January 2023 BoC Announcement: BoC Hikes by 25bp, Signals Pause

The Bank of Canada delivered a 25bp rate hike in its January policy decision, in line with market expectations, while signaling this could be the final move in its tightening cycle. The Bank had already pivoted towards more dovish guidance in the December statement, where it stated that Governing Council would consider whether interest rates need to rise further, but it took this a step further in the January communiqué by noting that the Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases, should developments evolve in line with the MPR. This is a strong signal that the Bank has reached its terminal rate after 425bps of rate hikes over ten months, but it will not rule out further action if momentum proves stronger than expected into 2023.

Elsewhere, the policy statement struck a relatively balanced tone, and echoed many of the same points as December. The Bank repeated that the economy remains in excess demand and that labour markets are still tight, but cited growing evidence that restrictive policy is slowing demand. The Bank also stated that core inflation has likely peaked as momentum continues to slow for CPI-trim/median. Accordingly, the January MPR showed a large downgrade to near-term CPI projections as inflation is forecast to slow to 5.4% y/y in Q1, which is slightly above our own tracking, with more modest downgrades to 2023Q4 (2.6% from 2.8%) and the annual average for 2023 (3.6% from 4.1%). GDP projections were largely unchanged from the October MPR with minor revisions to 2023 (1.0% from 0.9%) and 2024 (1.8% from 2.0%), as the Bank maintains that a modest expansion and recession are equally likely over the first half of 2023.

Going forward, we maintain our forecast for the BoC hold the overnight rate at 4.50% for the remainder of 2023. The Bank's forecast for growth and inflation in Q1 is strong enough that it sets a reasonably high bar for additional tightening, and we doubt that we'll have enough information to assess the accuracy of that forecast by the time of the March meeting (we'll have flash GDP, employment, and CPI only for January at that point). Hence, a hold at the March meeting looks very, very likely, with the Q2 and Q3 meetings posing greater risks for additional tightening. The caveat here, of course, is that we're assuming the Bank's messaging remains consistent through 2023H1, but we'd like to believe that after the tough lessons of the last year and a half the Bank will be faithful to its most recent forward guidance.

Really though, going forward the conversation will fully turn to the timing of the first rate cut. In our view, two conditions need to be fulfilled for the BoC to ease: First, Headline and Core CPI inflation need to be below 3% and confidently on their way to 2% (or thereabouts); second, growth needs to be demonstrably below 2%. In our view, inflation will be sticky enough that the BoC will not be able to ease until 2024Q1, but if the BoC's inflation forecast materializes a rate cut in October or December 2023 seems plausible.

Rates: We had been waiting for a catalyst in order to increase our conviction in long Canada vs the US. The Business Outlook Survey's increasing importance may have been just the catalyst, but it's nice to see that realized in the BoC's new guidance towards pausing. We are taking this at face value and this meeting helps to dial up our conviction on CAN-US type views, including in CAN-US 10s. We will continue to like core flattener positions vs the US in 5s30s, but would not add to this theme as we can see it lagging during a strong period of Canada outperformance.

FX: The CAD fell following the initial announcement. The explicit language that the BoC expects to hold policy is rather strong. While the CAD - and the G10 more broadly - are not reflecting as much sensitivity to central bank repricing in recent weeks, it does help to reframe the risks around the outlook for the currency. Clearly, the BoC has emphasized a slowdown in the household sector, and given the economy's debt imbalance on household balance sheets, the market may need to tread more cautiously on the CAD. What the BoC has effectively done is emphasize data dependence with a dovish tilt. In doing so, the risks around the CAD particularly on curve pricing for the BoC may now become asymmetric. That is, it will be harder for the BoC to cajole the market into pricing in tightening (even if the data surprises to the upside) than it will be to price in cuts.

Currently, the CAD is displaying a lot of sensitivity to data surprises, risk sentiment and broad USD dynamics. This is likely to persist for some time. We would pay particular attention to Jan/Feb data as that is likely to motivate asymmetries in curve pricing around the BoC later this year. For now, we think CAD is likely to lag on most crosses. USDCAD is anchored by broad USD dynamics, but we note here that the USD and broader FX complex have seen an increased sensitivity to risk dynamics. With disappointing earnings guidance, there may be room for risk to extend lower. That leaves USDCAD at risk of a test into 1.3500/25 near-term, where we see a lot of technical significance.