BoC Pivot Complete – Long Canada 2Y Vs US 2Y Remains Attractive

Summary

• The Bank of Canada (BoC) hiked the policy rate to 3.75% (+50bp). A smaller move than markets had expected, something we had alerted markets were assigning too small of a probability to.
• The 50bp move was driven by a promising outlook on inflationary pressures from the Business Outlook Survey, as well as anchored long-term inflation expectations, despite elevated short-term inflation expectations and core-CPI failing to meaningfully turn over.
• Markets are assigning a 50/50 probability to a 25bp or 50bp hike, we are leaning toward the smaller-sized move, though it is too early to say with certainty. We note the decision is likely to be swayed by the October CPI print (16 November).

Market Implications

• The Fed is underpriced vs the BoC – continue to be long Canada 2Y vs US 2Y.
• USD/CAD could break through 1.45.
• AUD/CAD could fall to 0.85, or lower.

The BoC Hiked the Policy Rate by 50bp

The BoC hiked the policy rate to 3.75% (+50bp). A smaller move than markets had expected, something we had noted they were assigning too little probability to. The Bank noted several reasons to slow alongside reasons to keep up the pace, though former proved stronger. They focused on a lower global growth projection, easing domestic growth (in particular, in interest rate sensitive sectors), signs of a peak in labour force strength, and a faster-than-expected decline in headline inflation.

Why Did They Opt For a 50bp Hike?

The case for another 75bp hike was strong. Two of the three criteria they were watching (short-term inflation expectations and core inflation) suggested more hawkishness (Charts 1 and 2). While five-year expectations remained anchored.

However, lower-than-forecasted headline inflation, easing business price rise expectations (both on inputs and outputs), and an improved inflation outlook, justified the pivot (Charts 3, 4, 5, 6, and 7).

Will the BoC Hike by 25bp or 50bp in December?

The press statement was very clear: ‘This tightening phase will draw to a close. We are getting closer, but we are not there yet.’Macklem provided even more detail in the Q&A section of the presser stating the outcome for December was binary (25bp or 50bp). They will be evaluating:

1. Whether two-year inflation expectations have reversed, and five-year inflation expectations have remained anchored.
2. If underlying inflation has meaningfully declined. In particular, they are looking for ‘a more sustained further decrease in the 3-month measures’.

We, just like markets, believe it is too early to call the exact move they will make on 7 December – though we lean toward a 25bp hike from the BoC, while the market is implying a 50% move either way. We will be in a clearer position following October CPI (16 November) and updated labour force figures (4 November and 2 December).

The Path Past December

The path beyond December is not bound to a binary outcome. The Board has taken a more patient stance – they trust that the 350bp of hikes over six meetings will prove sufficient.

So, while services (excluding shelter) inflation is picking up (Chart 8). As are goods purchased from stores – it has forced a record number of Canadians to visit food banks and supermarkets to freeze some product prices. BoC research suggests it will take eight quarters for 100bp of hikes to reach peak impact on services and 10 quarters to reach peak impact on food (Table 1).

Risks do remain, however. Should short-term inflation expectations persist, alongside higher wages, then a more aggressive path would be needed (Chart 9). Moreover, within their forecasts, the Bank is assuming that pent-up savings are spent at a historically normal rate. That is, there is a strong risk that Covid savings could push the BoC to further hikes.

Bottom Line

The BoC are set to hike by 25bp or 50bp in December, we are leaning toward a smaller sized move while the market is assigning a 50% probability to both.

We had seen value in going long Canada vs US (2Y and 5Y) with the expectation that they would widen by another 30bps. They widened by over 20bps following the decision, taking the 5Y spread close to previous extremes. We believe there remains value in long Canada 2Y vs US 2Y with previous extremes at least 30bps away and the US terminal rate underpriced.

Meanwhile, on FX, we remain in favour of being long USD/CAD.

[1] – ‘Disaggregating Household Sensitivity to Monetary Policy by Expenditure Category’; Staff Analytical Note 2018-32

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.)