BoC: Market starts to think beyond two hikes this year - AmpGFX

Greg Gibbs, Analyst at Amplifying Global FX Capital, notes that following the Bank of Canada policy announcement yesterday, CAD has strengthened significantly further and 2yr Canadian swap rates are up 7.5bp, against a fall in the US of 2.5bp.

Key Quotes

“There was nothing too surprising in the policy statement.  The Bank had set the stage for a rate hike and one was 93% priced into the money markets.  And by year end 45bp of hikes were priced-in, suggesting that the market was pricing in a high probability of a second hike by year end.”

“The market reaction to this policy meeting is none-the-less quite significant.  The market has moved to fully price a second hike by year end, and even a small risk that there might be a third.”

“The market is not fully pricing a second hike at the next MPR date on 25-Oct (it has 18.4bp priced for this date), but it has 26.4bp priced in by the 6-Dec policy meeting (which is not an MPR date).”

“The market is starting to think beyond the next two hikes towards further hikes in 2018, accounting for the further rise in 2-year yields today.”

“The Bank dressed up its rate hike delivered today as removing the accommodation put in place in 2015 to deal with the oil prices shock.  It cut twice in 2015, and thus the market has in mind there are two hikes in planning (the first delivered yesterday).”

“However, the broader analysis and output gap framework of the Bank of Canada points to the risk of ongoing policy hikes beyond these two hikes as the economy normalizes.”

“The Bank estimates that growth will continue above trend through the three-year horizon, so this suggests that it will be moving into a positive output gap (inflationary) in 2018 and beyond.”

“If it delivers a second hike this later this year, rates will be 1.0%, still well below the Bank’s estimate of neutral (2.5 to 3.5%)”

“The inflation rate is forecast to still be below target at the end of the year, but the Bank sees most of the recent fall in CPI as due to factors that it believes are temporary and will wash out by mid-2018.”

“As it stands, Canadian rates markets are not pricing all that much for additional rate hikes in 2018.  My rough calculation from IOS is only 18bp more hikes by mid-2018 (presuming a second hike to 1.0% is delivered by end-2017), and 35bp by end-2018.  Rates below 1.5% by end-2018 would be still well below neutral (3%).”

“Presumably, the Bank of Canada could not diverge too far from Fed rates policy, or else the CAD could rise significantly, but its current policy outlook and output gap model suggest that rates continue to rise next year, much more than currently priced-in by the market.”