The Bank of Canada on Wednesday became the latest central bank to suggest (tacitly) that tighter monetary policy will be effective at controlling cost-push inflation.
The BoC ended QE and adopted hawkish forward guidance around rates. Bond-buying will now be confined to reinvestments to replace maturing securities.
The statement cited inflation. “The recent increase in CPI inflation was anticipated in July, but the main forces pushing up prices – higher energy prices and pandemic-related supply bottlenecks – now appear to be stronger and more persistent than expected,” the statement read.
Policymakers now expect consumer prices to stay elevated into 2022, before moderating late next year. “The Bank is closely watching inflation expectations and labor costs to ensure that the temporary forces pushing up prices do not become embedded in ongoing inflation,” the statement went on to say.
At the risk of stating the obvious, it’s not clear that rate hikes (or the threat of rate hikes) and the cessation of balance sheet expansion are going to do anything to alleviate the factors driving up prices. That’s certainly not to suggest it’s better to keep policy ultra accommodative, it’s just to say that policymakers are assuming they can flip a switch — hike rates and end QE — and just like that, the transmission mechanism between transitory, supply-side price pressures and CPI/expectations, will be short circuited.
It’s just as likely (if not more so) that hiking rates while the economy remains out of balance on multiple fronts will introduce additional uncertainty at the worst possible time. Preemptive rate hikes can work, but if they do, it’ll likely be because they choke off growth and facilitate demand destruction.
Overnight, Aussie three-year yields jumped as much as 24bps following a hot inflation print. The BoC decision triggered a ~25bps jump in Canadian two-year yields (figure below).
The long-end richened (likely reflecting growth concerns tied to tighter policy), leaving Canada’s 2s30s dramatically tighter.
“We just witnessed a flash-like crash in the front-end of Canada,” TD’s Andrew Kelvin and Chris Whelan wrote. “We are settling in to more in line moves now [but] the move of +20bps in 5s at one point was truly massive,” they went on to say. “That was a very long hour post the release in Canadian rates trading.”
I’ve talked quite a bit over the past two years about the dearth of experience on Wall Street when it comes to trading professionally in a regime not characterized by the post-financial crisis monetary policy dynamic. The peril of that was on display Wednesday. “One thing that’s evident today is that STIR traders need to revise their world views if they want to succeed,” Bloomberg’s Cameron Crise wrote, recapping dramatic front-end action catalyzed by the BoC statement. “If you’re a STIR trader younger than your mid-30s, you’ve never seen anything like this in Canada,” he went on to say.
That is precisely what I meant last weekend, when I wrote that the Bank of England is on the brink of challenging the status quo with preemptive rate hikes. There are myriad reasons why such a move could turn out to be a policy mistake, but the MPC (and other central banks) may be underestimating the biggest risk of all — that associated with deviating from the behavioral patterns that define and govern markets in the post-Lehman world.
In a separate note, I elaborated, citing Deutsche Bank’s Aleksandar Kocic in writing that a central tenet of the post-Lehman system would be challenged (in spirit at least) by a decision from a major, developed market central bank to deploy preemptive hikes to manage risk — any kind of risk, be it inflation, financial stability or otherwise. I was talking about the BoE, but now we have the BoC moving quickly in that direction. And in all likelihood, RBNZ will pull the trigger again soon. The RBA may try to stick with the existing timeline, but swaps are pricing three hikes by the end of 2022 versus the bank’s projection of no hikes until 2024.
In short, the risk discussed here last weekend (and every day last week) is playing out in real time.
“The global rates market has scrambled to add and pull forward hikes into the front-end, as the inflation mess has only accelerated, and accordingly, central bank messaging has inflected by and large to ‘hawkish,'” Nomura’s Charlie McElligott said Wednesday, noting that even assumptions about the ECB are being challenged. “The market is now panicking that the ECB might not walk back hikes which have been priced into the front-end aggressively in recent weeks, particularly as both credit- and sovy- spreads aren’t really moving, while financial conditions remain easy as well,” McElligott went on to say, flagging a “full-tilt raging rate vol squeeze” in the EUR grid.
TD’s Kelvin and Whelan were taken aback Wednesday. While the move in Canadian 5s settled down eventually, Kelvin said TD “underestimated the liquidity impact and blow-out risk around a hawkish response.” Although the bank intended to enter some trades post-BoC, they decided to wait and “let the market breathe.” “We certainly did not anticipate this kind of market reaction,” they wrote. “This is wild.”