Why market bets for interest rate hikes in Canada are so high
The future path of interest rates in Canada is up for debate, with most economists coming down on the side of holds, while market bets are rising for two, perhaps even three, rate hikes by the end of this year.
“Traders that are pricing in Bank of Canada tightening believe that (the war in Iran) is going to trigger a renewed inflation cycle,” David Rosenberg, president of Rosenberg Research & Associates Inc., said, referring to the white-hot price increases recorded during the years right after the pandemic. “Why we had the inflation cycle during COVID-19 wasn’t just about supply; it was also about demand.”
After the economy reopened back then, government stimulus flowed to Canadians, fuelling pent-up demand that ran headlong into snarled supply chains around the world.
“But we are in a totally different orbit than we were back then,” Rosenberg said. “Where is the vibrancy of demand growth in a Canadian economy? It is nonexistent.”
First-quarter growth will likely come in below one per cent annualized, according to t he latest gross domestic product data, well off the Bank of Canada’s forecast of 1.8 per cent, and core inflation has inched ever closer to the central bank’s two per cent target, though headline inflation is expected to accelerate on higher energy prices.
The Bank of Canada held its key lending rate at 2.25 per cent — the bottom of its neutral target range — for the third consecutive time earlier this month.
But overnight index swaps are betting that a first rate hike could come as soon as July, according to Bloomberg. Bets for later in the year have significantly ramped up, with markets pricing in two hikes by October and an elevated change of a third hike at the final Bank of Canada meeting of the year.
Most big-bank economists, however, are calling for rates to stay on hold for the remainder of the year.
“Policy rate markets tend to get out over their skis during times of market stress,” Joe Brusuelas, chief economist at consulting house RSM US LLP, said.
He said there is just too much uncertainty around the Middle East to place much faith in the market’s rate bets.
The United States and Israel started the war on Iran on Feb. 28, but the situation is fluid. Some media reports on Tuesday said the U.S. is looking at sending troops into the country, but U.S. President Donald Trump on Monday extended the deadline for Iran to reopen the Strait of Hormuz, a critical shipping corridor, by five days.
“Should the war in the Middle East continue, there is a risk the Bank of Canada may need to hike rates should inflation expectations rise and topline inflation bleed into core inflation,” Brusuelas said. “This risk isn’t limited to Canada; should the increase in oil prices persist and result in second-order effects that risk a wage-price spiral, central bankers around the world would need to consider hiking rates.”
But he said to bring policymakers around to rate hikes, the price of oil would need to move much higher, consumer and business inflation expectations would have to become “unanchored,” service prices would have to start rising and wages would need to start spiralling upwards.
“We are not there yet,” he said.
Brusuelas said central bankers will “look through” the impact of oil prices on inflation over the next four-to-six-month period.
He also said the Canadian economy is capable of absorbing the oil price shock as it currently stands “a little bit better than what one would think on first glance.”
Despite an unemployment rate of 6.7 per cent, he said households continue to spend at a “moderate pace” and the Canadian economy will continue to benefit from “fairly brisk” U.S. consumption and “solid” demand for Canadian exports, including oil.
Currently, Brusuelas said there is a 30 per cent chance of a recession in Canada and North America.
As for a possible rate cut, that would require demand destruction from higher oil prices to slow growth and for the war to come to a conclusion sooner than later.
“We’re flying blind here right now, so you tend to see risk aversion on inflation, given the understandable sensitivities amongst the public policymakers to the inflation shock that’s still fresh in the memory,” he said. “That does not mean the Bank of Canada is going to hike three times this year.”
• Email: gmvsuhanic@postmedia.com