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Hawkish Taper by Bank of Canada Sends Loonie Soaring

by Karl Schamotta | April 21, 2021

With the economy on course toward a full recovery, the Bank of Canada has begun reducing the dosage of monetary morphine.

In its latest decision, the country’s central bank cut its government bond purchases from $4 billion a week to $3 billion, while signalling that it could begin raising interest rates as early as next year – significantly earlier than previously expected.

Technical factors played an important role in the tapering decision. The Bank currently holds more than 42% of outstanding government bonds and bought more than 80% of issuance last year. With the Trudeau government poised to reduce its financing requirements in the coming months, the central bank’s ownership is expected to exceed 50% – severely impacting market functioning and exacerbating financial distortions.

But improving economic fundamentals were critical in shifting the Bank’s forward guidance strategy. A recent surge in coronavirus infections and new social distancing restrictions have (thus far) failed to derail underlying growth momentum, and an accelerating vaccine rollout is brightening prospects for the future.

Real estate markets remain incredibly hot, with construction and resale activity at “historic highs”, with the Bank suggesting that this is “driven by the desire for more living space, low mortgage rates, and limited supply”.

Employment markets are healing rapidly, with more than 90% of the jobs lost during the pandemic now recovered. Huge gains in February and March are widely viewed as unsustainable, with the third wave of infections considered likely to weaken momentum in the coming two months, but conditions are expected to improve through the summer.

External demand is also expected to remain robust, with a rapidly recovering global economy powering commodity prices higher, while extraordinarily strong consumer demand in the United States lifts exports.

Inflation, already sitting near target, is expected to rise toward 3%, close to the top of the Bank’s inflation-control target range – but this is expected to be temporary, with base rate effects and gasoline price changes expected to fade over time.

Updated projections contained in the official statement and the accompanying monetary policy report show gross domestic product expanding 6.5% in 2021, with economic slack disappearing by the second half of 2022 – suggesting that rates could begin climbing at around the same time.

Of course, by signalling that policy is poised to tighten, the Bank risks putting sustained upward pressure on the exchange rate. The Canadian dollar spiked more than 120 basis points after the announcement, breaking through a number of key technical and psychological levels as traders revised expectations upward.

Implied overnight interest swap rates suggest that two 25-basis point hikes are now expected within the next two years, with three more coming in the following year –  enough to make Canada a clear outlier among developed nations. 

Karl Schamotta
Chief Market Strategist
@vsualst

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