Expectations of further rate hikes from both the Bank of Canada and the US Federal Reserve strengthen the loonie and the greenback but weigh on markets. Hawkish comments from the Fed supported the US dollar to its strongest level in roughly a year. The CAD had a lacklustre performance as many currencies lost ground against the USD, but an anticipated 50-basis-points hike from Canada’s central bank next week should see the loonie appreciate later this year. Investors are already expecting a further rise in rates from the Fed, which is likely to put pressure on equity valuations. Meanwhile, Canada’s latest federal budget release was slightly positive for the Real Estate Investment Trust (REIT) sector, with some of the previously communicated initiatives still under review. 

Scotiabank analysts weigh in on how economic indicators and trends are influencing currencies, equities and REITs right now.

Foreign Exchange

  • Hawkish comments from Fed policymakers and the bank’s minutes from its March policy meeting reinforced the market’s expectations of a steep increase in the Fed’s policy rate this year, supporting the USD to its strongest level in close to a year (DXY index). With even Lael Brainard, one of the FOMC’s most dovish members, indicating that the bank is on a quick path to normalisation, the Fed looks almost certain to hike by 50 basis points (bps) at its policy decision in early May; odds are rising that it also hikes 50bps in June. We think the Fed’s hawkishness will continue to act as a strong support for the USD over the coming quarters, with additional impetus coming from the fast reduction in extreme USD liquidity amid the Fed’s quantitative tightening, and robust economic prospects in the US.
  • The CAD was a middle-of-the road performer among the majors, with all currencies losing ground against the dollar throughout the week. Aside from the Fed’s hawkish tone, the CAD was impacted by a decline in front-month WTI oil prices to below the $100/bbl mark. The White House announced a release of 1 million barrels per day of crude from its strategic petroleum reserves over the next six months to tackle high energy prices; the US’s decision was complemented by a 60-million-barrels release from its peers in the International Energy Agency. China’s Covid-19 lockdowns have also worsened the near-term picture for oil demand, although ongoing sanctions on Russia and the incoming seasonal rise in demand for crude should keep prices elevated.
  • The Bank of Canada is expected to deliver a 50bps hike at its policy decision next week. In a world where caution over the impact of energy prices is keeping the European Central Bank, Bank of England, Bank of Japan, and others on the sidelines, the hawkish BoC and Fed are monetary policy standouts. The BoC’s steep hiking cycle — that looks set to at least match the pace set by the Fed — is a key component of our forecast that sees the CAD appreciating toward the low 1.20s CAD per USD mark in the second half of the year. A hawkish statement that tees up another big rate increase would likely see the CAD trade at a year-to-date high. 

—  Shaun Osborne, Managing Director, Chief FX Strategist, and Juan Manuel Herrera, FX Strategist 

Equities

While we remain constructive on equities, we believe the risk-reward profile is less compelling than it was just a few months ago. Risks of a Fed policy mistake have gone up sharply, in our opinion, and macro uncertainty is extremely elevated. On the monetary policy front, the Fed seems to be on a mission: getting inflation under control at all costs. While the medicine to get inflation down is well known (higher rates), the dosage needed to achieve such a goal is the tricky part. By aggressively jacking up rates, the Fed runs the risk of doing some collateral damage in the form of slower growth (or in a worst-case scenario, creating a recession). Investors are now clearly anticipating this hawkishness: Back in December, only three Fed rate hikes were priced-in for all 2022 versus a grand total of 10 currently (we got the first one a few weeks ago, the market is expecting another 8+ and Quantitative Tightening should be the equivalent of one full rate hike, according to Powell).

  • Bond yields vs global manufacturing PMI. Despite bond yields sharply increasing year to date, our US 10Yr yield Fair Value model points to even higher yields ahead. Higher rates take time to filter through economic activity. Hence, 2022 should still record strong growth before an eventual slowdown in 2023 if the Fed sticks to its current game plan.
  • Shrinking price-earnings ratios. A further rise in rates would likely put equity valuations under renewed pressure. Our global monetary policy cycle indicator displays an inverse relationship with P/E ratios.
  • All eyes on the yield curve (but keep an eye on other macro data, as well). The US yield curve is flashing worrying signs, but we would need more segments to invert (especially the 3-month-10-year) before calling for a recession. Our US-recession-odds model is also quite sanguine about recession prospects 12 months out.
  • Overall, we believe that a flat/inverted yield curve, intensifying tightening, and further moderation in Institute for Supply Management (ISM) and/or Purchasing Manager’s Index (PMI) suggest owning more defense until we have better visibility.

—  Hugo Ste-Marie, Director Portfolio & Quantitative Strategy, and Jean-Michel Gauthier, Associate Director, Portfolio & Quantitative Strategy

 

Real Estate & REITs

  • Slight positive. In one of the more anticipated federal budget/announcements in our recollection (from a REIT investor standpoint) aside from the 2006 Halloween Trick-or-Treat special, which effectively eliminated Income Trusts (yes, we’re aging ourselves), there was not much to see, with several previously communicated initiatives still under review.
  • Comparing what is in the budget to prior communication, in a nutshell, we didn’t get some worst-case scenarios clients have questioned (i.e., removal of Residential REIT status, implementation of some form of national vacancy-decontrol elimination, punitive taxes on capital investments), although the timing of policy reviews — end of 2022 vs. before the end of 2023 previously — may be a bit of an overhang on performance. That said, it also provides time to educate on the apartment industry’s role in the solution and current role in providing quality affordable living. 
  • We think the net implication from the two-year foreign buyer ban may indirectly stop cap rate compression in its tracks while also possibly lowering the odds of REIT privatizations in the event of negative policy review outcomes.
  • We expect some outsized recovery in Canadian apartment REIT unit prices through the summer, particularly for Ontario-focused REITs if the Ontario provincial election doesn’t result in negative outcomes.

— Mario Saric, Managing Director, Real Estate & REITs Equity Research

 

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