October BoC Preview: Throw Caution to the Wind

By: Andrew Kelvin, Robert Both, Chris Whelan, Mazen Issa

October 24, 2022 - 5 Minutes
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We look for a more aggressive 75bp hike in October. Governor Macklem has already been in the press twice this month, delivering an unambiguously hawkish message. The Governor argued that the Bank did not have enough data in hand to consider a more finely balanced approach to monetary policy in his speech on October 6th. And on the sidelines of the October IMF meetings the Governor pre-emptively downplayed the importance of the most recent CPI figures, stating that the economy was clearly in excess demand regardless of the September inflation print. Most tellingly, the Governor stated that he believed that undertightening was a larger danger than overtightening, which supports the idea the Bank's plan here is to err on the side of too much tightening.

This all harkens back to Macklem's comment from 2020 that the best way to confront a crisis is to "crush it". In 2020, policymakers avoided a long recession at the cost of higher-than-expected inflation and parabolic property prices. Today, the Bank is looking to crush the inflationary impulse at the cost of prolonged negative per capita GDP growth and a probable recession in 2023H1.

Scales Tilt Towards the Hawks

The two crucial reports heading into this meeting were September CPI and the Q4 BoC surveys. CPI was firmly hawkish — less so the upside surprise on headline inflation than the persistence in core inflation (stable at 5.3% y/y) and increasing breadth (more than half the basket is seeing inflation above 6% y/y). On the other hand, recent BoC surveys suggest a) that the rate hikes already in the system are starting to have an impact on growth and forward-looking measures of inflation, and b) longer-term inflation expectations remain anchored on balance.

With the BOS and CPI figures roughly balancing each other out, we are turning to Macklem's media roundtable for the tiebreaker. The Governor's hawkish tone on October 14th appears especially striking now that we have the BoC survey data in front of us. Headlines suggest that Macklem was selectively picking out elements from the outlook and surveys that support a maximally hawkish stance.

The hawkishness feels like a deliberate choice rather than a reaction to the data. Market expectations also play a factor, as the fragile backdrop for inflation expectations will make it difficult for the BoC to deliver a dovish surprise, and markets are now pricing in ~70bps of tightening. On balance, arguments favour a 75bp move. It's not a slam dunk, but we see more notches on the 75bp side of the ledger than the 50bp side.

400bps, Then a Sheer Drop

Looking at the bigger picture, we maintain that the most prudent course of action is to slow the pace of tightening now that growth is softening, particularly given the uncertainty around the transmission of monetary policy at current rate levels (the BoC was last above 3.00% in 2008, when the household debt-to-income ratio was 30p.p. lower). As such, we look for the pace of tightening to slow to just 25bps in December, bringing the BoC to 4.25% by year-end. Macklem may not be close to a pivot yet, but it's worth reiterating that central bank statements have short shelf lives. Macklem feels like he needs to sound hawkish today, but he may be more circumspect by the start of December. We are sticking with 4.25% as our terminal rate, though risks obviously skew higher, before looking for rate cuts to begin in H2 2023.

FX Outlook

We do not think the USD is done wreaking havoc on CAD. The currency market reaction to the recent CPI data suggests that the more that the BOC fights inflation, the greater the risk of macro downside and hence, the more the CAD needs to reflect it. So, even if Macklem were to surprise with a 100bp hike at this meeting, we think a knee-jerk reaction higher in the CAD will be promptly faded. The last two major expansions for Canada were driven by consumer spending and residential investment. Hopes for this to occur this time around have been obliterated by the most aggressive tightening cycle since the adoption of the inflation target in the 1990s.

Canada will need to feel pain and the CAD will be the barometer for this. We see it as highly probable that USDCAD will trade above 1.40 over time once it becomes clear that the BoC can no longer keep imposing large rate hikes on overly indebted Canadians. Once the BoC transitions to a lower pace of tightening as it nears its assumed terminal rate, the CAD will likely lose further ground.

To see the CAD strengthen would require a relaxation of positive USD drivers like a Fed pivot and a series of moderation in m/m core CPI. Neither is likely in the near term. We continue to see the USD in a primary uptrend even though we think the 'easy' part of the rally has been realized.

Rates Outlook

We ask, why isn't the curve flatter i.e. more inverted? On the flip side, many participants look at the market and say how can the curve go much flatter? From our frame of mind, we see the interest rate hikes this cycle as temporarily elevated and not indicative of long-run rates, as the debt stock composition at both the consumer and government level just cannot sustain these levels for several years without substantial growth impacts, in turn leading to disinflation and lower interest rates.

We see a lot of technical reasons for the curve to be pressured steeper at the moment: Canadian bank year-end, outflows, a lack of index extension needs, and a full GoC auction schedule in October. However, we do see December shaping up quite differently in terms of technicals, looking like a repeat of June and September supply imbalances which were major catalysts to ignite and bolster the Canada outperform thesis we have held (higher debt sensitivities and material shift in net supply). We continue to like flatteners across the curve and anticipate further inversions both from macro pressures (BoC hawkish in the near-term and strong December technicals).

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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.

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Robert Both
Vice President and Macro Strategist, TD Securities

Headshot of Robert Both

Robert Both
Vice President and Macro Strategist, TD Securities

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Robert Both
Vice President and Macro Strategist, TD Securities

Mark helps to manage the bank’s research efforts for the major foreign exchange markets, along with developing the analytical framework used for market analysis, forecasts and trade ideas across different asset classes. Before joining the bank, he worked as a Global Macro Strategist at Credit Agricole Corporate and Investment Bank in New York.

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Chris Whelan
Director and Senior Rates Strategist, TD Securities

Headshot of Chris Whelan

Chris Whelan
Director and Senior Rates Strategist, TD Securities

Headshot of Chris Whelan

Chris Whelan
Director and Senior Rates Strategist, TD Securities

Chris applies quantitative and fundamental frameworks when assessing domestic and cross-market opportunities in Canadian rates across both federal and provincial bonds and swaps. Chris joined TD Securities in 2019.

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Mazen Issa
Director and Senior FX Strategist, TD Securities

Headshot of Mazen Issa

Mazen Issa
Director and Senior FX Strategist, TD Securities

Headshot of Mazen Issa

Mazen Issa
Director and Senior FX Strategist, TD Securities

Mazen covers all aspects of G10 FX strategy. Previously, he was a Senior Macro Strategist based in Toronto where his coverage had a particular emphasis on Canada. Before joining TD Securities in 2010, Mazen spent several years at BCA Research in Montreal as part of the Global Fixed Income Strategy team. In that role, he was responsible for providing macro analysis and investment recommendations for the developed markets.

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