As Bank of Canada tackles inflation, investors bet on shorter economic cycle
Money markets expect an interest rate hike as soon as March and five in total next year
TORONTO — The Bank of Canada risks cutting short the current economic expansion if it shifts its focus from reducing slack in the economy to tamping down inflation, potentially setting the stage for the next cycle of rate cuts.
The dilemma for the central bank comes from a situation where inflation is driven not so much by economic strength but by factors, such as supply shortages, that are outside of its control and could lead to more enduring price increases if inflation expectations were to rise.
At a policy announcement last month, the BoC became the first central bank from a G7 country to exit quantitative easing and signalled it could begin hiking interest rates in April, three months earlier than previously thought.
“Investors are saying that the BoC will need to hike several times to deal with inflation,” said James Athey, investment director at Aberdeen Standard Investments in London. “Inflation is supply-side (driven), cost-push and transitory, thus hikes will come at a time of falling growth.”
Typically, investors demand a higher yield for longer-term bonds unless they expect rates to fall. A negative spread, so-called curve inversion, would be seen as a recession warning.
“The repricing of the front-end has left the curve entering the coming hiking cycle flatter than it ever has been this far ahead of actual rate hikes,” said Ian Pollick, global head FICC strategy at CIBC Capital Markets.
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“That raises the risk the curve will prematurely invert.”
The recovery could be boosted by Canadians spending some of their record cash hoardings built up during the pandemic.
But inflation is weighing on consumer confidence and the economy could be more sensitive to hikes than just a few years ago, after households ramped up borrowing to participate in a red-hot housing market .
“The market is a little pessimistic right now,” said Robert Robis, chief global fixed income strategist at BCA Research. It is betting that “any rate hike cycle will be short-lived and potentially reversed fairly quickly.”
© Thomson Reuters 2021