Moving closely but just behind the Royal Bank of New Zealand (RBNZ), the Bank of Canada (BoC) is almost the most hawkish central bank in the G10 – and with an economy 8 times the size of its junior cousin, New Zealand. The economies of each country are similar in some ways: both are based heavily on commodities, both have a precariously large housing market component, and both are currently running inflation at just under 7%. Together with the Australian dollar, their currencies are also the best performing in the G10 (vs USD) year-to-date. Given the bull trend in commodities, housing, yields and currency, it comes as no surprise that both central banks have led the developed world in terms of monetary tightening. The question is, will they also serve as a leading indicator on the way back down?
At the most recent BoC policy meeting on 1 Jun, the Governing Council hiked its overnight rate by 50bps for the second consecutive time, as the RBNZ had done a week earlier. Among the very few developed economies with overnight rates above even 1%, and as the early movers, Canada and New Zealand have managed a less significant gap between policy rates and inflation. This gap, at latest measure, was 7.3% in the US, 8.0% in the UK, and a whopping 9.2% in Germany where policy rates are still negative. Nevertheless, there are renewed calls domestically for the BoC to do more, even prompting an admission from Deputy Governor Beaudry, who was responding to political critic Pierre Poilievre, that the Bank should indeed be held accountable for its inability to keep inflation in check.
In worrying that there are signs elevated inflation expectations may be becoming entrenched, the Bank of Canada also stated at its meeting that it is ‘prepared to act more forcefully’. This could be interpreted in several different ways: 1) a 75bps hike at an upcoming policy meeting, 2) a higher terminal rate / push into restrictive policy territory, or 3) taking an active roll in unwinding the balance sheet (i.e. quantitative tightening). All actions could be considered as aggressive to some extent, but very much in trend with global central banks de-prioritizing equity market performance and mortgage costs this time around. Though even with inflation creeping across sectors and appearing broad-based, the inevitable ‘roll over’ of CPI will pose a difficult question for policy makers: how fast will price pressures come down and how can stagflation be avoided?
Luckily for central bankers so far, most economies have held up surprisingly well so far, including Canada and New Zealand. Specifically, consumer appetite fresh out of the pandemic has stayed robust and labour markets remain considerably tight in Canada and the US. Additionally, some key cost pressures seem to be abating and pointing to some alleviation of supply-side jams: semiconductor prices are down 14% since mid-2021, shipping container spot prices are off their all-time high last September by 26%, and fertilizer prices in North America are off their all-time high in March by 24%.
If the BoC and RBNZ remain prescient and begin to let the proverbial foot off the gas pedal while others continue to tighten policy into the CPI turn around, there could be an outsized downside risk to CAD (and NZD). Firstly, USD/CAD has traditionally been well correlated to movements in the 2-year rate differential between Canada and the US. If US rates were to gain ground on CAD rates (especially in the real rates space), there is good reason to expect softening in the Canadian dollar. This is particularly relevant given the sensitivity of Canadians to short-term rates via the 5-year mortgage standard versus the availability of a 30-year rate in the US market, making hikes more potent. Secondly, the global commodity complex may be due for pull back from highs across the board. Increased talk of a recession – particularly in the US – amidst tightening financial conditions globally would certainly damper demand for energy and base metals, two key Canadian sectors. Finally, instability in some of the world’s most over-valued real estate markets may begin to show further if rates reach a pinnacle right at the turn of the economic cycle. Price gains of 50% nationally in Canadian house values since the onset of the pandemic have created a lot of downside. Ironically, it is in these same factors that CAD (NZD) found initial support and in which the BoC and RBNZ found reason to initiate the hiking cycle, which now pose the largest risk to each currency and economy going forward.
The race among global central banks is on. Watch the BoC and RBNZ for clues on what’s next.