Central bank divergence re-emerging

After a stubbornly dovish March FOMC meeting—strong growth forecasts accompanied by a flat dot plot and no taper talk—we thought a more balanced tone from the US central bank was just a matter of time. And the Fed indeed changed its tune in June, signaling rates will indeed have to rise in 2023 given strong growth and above-target inflation (a growing number of participants even see rates moving up next year). Policymakers also began discussing tapering plans and we continue to expect more details will be revealed later this summer before QE starts to be scaled back around the turn of the year.

The Fed’s shift gave the US dollar a boost with the trade-weighted index now up nearly 3% year-to-date. The Canadian dollar is down by about 3 US cents since the start of June even as oil prices continue to firm. Rates markets also recognized the Fed’s change in tone with 2-year Treasury yields rising to their highest level in more than a year. The long end of the curve, however, has seen a surprisingly strong rally due in part to expectations that the Fed will be less tolerant of high inflation—10-year breakeven inflation is down by 1/4 percent from May’s highs even as oil prices have generally firmed. We think the rally at the long end is overdone and look for yields to move higher over the second half of this year as expectations for a 2022 rate hike continue to build (we’re now expecting Fed liftoff in Q4/22).

Rising US yields should push borrowing costs higher in other geographies, including the UK and euro area where we don’t expect rate hikes next year. The ECB’s increased emphasis on symmetric 2% inflation (even if it isn’t adopting average inflation targeting) suggests it will remain on the sidelines for an extended period. The RBA also looks set to keep rates on hold through 2022 but will taper its QE program later this year. We expect the BoC will continue slowing its bond buying and will look relatively aggressive with two rate hikes in 2022.

Highlights:

• The Fed made waves in June by revising up its growth and inflation forecast and signaling interest rates will have to rise sooner than it previously indicated. We expect taper talk (which began in June) will continue over the summer with a more explicit signal helping to reverse the recent decline in 10-year Treasury yields.
• The BoC is expected to continue tapering its QE program in July. Markets see the Fed’s shift giving the BoC more room to raise interest rates—our forecast for two rate hikes in H2/22 is unchanged and we expect the bank’s forward guidance will remain consistent with that.
• The US and UK are expected to post impressive GDP gains in Q2 given their advanced stage of re-opening. Canada and the euro area will likely see more moderate gains with restrictions having been kept in place longer, but we see growth accelerating in Q3 and re-opening continues.
• The BoE acknowledged stronger-than-expected near-term growth and inflation but doesn’t expect this pace to last. It wants to see the economy well on its way to absorbing slack before beginning to raise rates, and we don’t see that happening in 2022.
• The ECB’s strategic review has it putting more emphasis on “symmetric” 2% inflation. For a central bank that has long battled disinflation, that makes rate hikes a distant prospect.

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Josh Nye is a senior economist at RBC. His focus is on macroeconomic outlook and monetary policy in Canada and the United States. His comments on economic data and policy developments provide valuable insights to clients and colleagues, and are often featured in the media.

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