Douglas Porter

April 8, 2022

This is the most wonderful time of the year for sports fans—opening day in baseball, the NCAA basketball finals, the Masters, the playoff push in the NBA and NHL, and the world men’s curling finals. And it’s appropriate that this busy week began with the basketball final, because Fed officials are putting on a full-court press of hawkish commentary. The hits came fast and furious this week, with the normally dovish Lael Brainard warning that quantitative tightening would be coming soon and forcefully, the FOMC Minutes all but laying out a surprisingly rapid QT pace, and the reliably hawkish James Bullard flatly stating the Fed was behind the curve. This sent bond yields skittering higher, with the 10-year Treasury yield leaping more than 30 bps on the week to around 2.70%, its highest perch in three years.

Just a week ago, markets were abuzz with the inversion of the 2s/10s Treasury yield curve, and what that may mean for recession risks. Well, presto, change-o, the attack of the hawks quickly normalized the curve, with 10-year yields now roughly 20 bps north of 2s again (even with a further upswing of 5 bps in the latter to about 2.50%), and recession chatter suddenly on the backburner. It was a broadly similar story for Canadian yields, albeit the 2s/10s curve did not quite invert last week—but the gap did widen back out to about 20 bps this week. Notably, this broad-based lurch higher in yields unfolded even as oil prices took another big step back on the week to around US$96, down $20 in the past two weeks alone and not far from pre-invasion levels ($92). Even so, we are still likely to see enormous gasoline price gains in the coming March CPI reports, with next week’s U.S. reading likely to peak above 8.5%.

While the curve did steepen, the two-year GoC yield still perked up about 10 bps on the week to nearly 2.45%. Note that this marks the highwater level for this maturity going all the way back to 2008. Even during the 2017/18 tightening cycle, when the Bank of Canada’s overnight rate ultimately rose to 1.75%, the two-year yield topped out at just below 2.40%. We find ourselves today with the overnight rate at just 0.50%—albeit soon headed higher—and the entire curve from 2s to 30s is at or above the peak yields of the past tightening cycle.

Of course, some of that seeming anomaly can be readily explained by the vast amount of tightening the market has priced in from the BoC through the rest of this year. A 50-bp rate hike at next Wednesday’s decision is now seen as almost a done deal—an amazingly swift reassessment since Deputy Governor Kozicki’s hawkish speech two weeks ago. This would mark the first 50 bp gulp since May 2000, and would double the rate to 1.0%. Markets are priced for a cannonading 220 bps of rate hikes through the rest of the year (we’re holding at 150 bps), and we would readily allow that the market has been amazingly prescient in its hawkish view on the BoC, at least so far.

This week’s developments only further fuelled the already strong case for an upsized rate hike next week. The March jobs report revealed another solid gain of 72,500, slicing the unemployment rate two ticks to a modern-day record low of 5.3%. (On a slightly different measurement, it went even lower in the early 1970s, but this looks to be the tightest job market since at least then.) Curiously, wage trends remain mostly controlled, with the average hourly wage up a moderate 3.4% y/y last month, more than two percentage points south of inflation. Still, the latest Business Outlook Survey highlighted a drum-tight job market and still-rising inflation expectations. Fully 70% of businesses look for inflation to top 3% in the year ahead, a record high. Meantime, consumers are anticipating a 5.0% inflation rate in the coming year, which seems to be a pretty reasonable guesstimate.

The hotly anticipated Federal Budget also did little to dim the fires of coming rate hikes. True, the actual amount of net new spending came in on the low side of expectations—which had been stoked by the government’s supply & confidence deal with the NDP, as well as calls for a big uptick in defence outlays. In the event, the net new spending (less revenues from new taxes) came in at just over $7 billion for this fiscal year, or roughly 0.3% of GDP. That’s a far cry—appropriately so—from last year’s calls of new stimulus measures of around $100 billion.

And, importantly, the Budget did allow some of the revenue windfall from soaring commodities and rollicking nominal GDP growth to flow through to a lower deficit track. Note especially that the estimated deficit for the fiscal year that just ended in March came in a whopping $30 billion lower than projected just last December at just under $114 billion. Of course, that’s still off the charts compared with the pre-pandemic world—roughly double the previous high of $56 billion in 2009—but it’s also just about one-third of the mammoth $328 billion gap at the height of the pandemic. The shortfall is now expected to come down to a much more manageable $53 billion this year. And while the projections were based on a somewhat stale economic forecast (i.e., pre-invasion), we estimate that the run-up in GDP prices since then almost exactly offset a dimmer real GDP growth outlook and higher interest rates.

On balance, while the Budget recognized that massive stimulus was simply no longer needed nor appropriate, it still has its foot mildly on the accelerator. This implies that the Bank will thus need to push down on the brake just a little bit harder in the year ahead. We continue to expect the Bank to hike rates by 50 bps at each of its next two meetings.

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