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Bank of Canada Governor Tiff Macklem in Ottawa on Wednesday. As of Monday afternoon, interest-rate swap markets were pricing in 2½ quarter-point hikes by the Bank of Canada this year, starting in July.Adrian Wyld/The Canadian Press
Expectations for Bank of Canada interest rates have swung wildly in recent days, putting financial markets and Bay Street analysts at odds in terms of how they think the central bank will respond to the global oil price shock.
As of Monday afternoon, interest-rate swap markets, which capture bond investors’ expectations for monetary policy, were pricing in 2½ quarter-point hikes by the Bank of Canada this year, starting in July.
This time last week, traders were expecting one hike by the central bank later this year, according to Bloomberg data. And less than a month ago, they saw the bank remaining on hold through 2026, or possibly even cutting rates near the end of the year.
The extraordinary repricing is part of a global shift in interest-rate expectations owing to the war in the Middle East, which has pushed up the price of oil and reignited fears of inflation around the world.
At the same time, analysts warn that the oversized move in bond markets is partly the result of technical factors, and may be overdone – particularly in Canada, where weak economic growth and uncertainty around trade with the United States could make the central bank reluctant to increase interest rates.
U.S. Federal Reserve, Bank of Canada keep key interest rates unchanged amid oil-driven inflation risks
“The Bank of Canada is giving no indication that they are looking at near-term rate hikes, and they remain very concerned with the growth outlook,” Andrew Kelvin, head of Canadian and global rates strategy at TD Securities, said in an interview.
“So in that sort of a world, market pricing does look frankly detached from reality.”
Bank of Canada Governor Tiff Macklem said on March 18 that he was prepared to raise interest rates if needed, but suggested he was in no hurry to do so.
After holding the policy rate steady at 2.25 per cent, he said the bank would “look through” the oil price shock in the near term, so long as it didn’t bleed into a broader set of prices and push up consumer and business inflation expectations.
“With inflation close to target and the economy in excess supply, the risk that higher energy prices quickly spread to the prices of other goods and services looks contained,” Mr. Macklem said.
Bond markets initially appeared to absorb Mr. Macklem’s relatively dovish remarks.
However, hawkish commentary from the U.S. Federal Reserve, the European Central Bank and the Bank of England later on March 18 and 19 – alongside strikes by both the U.S. and Iran on energy infrastructure – sparked a global sell-off in bonds that pulled the Canadian market along for a ride.
Yields on short-term bonds spiked. (Bond prices and yields move in opposite directions.) And by the end of the week, financial markets were pricing in more than three hikes from the Bank of Canada this year.
That reversed somewhat on Monday, as U.S. President Donald Trump said he was in discussions with Iranian officials to end the conflict and oil prices dropped. But bond markets are still positioned far more aggressively than they were a week ago.
Ian Pollick, head of fixed income, currencies and commodities strategy at Canadian Imperial Bank of Commerce, said the extent of the move was the result of major bond investors being caught offside. They built up significant long positions in short-term Canadian bonds in February, only to get side-swiped by the shift in sentiment caused by the oil price shock and the hawkish commentary from global central banks.
“You’ve had this exaggerated move in the level of interest rates as a result of this huge positioning change, that’s the technical story,” Mr. Pollick said in an interview.
“When you see a shock like you just did, and all the signals move from being very long to suggesting you should be very short, it inundates the liquidity of the system,” he said, referring to investors looking to sell bonds.
Fundamentally, however, the outlook for Canadian monetary policy has not changed all that much, Mr. Pollick said. While the oil price shock will certainly push up headline inflation in the near term, weak economic growth, rising unemployment and uncertainty about the future of Canada-U.S. trade should act as a counterweight, putting downward pressure on inflation.
“Our fundamental view here is that we don’t think the Bank of Canada has to hike interest rates. We don’t think what the short end is suggesting is indicative of true sentiment,” he said, referring to bond market pricing.
Taylor Schleich, director of economics and strategy at National Bank of Canada, said that market repricing reflects a “tail risk” scenario, where oil prices keep rising and stay elevated for an extended period of time.
“That’s definitely not our base case, but if you’re a trader, you kind of have to be pricing in some risk of that playing out,” Mr. Schleich said in an interview.
The Bank of Canada likely has more leeway to look through the oil price shock than other central banks, he said, given the weak economic backdrop, relatively mild inflation heading into the war, and the fact that Canada is an oil exporter, not an importer. But it will be wary of any signs that businesses and households are coming to expect higher inflation.
“The last thing they want is for these inflation expectations to be entrenched at a higher level. That’s what nightmares are made of for central bankers.”
