A smaller-than-expected 50 basis points interest rate increase from the Bank of Canada and signs the global economy is stalling caused Canadian bonds to adjust downward but only briefly weakened the loonie against the U.S. dollar. Recent trends are showing that Canadian dollar might be more at risk from the euro and pound, which are benefiting from a relatively more aggressive central bank and a more settled political backdrop, respectively. Meanwhile, several political decisions in China, including the government’s harsh rhetoric toward the West, are causing investors to reconsider the country.
Scotiabank economists and analysts weigh in on how economic indicators and trends are influencing bonds, currencies and equities right now.
- The Bank of Canada hiked its policy rate 50 basis points (bps), which was less than expected, while suggesting further rate increases were in store. That move opened the door to slowing the pace into the next meeting via either a 25- or 50-bps hike but shut it against pausing.
- As a result, the Canadian rates curve rallied big time as the two-year yield plunged 24 bps, the five-year yield dropped by 18 bps and the 10-year yield fell 19 bps. The aftermath even dropped the very long-end by 12 bps on the day. Some of this may be a repositioning undershoot, like when the wind suddenly shifts on a small sailboat and everyone dives to the other side.
- The BoC’s forecast for the global economy is essentially that of a global recession. Global gross domestic product (GDP) is projected to grow only 1.5% in 2023 and mildly accelerate to 2.5% in 2024. The global economy is stalling out and it will be marked by recessionary conditions in multiple areas. The BoC’s Canadian inflation forecasts were marked down a touch but are still high throughout the forecast horizon with 2022 inflation dropping to 6.9%, from 7.2% year-over-year; 2023 down a half point to 4.1%; and 2024 little changed at 2.2%, from 2.3%. So the BoC is saying it will take until 2024 to get inflation in line with its 2% target, bearing in mind its inflation forecasting track record.
— Derek Holt, Vice-President and Head of Capital Markets Economics
- Currency trading along with other markets, was surprised by The Bank of Canada’s raising of its key target rate only 50 basis points (bps) to 3.75% at Wednesday’s policy decision. Consensus expectations, reflecting persistent price pressures and the BoC’s own communications that it was determined to regain control of inflation, had expected a more aggressive 75 bps policy tightening. The policy statement noted that the interest rate will need to rise further but markets are now leaning toward the idea of the rate cycle peaking around 4.25% early next year (a bit lower than market pricing had indicated recently but in line with Scotia’s outlook) and are tilting toward a rate cut in late 2023 by which point the Bank expects inflation to ease back to 3%, the top of its control range of 1% to 3%.
- The Canadian dollar (CAD) weakened briefly against the U.S. dollar (USD). The reaction was less than might have been the case were it not for the fact the USD has been trading more defensively against its major currency peers in the past few days. The Federal Reserve is expected to tighten interest rates 75 bps at its early November policy decision but there is mounting speculation — fuelled by comments from some Federal Open Market Committee (FOMC) members and perhaps by the BoC decision — the Fed could slow the pace of tightening before the end of the year. This has breathed life into equity markets and undercut the USD as U.S. term yields have fallen sharply.
- Japan has been aggressively selling USDs to curb the yen depreciation, while the pound rebounded sharply from its late-September low following the departure of Liz Truss, who briefly served as Britain’s prime minister, and the euro has regained parity with the USD and looks to have broken out of its downtrend that has persisted since February. The USD is trading generally lower and looks prone to a deeper correction to what, in our opinion, is an over-extended rally.
- The CAD quickly regained much of the ground lost on the USD and it looks unlikely at this stage that it will weaken significantly against the USD. Firmer equity market trends may extend the CAD a little support, given still tight and positive CAD/equity market correlations. We think the CAD may be more at risk on the crosses — EURCAD and GBPCAD, for example — where recent trends have turned more CAD-negative and the very depressed euro and pound may benefit from a relatively more aggressive central bank and a more settled political backdrop, respectively.
— Shaun Osborne, Managing Director, Chief FX Strategist
- Global investors are re-appraising China’s country risk-profile following the Communist party’s congress that ended on Sunday. U.S. Exchange Traded Funds (ETFs) tracking Chinese shares suffered heavy declines on Monday as investors dumped Chinese equities. For instance, the iShares MSCI China (MCHI) ended almost 10% lower, while the Invesco Golden Dragon ETF (PGJ) dropped 14%, closing at its lowest level since 2013.
- The harsh rhetoric against the West casts a cloud on the long-term economic relationship, adding to well-known headwinds in the real estate sector and a zero-COVID policy. The pledge to regulate wealth likely won’t help to boost sluggish growth and appease investors’ concern. As illustrated in the chart below, 2022 GDP growth forecasts have been trimmed all year. While third quarter GDP growth rebounded to a two-year high of +3.9% (quarter-over-quarter), the pace of expansion is still well off the official target of 5%+, with soft domestic demand (September retail sales were at their lowest levels in nearly 30 years, ex-COVID disruptions).
- The sell-off in Chinese equities hurt broad emerging market indices, with the iShares MSCI Emerging Markets (EEM ETF) slipping 3.8% yesterday. As illustrated in the second chart, money has been flowing out of EM/China stocks for most of 2022, a situation that could endure as long as the U.S. dollar continues to reign supreme, and China focuses more on COVID control than boosting growth. From a regional standpoint, North American equities remain well positioned to outperform EM/Europe/EAFE for now.
China 2022 Real GDP Growth Consensus Forecasts (%)
Source: Scotiabank GBM Portfolio Strategy, Bloomberg.
Emerging Market Equity Flows (Monthly, US$B)
Source: Scotiabank GBM Portfolio Strategy, Institute of International Finance.
— Hugo Ste-Marie, Director, Portfolio & Quantitative Strategy; Jean-Michel Gauthier, Associate Director, Portfolio & Quantitative Strategy
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