Doug Porter

January 28, 2021

Central banks broke out the semaphore flags this week to signal rate hikes lie straight ahead. No more need for your copy of ‘Fedspeak for Dummies’ when Chair Powell intones that the FOMC “is of a mind to raise rates in March.” No need for a BoCTalk decoder ring when Governor Macklem states “interest rates will need to increase to control inflation. Canadians should expect a rising path for interest rates.” The rare bout of extreme clarity from this week’s pair of meetings is due to both likely wanting to raise rates immediately but facing constraints from previous pledges to a) provide a warning before hiking rates (BoC), and b) to end QE before hiking (Fed). In other words, both delivered a hawkish hold, sending two-year Treasury yields jumping almost 20 bps and somehow lifting like-dated Canadian yields slightly even as the Bank defied market expectations of an immediate hike.

Not surprisingly, this relentlessly hawkish set of messages went over like a lead zeppelin with investors, already reeling from hot inflation, geopolitical concerns, and a few high-profile earnings misses. (On the other side, Apple’s robust Q4 results helped nearly save the week.) The end-of-day and end-of-week changes in equity averages simply did not do justice to the heavy volatility; Monday set the tone with a massive intra-day swing. But with the dust settling, stocks were sitting at yet another week of declines, making it four-for-four so far in 2022. The S&P 500 is perched right on the edge of a 10% setback from its all-time high, set on the very first session of the year. Growth stocks have been particularly walloped, with the Nasdaq sagging another 2% this week, off roughly 16% from its high and now basically unchanged from a year ago—yes, it’s true.

The flip really switched for markets during Powell’s press conference, following a relatively innocuous statement. The hawkish hits came fast and furious, with the Chair in quick succession delivering these top 10 warnings:

• There is quite a bit of room to raise rates without threatening the labor market
• The economy is quite different this time than in 2015, 16, 17, 18 (when rate hikes were leisurely)
• We can move sooner, faster
• There is a risk that inflation will be prolonged
• The inflation situation is slightly worse than in December (when they already made a big pivot to the hawkish side)
• We haven’t made a decision on the size of rate hikes (50 bps?)
• There will be a significant reduction in asset holdings (QT, this year)
• We’re not looking at one market (i.e., the sudden struggles in equities)
• We will be humble and nimble (i.e., won’t be held to a quarterly rate hike path)
• It will soon be time to raise rates

While we had already pencilled in the first rate hike at the March meeting prior to this fusillade, the clear heightened determination suggests a faster Fed response in following meetings. We now believe that the Fed will begin the process with a quick series of rate hikes at the next three decisions, and then settle into a quarterly pattern (thus, 125 bps of total tightening this year, versus our prior 100 bps). There is still upside risk to this call, and—frankly—the market has almost entirely taken this view on board. The fact that Powell did not rule out a 50 bp hike keeps the prospect in play. The litmus test for inflation and policy may well arrive in the spring; the conventional wisdom is that inflation will begin to moderate at that point due to favourable base effects, more stable energy prices, and perhaps some improvement in the supply picture. If those assumptions prove incorrect, that would be the time to look for an even more aggressive Fed.

Even for the Bank of Canada, we have also cranked up our outlook for total rate hikes in 2022 by 25 bps (also to 125 bps). That ramping up may seem somewhat odd, given that the Bank just flummoxed markets by passing on a chance to start hiking this week. But the Bank’s stern warnings, its new inflation forecast of 4.2% this year, the relentless strength in housing, and the ongoing march in energy prices all point to more than our prior view of 100 bps this year. We now expect the Bank to rattle off a series of four rate hikes beginning in March, and then settling into a quarterly pattern thereafter.

Could the Bank also be pondering a 50 bp hike at some stage? The last time they moved in such a gulp was in May 2000—not just more than two decades ago, but also pre-dating their shift to fixed-announcement dates for interest rate decisions (in Nov/2000). Of course, the Fed also hasn’t hiked at a 50 bp clip since 2000, and such a move by the FOMC would certainly provide cover for the Bank. In fact, with inflation already running too hot for comfort, the BoC would probably prefer to not see much daylight between U.S. rate moves, lest the Canadian dollar suffer further.

It’s notable that the loonie sagged 1.4% this week to 78.4 cents ($1.276/US$), even as WTI prices rose 4.5% to their highest level in more than seven years at around $88. (Natural gas also jumped almost 20% on the week, supported by tensions on Ukraine, but also by a relatively cold winter.) That seemingly counter-intuitive move was entirely due to the Fed’s relative hawkishness and the sharp tightening in short-term Canada/US spreads (the gap on two-year bond yields has collapsed below 10 bps from around 60 bps just two months ago). Still, energy prices have not completely deserted the loonie, as the currency has mostly firmed this year on the crosses, mirroring its relatively firm performance versus others in 2021.

Finally, where is the broader economy going amid all this market volatility, hot inflation, surging energy prices and the prospect of an aggressive Fed? That is, are the risks of an outright downturn at some point in the coming year on the rise? No doubt, the risks are rising, and the longer inflation lingers the more these risks build. But note that the U.S. economy quietly clocked in a 6.9% GDP growth rate in Q4, the best of the year, and capping a 5.7% advance for all of 2021, the fastest annual rise since 1984. Nominal GDP was even more impressive, surging at a massive 14.3% pace in Q4 and up 10% for all of last year—and it is nominal growth that drives incomes, profits and government revenues.

This end result followed a long and fitful ride for expectations for the U.S. economy last year, which began with the consensus looking for a moderate 4% advance, then rocketing to nearly 7% growth by mid-year on surprising fiscal juice, but then various virus waves and supply chain issues pulling it back to around the final result. The key takeaway is that while growth didn’t quite live up to the most bullish expectations, it nevertheless proved resilient in the face of many, many challenges in the past year. And while we may be a tad below the latest consensus, we believe that resiliency will be maintained with 3.5% average growth in the year ahead.

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It’s a somewhat different story for Canada, which suffered through both a deeper downdraft in 2020, but also a cooler recovery last year. This sustained stretch of weaker growth largely reflects more intense and longer-lasting restrictions, which are also expected to hold GDP flat in Q1. The coming week will unveil some early results on how the North American economy fared in January, when the spread of Omicron began to bear down. The impact will land both on the supply side—people unable to work due to illness—and the demand side—people unwilling/unable to venture out as much. After a warm-up from manufacturing surveys, auto sales, and monthly GDP in Canada, the main event will be Friday’s jobs reports. A back-up in claims points to a soft U.S. result, while Canada could post a triple-digit setback on heavy restrictions in the two biggest provinces. But we have seen this in prior waves, and jobs are likely to quickly return in following months.

One curious sidebar to this week’s Bank of Canada announcement was the MPR’s forecast revision for GDP growth to 4.0% for this year and 3.5% in 2023 (after their estimate of 4.6% in 2021). That just happens to match our most recent forecast to the decimal point in both years (giving us newfound appreciation for the deep wisdom of the central bank). The view depends heavily on a marked acceleration in the middle quarters of the year, helping begin to close the growth gap with the U.S. economy.

Doug Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.