Reuters: Bank of Canada’s fight against inflation gets more complicated as bond yields drop

Source: Reuters

Authors: Fergal Smith and Steve Scherer

Article: Original article

Publication date: Thursday, December 15, 2022

The Bank of Canada is likely to face a problem in 2023 persuading markets not to expect a quick reversal of its rate-hike campaign, as a recent drop in bond yields has already caused a decline in borrowing costs.

The central bank sets short-term interest rates, but the cost of long-term borrowings, such as loans to businesses and mortgages, is determined by the bond market.

Yields of Canadian bonds, as well as U.S. bonds, have fallen since October due to investors’ expectations of the tightening cycle ending, and the central bank’s willingness to lower rates next year.

Bond yields help to determine the availability of financing in the economy. If it improves, it could prevent inflation pressures from easing.

Doug Porter, chief economist at BMO Capital Markets, noted that markets expect the central bank to stop raising rates and even see the possibility of lowering. These expectations significantly complicate the Bank of Canada’s job. If markets grow way too fast and be way too sustainable, it would be much harder to get inflation out of the system.

The Bank of Canada stated that the economy remains overheated, even though there are signs showing that monetary policy tightening has helped in cooling down economic sectors, which are quite sensitive to interest rates, such as housing market. At the same time, its officials also outlined the possibility of taking a pause at the bank’s meeting on January 25.

In contrast, the Fed announced on Wednesday that it’ll raise rates next year even higher.

Money markets estimate the Bank of Canada’s rate peak of 4.40% in March, expecting the fall in rates to about 3.9% in late 2023.

Inflation dropped to 6.9% in October after its highest of 8.1% in June, but is likely to be more resilient than it was previously expected, as it extended from commodity prices to services and wages.

According to Derek Holt, head of capital markets economics at Scotiabank, central banks should avoid actions supporting these expectations. Otherwise, there is a high possibility to experience an roller-coaster of rates and inflation in the upcoming years, with higher average inflation.

Forecast: USDCAD is likely to grow