May finally brought some relief in what has been a consistent Treasury market selloff this year. With global growth concerns intensifying and financial conditions tightening through other channels like credit spreads and equity markets, investors began to question just how high central banks will raise interest rates. 10-year Treasury yields slipped back below 3% and lower policy rate expectations helped risk assets stabilize. The S&P 500 avoided bear market territory with a late-May rally that left the index flat for the month but still 13% lower year-to-date. The bond rally didn’t last long, though, as upside surprises on inflation and economic data emphasized the need for tighter monetary policy. Canadian yields in particular came under upward pressure following a hawkish BoC meeting at the start of June, pushing spreads relative to the US to their widest in months.
We continue to think growth risks will factor more into policymakers’ calculus later this year, and central banks won’t go quite as far as the market is pricing. But the onus is on inflation, which has persistently surprised to the upside, to begin slowing in the second half of the year. For now, central banks will follow through on guidance that policy rates need to move higher. Larger-than-usual 50 bp moves are the near-term norm for the BoC and Fed as both aim to remove accommodation in short order. The ECB is primed to begin raising rates with Lagarde flagging a July hike and exit from negative rates by the end of Q3. The RBA remains on a tightening path and we think the BoE, which got an earlier start to policy normalization, will continue to lift rates in the coming months. Those moves are already well priced into markets, so assuming inflation evolves as we expect, we see limited scope for a further selloff at the long end and look for flatter curves going forward.
Hawkish BoC pushes our overnight rate forecast slightly higher…
The BoC delivered a unanimously-expected 50 bp hike in June and emphasized there’s more to come in a hawkish policy statement. The latest leg higher in inflation—April’s CPI reading was a full percentage point above the bank’s Q2 forecast—was clearly front of mind with the statement mentioning growing risk that above-target inflation becomes entrenched. The bank also said it is prepared to act “more forcefully” if needed. Deputy Governor Beaudry later noted that could mean larger hikes (75 bps) or potentially a higher terminal rate than previously thought. Governing Council is guiding markets away from a “pause” at the lower end of its estimated neutral range for interest rates (2-3%)—one of the potential scenarios laid out in earlier remarks. Given the bank’s hawkish tone and higher starting point for inflation we now think the BoC will continue with 50 bp hikes through September. That lifts our peak overnight rate forecast to 2.75% from 2.50% previously.
Following the bank’s June meeting and particularly Beaudry’s comments markets are now putting some odds on a larger 75 bp hike in July. With the bank saying it expects inflation to move higher in the near-term before beginning to ease, we think it would take another significant upside surprise on May CPI (the only inflation report between now and July’s meeting) or worrying trends in inflation expectations (the bank’s BOS and CSCE surveys will be out in early-July) for the BoC to accelerate its tightening cycle next meeting. But a 75 bp hike could remain on the table if inflation doesn’t begin to slow over the summer, as we expect. Our thesis has been that a combination of slowing inflation and less robust growth later this year would keep the BoC from moving monetary policy into restrictive territory. But Beaudry made clear that the overnight rate might need to rise to 3% or higher to rein in inflation, even if such action increases the risk of tipping the economy into recession. We ultimately expect a change in tone once inflation is past its peak and above-trend growth is in the rear view mirror.
…as both Canadian and US economies overheat
A perception that central banks will tame inflation whatever the cost has added to recession fears. In addition to tightening financial conditions, the global economy has faced a series of economic and price shocks and there’s growing concern that one more could tip the scales toward a downturn. We agree that recession odds have increased, as is often the case late-cycle when economies are operating in excess demand and there’s more scope for growth to surprise to the downside than upside. Both the Canadian and US economies continue to show solid momentum, though, pushing back against worries about an imminent slowdown. That’s both good news and bad news, because the more above-trend growth pushes these economies into excess demand, the greater the risk that inflation proves persistent and requires more forceful action from central banks.
Canadian GDP rose an annualized 3.1% in Q1, prompting the BoC to note the economy is “moving further into excess demand.” Final domestic demand rose an even stronger 4.8% as consumers spent more on durable goods and services and business investment continued to recover. We see scope for further gains in consumer spending as auto supply chain bottlenecks ease and activity in high-contact services continues to normalize over the summer. Even with solid spending growth, household savings ticked higher in Q1 adding to a stockpile that will help buffer the negative effects of rising interest rates and consumer prices. Canadian businesses have their own stock of savings with undistributed corporate profits totaling C$150 billion (6% of GDP) over the past two years. That should provide ongoing support to business investment as companies aim to expand capacity in the face of strong demand, labour shortages and rising commodity prices. The latter drove Canada’s terms of trade (the price of exports relative to imports) to a record high in Q1 supporting national income. We look for above-trend gains to continue in the second and third quarters and have lifted our Q2 GDP tracking to 6.5% annualized.
Early signs of softening amid price pressure and rising rates…
The US economy also looks set for solid GDP growth in Q2—we expect a 3% gain that will more than reverse the first quarter’s 1.5% decline. Consumer spending wasn’t an issue in Q1 and looks set for another healthy increase in the current quarter with services spending continuing to push beyond pre-pandemic levels. Durable goods spending showed few signs of fatigue in April despite a rising interest rate environment, though auto sales continue to be held back by supply issues. A healthy labour market—the US economy added another 390,000 jobs in May—and robust wage growth continue to support household incomes. However, high inflation is eroding those gains with real disposable income now little changed from pre-pandemic levels even as nominal PDI is up 10%. Rising prices have dented sentiment with consumer confidence having retraced about half of its early-2021 recovery even though households maintain a rosy view of the job market.
Where both the Canadian and US economies are really starting to see some loss of momentum is in housing. Rapidly rising policy rate expectations and front-loaded hikes have pushed mortgage rates sharply higher, resulting in an almost immediate impact on the resale market. With home sales coming down from elevated levels, better balance between supply and demand should start to rein in price growth. There are already clear signs of that in Canada. As long as any price correction remains orderly, this should be welcome news to central banks with rising shelter costs (+7.4% year-over-year in Canada and +5.1% in the US) acting as a key contributor to inflation. While price pressure has broadened in recent months, we think less upward momentum in key components like energy and shelter will see inflation begin to soften in the second half of the year. US inflation has likely already peaked and we expect Canadian CPI will top out in May and June.
…but little reason for the Fed to ease up anytime soon
With the US economy running hot, the Fed is moving “expeditiously” to a more neutral policy stance. Chair Powell noted broad consensus on the committee that 50 bp hikes should be on the table at upcoming meetings—we’re with the market in thinking such moves are a virtual lock in June and July. We look for the Fed to revert to 25 bp hikes in September though it could continue with larger increments—a number of policymakers think front-loading hikes will put the committee in a better position later this year to evaluate the impact of tightening and assess whether more is needed. Inflation dynamics will be key to that assessment with the Fed wanting to see clear evidence (i.e. multiple CPI reports) that inflation is moving toward its 2% target before easing up on rate hikes.
As with the BoC, some FOMC members have noted monetary policy might need to be made restrictive to return inflation to target. That’s not our base case, and we continue to forecast fed funds peaking just below 3%. Our view has been that the BoC wouldn’t raise interest rates quite as far as the Fed (similar to recent tightening cycles) given the Canadian economy’s greater exposure to housing and higher debt loads. However, the BoC’s more hawkish tone has shifted our forecasts and we now see the two policy rates peaking at similar levels. Concerns about the Canadian economy’s ability to handle rapidly rising borrowing costs could still exert some downward pressure on the Canadian dollar, which at 79.5 US cents is still well within the roughly 77-81 cent range that has held for nearly a year. But interest rate differentials might not be quite as much of a currency driver as we previously envisioned.
UK and European recoveries starting to flag…
While we’re looking for above-trend growth in the Canadian and US economies in Q2, the same can’t be said of the UK and Europe where greater exposure to the Russia-Ukraine conflict has resulted in a more significant economic and inflationary toll. The UK economy expanded for a fourth consecutive quarter in Q1 but carried no momentum into the second quarter. GDP was flat in February and ticked lower in March with both manufacturing and services industries softening. Survey data suggest that trend continued more recently with the UK’s composite PMI falling to a 15-month low in May. The services index saw a particularly steep decline after earlier readings seemed to overstate the pace of growth. With re-opening gains in the rear view mirror, eye-watering 9% inflation eating into consumers’ spending power and manufacturing continuing to be restrained by supply chain issues and the war in Ukraine, we think Q2 GDP will come in flat. We aren’t forecasting a recession but gains in the second half of the year are expected to be modest (0.2% non-annualized).
We think the euro area is in for another quarter of modest growth with a 0.2% gain expected in Q2. PMI data suggest the currency bloc hasn’t lost quite as much momentum as the UK economy as it continues to benefit from re-opening in the service sector. However, manufacturing is facing similar production headwinds as well as softening demand with new orders now in contractionary territory. Euro area inflation surprised to the upside once again, rising above 8% in May. Core inflation is running at less than half that pace but is still well above historical rates. Pay growth has been muted despite low unemployment, though there were early signs of that changing with negotiated wage settlements picking up in Q1.
…but ECB and BoE to hike over the summer
The ECB is watching wage developments closely given their “critical importance” to the medium-term inflation outlook. In a May blog post, Lagarde said the euro area is facing a “new inflation landscape” due to a combination of temporary, cyclical and structural factors. We agree that the currency bloc’s disinflation era is over, with market-based inflation expectations now at or above levels consistent with the central bank’s 2% target (after spending a decade persistently below that mark). With this new era calling for a shift in monetary policy, Lagarde flagged a July rate hike and said the central bank should exit its negative interest rate policy by the end of Q3. That guidance is in line with our forecast, though the market is pricing in a more aggressive policy path than we’re projecting. We’ve lifted our short-term yield forecasts but think much of the selloff has already occurred.
Recall that divisions emerged within the BoE in May with some arguing for an even larger hike while others thought guidance on further rate increases was too strong. As with other central banks the market is seeing growing odds of larger-than-normal moves although we think the BoE will take more tentative approach and stick to 25 bp hikes at each of its next two meetings. With sluggish growth expected in the coming quarters we think the BoE will pause its tightening cycle after the summer, holding Bank Rate at 1.50% through year end. The market sees the BoE going much further than that despite the central bank’s warning in May that the market path for Bank Rate would ultimately leave inflation below target.
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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