BoC & the Fed: How much higher will rates go?

By: Andrew Kelvin and Priya Misra

April 14, 2022 - 3 minutes
Exterior shot of Canadian Parliament.
Hot off the heels of the Government of Canada unveiling it's 2022-2023 budget last week, Bank of Canada announced it hiked the overnight rate by 50bps this month and that quantitative tightening (QT) will begin on April 25. The Bank also unveiled a sharp increase to inflation forecasts for 2022 and 2023.

More surprisingly, the Bank also lifted its projection for the neutral rate to a 2.00-3.00% range, up 25bps from its prior assessment. While the Bank repeated that it would not consider bond sales, it did announce it will cease primary market retention from April 25 onward that should result in a more rapid wind-down of its balance sheet.

Hawkish commentary to accompany a hawkish decision

The statement was broadly hawkish, consistent with the policy decision itself. The Bank noted the economy is moving into excess demand and cited increasing risks that higher inflation becomes entrenched in long-term expectations. The forward-looking components echoed those from March, with the Bank stating that rates will need to rise further as guided by the inflation target and added that QT will complement rate hikes.

The Monetary Policy Report also struck a hawkish tone with the sharp increase to CPI projections alongside an upward revision to 2022 GDP growth. The Bank provided more insight towards the impact of Russia's invasion into Ukraine. It concluded a mixed impact on Canadian GDP and more inflation pressures from higher commodity prices and new supply chain disruptions.

Overall, the most striking things about the announcement might have been how one-sided it was; virtually every change and new development was consistent with further tightening. We continue to look for the policy rate to reach 2.50% by the end of 2022.

How high can U.S. rates go?

The move to higher U.S. rates has been a function of both strong economic data and a hawkish Fed committed to price stability. Much of the move in the last few months was concentrated in the front-end, but over the last few weeks the long-end has moved more. This is consistent with a recent rise in term premium even as most of the YTD increase in rates has been in Fed hike expectations. Both real rates and BEs have risen during the move, but recent price action has been concentrated in real rates.

A "nimble" Fed amid constrained dealer balance sheets can also result in "gappy" price action. Lower liquidity tends to exacerbate market volatility, and we think that realized volatility is likely to remain high for the time being.

How do these decisions line-up with inflationary pressures?

Even though the Fed is playing catchup to high inflation readings, we think that front-end rates are fairly priced.

We expect a 50bp hike in the May and June meetings followed by 25bp hikes thereafter. The market is effectively priced for this path and is looking to reach neutral by year end and a terminal rate of 3% by mid-2023.Given that the neutral rate is around 2.5%, we think that the Fed's restrictive policy stance will tighten financial conditions. QT will also add to the tightening. We think this will make the Fed cautious about hiking much above neutral.

Long-end rates are more a function of supply and demand. Even though we expect another round of coupon-size cuts at the May refunding, finding the marginal buyer for duration is likely to require higher real rates. We expect demand from asset managers, banks, and foreigners -- particularly amid elevated volatility -- to stay weak in the months ahead.

Subscribing clients can read our full analysis on the 2022-2023 Canadian Federal Budget and Bank of Canada announcements on our Research Portal

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Headshot of Andrew Kelvin

Andrew Kelvin
Director and Chief Canada Strategist, TD Securities

Headshot of Andrew Kelvin

Andrew Kelvin
Director and Chief Canada Strategist, TD Securities

Headshot of Andrew Kelvin

Andrew Kelvin
Director and Chief Canada Strategist, TD Securities

Andrew contributes to our firm's economic commentary and provides advice on developments in government debt markets. Prior to joining our firm, he spent four years working at the Bank of Canada in the International and Financial Markets Departments where he was responsible for analysis and forecasts on the U.S. economy, including coverage on market developments.

Headshot of Priya Misra

Priya Misra
Managing Director and Global Head of Rates Strategy, TD Securities

Headshot of Priya Misra

Priya Misra
Managing Director and Global Head of Rates Strategy, TD Securities

Headshot of Priya Misra

Priya Misra
Managing Director and Global Head of Rates Strategy, TD Securities

Priya is responsible for the macro calls on the U.S. and global interest rate markets and provides investment advice to clients. She represents TD at the Fed's Alternative Reference Rate Committee (ARRC) and is actively involved in the transition from LIBOR to SOFR. She publishes regular research on interest rates, discussing secular trends as well as trade ideas and manages a model portfolio of recommendations.

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