Following yesterday’s Bank of Canada decision, which saw the overnight policy rate rise from 0.25% to 0.5%, Governor Macklem today outlined the Bank’s stance on how quantitative tightening would be conducted in his economic progress report.
The fact that Governor Macklem decided to announce details of quantitative tightening at an inter-meeting event confirms our view that the Bank will formally announce the start of its plans to reduce its balance sheet at April’s meeting. Additionally, the repeated reference that the policy rate will remain the primary tightening tool suggests that the Bank will allow the balance sheet to reduce uninterrupted over time, adjusting the speed of normalisation via interest rate adjustments instead. Our base case remains that the Bank will formally announce quantitative tightening at April while raising the overnight target rate by a further 25bp to 0.75%.
The Bank’s stance on quantitative tightening is that it won’t aim to smooth the uneven maturity profile of its assets, which is how the Fed conducted quantitative tightening over 2017-2019 by capping the size of its maturities and actively selling assets in months where the size of the maturity undershot the cap. Instead, Governor Macklem announced that the Bank would allow passive roll-off. That is, naturally allowing maturing assets to unimpededly roll-off of the Bank’s balance sheet. Under our base case, this would see May’s C$12.6bn maturity being the first bond whose principal won’t be reinvested.
While the size of the bond sounds large in nominal terms, at just 1.25% of the overall market, the withdrawal of liquidity of this size is unlikely to be too disruptive in the Canadian bond market. This is especially the case given the Bank’s decision to clearly guide markets on its balance sheet management plans well ahead of time at today’s progress report.
Over the course of the two-year horizon, the Bank has estimated that roughly 40% of its footprint will be withdrawn from the Canadian bond market. By explicitly outlining this time frame and quantifying the magnitude of the withdrawal, Macklem has suggested the Bank initially aims to conduct QT over the next two-years. This is in line with the duration of the Fed’s previous QT cycle, which was abruptly ended in 2019 as liquidity conditions dried up and money markets forced Governor Powell’s hand. While we’re respectful that the Bank may have used this time frame merely as a measure to highlighted its shorter weighted average of maturity (WAM), and thus the need to not conduct active bond sales, we think such a horizon for BoC QT is a good first approximation.
Despite the announcement of the Bank’s quantitative tightening policy and Macklem’s reluctance to rule out larger rate adjustments in the future coming as new developments from the Bank, the market reaction was fairly muted.
Front-end Canadian bond yields rose and the loonie trimmed losses despite WTI prices falling from recent highs and the broad US dollar taking another leg higher. As highlighted by today’s market reaction, we think the Bank of Canada’s decision to continue tightening monetary policy will likely result in CAD being more resistant to the overall market risk conditions than its historical beta suggests. A material shift in the overall risk environment would likely be required for CAD to break out of its recent 1.26-1.2820 range and consolidate the move.
Bank of Canada’s maturity profile for 2022/23
Economic update: Bank references rise in inflation and broadening of pressures
In today’s economic progress report, Governor Tiff Macklem outlined how the Bank sees economic growth as robust and stronger than expected at the last round of projections, reiterating the message from yesterday’s rate statement. While Macklem briefly mentioned the previous and current quarter of growth, the bulk of the speech centered on the inflation profile. By all metrics, inflation is rising and above target, meaning that the Bank is more attuned to the upside risks to inflation than the downside risks. This is particularly important for the BoC given that elevated global commodity prices are feeding into Canadian inflation. The Bank specifically discussed the broadening of price pressures, which makes it more difficult for consumers to avoid inflation by substituting toward cheaper goods. As of January, almost two thirds of the 165 CPI components were growing above 3%. The Bank mentioned that services excluding shelter inflation only grew at 1.6% in January, but added the caveat that most Canadians haven’t been able to purchase many services because of the pandemic. The Bank attributes about half of the rise in inflation to supply-constrained goods, and while some measures of supply disruptions are starting to ease, Macklem suggested that one of the main channels through which Russia’s invasion of Ukraine could affect the Canadian economy is by further compounding supply disruptions and delaying shipments. Overall, the Bank’s assessment of current economic conditions suggests that they are on track to embark on successive 25bps hikes, as we expect. Nonetheless, the loose language around inflation and the speed of policy tightening, as well as the emphasis on the fluid global economic backdrop, allow the Bank to keep the door open to either holding or raising 50bps should economic conditions sharply change between now and April 13th.
USDCAD rises throughout Macklem’s progress report, but largely due to broad USD strength as CAD losses are more contained relative to other G10 currencies
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analyst
This information has been prepared by Monex Europe Limited, an execution-only service provider. The material is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is, or should be considered to be, financial, investment or other advice on which reliance should be placed. No representation or warranty is given as to the accuracy or completeness of this information. No opinion given in the material constitutes a recommendation by Monex Europe Limited or the author that any particular transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research, it is not subject to any prohibition on dealing ahead of the dissemination of investment research and as such is considered to be a marketing communication.