CAD, GBP Curves Could Be Mispriced

Summary

• The Fed, BoE, BoC and RBA’s benign neglect of steeper curves likely reflects growth expectations that could prove optimistic in the BoC’s and BoE’s cases.
• Nevertheless, the BoC seems unlikely to attempt to cap yields out of concern over financial stability and bond market functioning.
• Both the RBA and Fed will unlikely impede steeper curves, but growth could be stronger in the US than in Australia.

Market Implications

• Flatter CAD and GBP curves, steeper USD than AUD curve.

Global Central Banks’ Acceptance of Higher Yields Varies

Over the past few months, global yields returned to pre-pandemic ranges. Global central banks’ reactions varied. At one end of the spectrum, the Fed, BoE, BoC and RBA have taken a benign neglect attitude, arguing that the ramp up in yields reflects improved economic prospects. Fed Chair Jerome Powell likely speaks for the group when saying that higher yields are no issue provided market conditions remain orderly and recovery prospects are unimpacted.

At the other end of the spectrum, the BoJ’s operational target is the 10-year yield. At its 19 March policy meeting, it maintained the 0% target for the 10-year yield and widened the target band to +/-25bp from previously +/-20bp. Simultaneously, it specified it would introduce ‘fixed-rate purchase operations for consecutive days as a powerful tool to set an upper limit on interest rates when necessary’.

The ECB’s reaction falls between these two extremes. At its 11 March meeting, the ECB announced ‘significantly higher purchases’ in Q2 than in Q1 while keeping the size of its overall asset purchases program constant. This largely reflects divisions between governing council members, which subsequently reflect the divergence between member countries’ economies.

In part, central banks’ acceptance of a steeper yield curve reflects financial conditions that are looser than pre-pandemic in the US, Japan and Canada and little tighter in the other jurisdictions. It also reflects their expectations of growth and the return to full employment.

Fiscal and Monetary Policies Plus Immunization to Drive 2021 Growth

Growth expectations vary across central banks though are broadly aligned with markets. Of the six central banks we consider here, the ECB and BoJ (which are least willing to let the curve steepen) have the lowest 2021 growth expectations.

2021 growth in turn will reflect mainly fiscal policy plus immunizations and reopenings. In this regard, the ECB, BoJ, RBA and Fed growth expectations appear realistic while the BoC and BoE appear too optimistic due to fiscal policy and immunization campaigns. At the same time, the BoC appears less likely than the BoE to attempt to cap the increase in yields.

Financial Stability a Consideration in Central Banks’ Decision to Cap Yields

The BoC and RBA are traditionally more willing than other global central banks to lean on rates to control asset prices. This suggests the BoC will likely be sensitive to Canada’s property price increase since December 2019, the largest after the US and the UK.

Also, as Deputy Governor Toni Gravelle explains, the BoC wants to avoid holding too large a share of outstanding government bonds, likely over concerns of impeding smooth market functioning (Chart 7). This may be why the BoC scaled back its bond purchases last October while extending maturities. More recently, Gravelle pre-announced a taper that the bank could officially announce at the April policy meeting.

By contrast, the BoE has espoused the mainstream central banking view on relying on macroprudential policies to keep asset prices in check. Also, likely due to the bigger size of its government bond market compared with Canada’s, the BoE seems unconcerned by its relatively high ownership of government securities.

Market Consequences

I expect 2022 growth in Canada and the UK to be below central bank and market expectations, which could see curve flattening (Chart 8). Regardless, I expect the BoC neither to step up its asset purchase nor delay tapering to flatten the curve. Rather, I expect the BoC to fight market expectations of a 2022 lift-off.

Similarly, in the UK, a likely disappointment of growth expectations could also see the curve flatten, though the BoE is likely readier to top up its QE program than the BoC.

Finally, a faster immunization campaign and more policy support suggest the USD curve should be steeper than the AUD curve, especially as the Fed and RBA have committed not to raise rates until 2024.