivered the final piece of information we needed. It showed a larger share of participants expecting inflation above 3% (to 84% from 77%) and that it would take longer than previously expected for it to return to target, with the plurality of participants now expecting normalisation not to occur until 2026 or later (previously 2024, Chart 3).

However, warning signs are showing. Sales growth has dwindled and is expected to worsen going forward, CAPEX is below year norms (1/5 say tight financial conditions are holding their investments back), and overall indicators of future sales have retreated (Table 1). It comes as consumers are finding it more difficult to obtain credit ahead of an expected recession (Chart 4). This may very well be the last hike from the BoC, in line with markets pricing a c.4.5% terminal rate.

CAD and Canada Rates

Turning to markets, we think rates markets are wrong in two ways: (i) They are pricing just 20bp for the meeting, not 25bp as we expect and (ii) have yet to price in enough cuts. On (i), we stated our case above. On (ii), we made our case back in November and the premise still holds. Consider the two-year US-Canada spread, it sits at 56bps and has typically traded, at least, another 30bp higher in hiking cycles (Chart 6). We continue to like this trade with worsening Canada data likely to continue, the opposite is expected in the US.

Turning to FX, we remain bearish CAD with other commodity currencies better exposed to the China re-opening trade and less exposed to a slowdown in US growth. However, the 8% run higher in AUD/CAD could see tactical retracement on a fourfold basis:

1. The China reopening story fades from AUD and struggles to keep up appearances. Indeed, its relative strength has already dwindled versus Canada (Chart 5).
2. US data could prove better than expected. As a result, markets would assume a healthier Canadian economy. Meanwhile, Australian data begins to weaken, a scenario we have long expected to take place in March as mortgages begin to roll over to floating rates.
3. While two-year spreads are trending higher, it has spiked lower. A move FX is yet to respect (Chart 6).
4. AUD/CAD would hit a decade-long resistance level around 0.96 (Chart 7).

Bottom Line

We expect the BoC to hike the policy rate by 25bp to 4.5% tomorrow justified by strong labour market and core inflation data. Turning to markets, we continue to see value in positioning for the BoC to need to cut. To that point, the USD-CAD 2Y1Y swap spread could widen another 20bp. And in FX, the 8% run higher in AUD/CAD may meet some technical headwinds.

Ben Ford is a Researcher at Macro Hive. Ben studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)