September BoC Preview: Harder Tests Still to Come

By: Andrew Kelvin, Mark McCormick, Chris Whelan

September 6, 2022 - 4 Minutes 30 Seconds
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The economic situation clearly calls for restrictive policy rates, and we see a clear path for the BoC to hike by 75bps in September. We expect the pace of tightening to slow in October however, which may imply some moderation in the Bank's forward-looking language in the September communique.

Overview

We see a fairly straightforward case for the BoC to lift rates by 75bps at the September 7 meeting to 3.25%. The economic situation very clearly calls for restrictive policy rates. We are somewhat sympathetic to the idea that the precise path toward the terminal rate matters less than the actual terminal rate, but the time for caution has long passed. We don't see what the BoC gains by taking a slower path to restrictive territory. We look for an additional 25bp move in October, with 3.50% standing as the terminal rate for this cycle.

Indeed, hiking by just 50bps looks like a riskier move for the BoC than 75 or even 100bps. Falling so far short of market expectations could be seen as a signal that the BoC is unwilling to fully commit to the inflation fight, which would in turn erode its credibility as an inflation targeter. A possible subsequent move upwards in inflation expectations would make the BoC's job more difficult in the long run, potentially requiring a higher terminal rate and altogether more economic pain.

Big Picture: Mission Not Accomplished

Although inflation is below recent BoC forecasts, it will be cold comfort for Governing Council given the acceleration in core CPI measures. Specifically, the common component of CPI was revised sharply higher, and is now seen as running at 5.5% y/y, bringing the average of three core metrics up to 5.3%. The breadth of inflation also remains a concern with 57% of components running above 5%.

Labour market indicators continue to suggest that there is not much slack left in the economy, despite two consecutive months of material job losses. Wage growth was running at 5.4% y/y in July, and the spring Business Outlook Survey showed high levels of labour shortages and rising expectations for future wages. The combination of a tight labour market and unanchored inflation expectations threatens to materially extend the period of above-trend inflation, and as such the BoC cannot afford to be timid.

There have been early signs of slowing in the economy of course. But as much as the Bank of Canada genuinely believes that it can engineer a soft landing, its only mandate here is to bring inflation back under control.

A Shift in Messaging

The statement will reiterate the Bank's focus on containing price pressures, but we do expect to see a change in the forward-looking component. The Governing Council is likely to emphasize that rates are now in restrictive territory, and the recent moves have been part of an effort to front-load the tightening cycle. Critically, we expect to see some indication that the Bank believes that future rate increases will be more modest (i.e., 25s or 50s rather than 75s and 100s), along with the standard comment about the interest rate path being dictated by the outlook for growth and inflation.

Two Wildcards

While there is a huge number of possible permutations that could impact the upcoming BoC meeting, there are two that strike us as particularly interesting:

  • Hawkish BoC surveys. The Q3 Business Outlook and Consumer Expectations surveys will not be published until October 17th, but the Bank may have an early read of the results. If either of those surveys shows another sharp uptick in inflation expectations, it could be enough to push the Bank into hiking by 100bps again.
  • Tricky messaging. Trying to communicate a change in pace for rate hikes will be a difficult task for the BoC, and as it approaches the end of its tightening cycle we look for the Bank to put an increased emphasis on data dependence. We think there is a risk that markets will misinterpret such a change.

FX Market Implications

The BoC will be a critical risk event for CAD, though the broad outlook hinges on global factors like risk and the broad USD outlook. The domestic vulnerabilities highlight a pain point for CAD when rates run seemingly too high that it undermines economic growth. In short, we have reached the point where higher rates don't lend much support, especially if the global backdrop remains fragile. That raises the question of where CAD should be priced relative to risk sentiment. Our various models tend to point to levels around 1.29-1.30. So while we could see a modest jump above 1.32 in the very short-term, we are inclined to fade those rallies.

Rates Market Implications

We head into the September meeting at an 84% probability of a 75bps hike. Interestingly by July, the market is pricing a 50% probability of either 3.75% or 4% overnight rate here. We see fair value for terminal pricing around 3.65%, taking our view of the cycle ending at 3.5% and applying a probability for a move higher than that, which is where we see the risks (to the upside). In this context July OIS 2023 gap is about 22.5bps too high currently; we would look to fade pricing of 4% terminal with conviction.

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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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Mark McCormick
Director and Global Head of FX Strategy, TD Securities

Headshot of Mark McCormick

Mark McCormick
Director and Global Head of FX Strategy, TD Securities

Headshot of Mark McCormick

Mark McCormick
Director and Global Head of FX Strategy, 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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