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The global recovery is robust and interest rates will soon rise

American and Canadian flags next to each other blowing in the wind.

Key takeaways

  • The Bank of Canada holds its target for the overnight rate at 0.25%.
  • The U.S. Federal Reserve holds the target range for the federal funds rate at 0-to-0.25%.
  • Both central banks expect rate hikes in the near future.

Earlier on Wednesday, the Bank of Canada (BoC) announced that it would hold its target for the overnight rate at 0.25%. Also confirmed, it will continue with the reinvestment phase of its quantitative easing program – only buying bonds to replace maturing assets. Notably, the BoC has removed its commitment to hold its policy interest rate at the effective lower bound given it feels economic slack has been absorbed.

Later in the afternoon, the U.S. Federal Reserve (Fed) announced that it too would hold its target for the federal funds rate at 0-to-0.25%. Additionally, it will continue to reduce the pace of asset purchases, bringing an end to its quantitative easing program in early March. Also notable, the Federal Open Market Committee commented that it expects that raising the target range will soon be appropriate.

With financial markets no longer requiring emergency-level policy support and the robustness of the global recovery, we too expect central bank interest rates to head higher over the next 12 months. However, we also believe this expectation is widely held and that, as a result, bond yields are likely to move only modestly higher from current levels.   

The global economy continues to heal

For Canada, GDP is expected to have grown by 4.5% in 2021. The BoC expects Canada’s economy to grow by 4.0% and 3.5% in 2023 and 2024 respectively. The BoC’s measures, including employment and housing data, suggests that economic slack has been absorbed.

In the U.S., indicators of economic activity and employment have also continued to strengthen. Parts of the economy most adversely affected by COVID-19 have improved in recent months despite a sharp rise in infections. The labour market has also improved substantially.

The global recovery from the pandemic is strong but uneven. The BoC projects global growth to moderate from 6.75% in 2021 to 3.5% in 2022 and 2023 – bolstered by strong consumer spending, exports and business investment. We won’t have the Fed’s latest projections until mid-March when its next Summary of Economic Projections will be published.

Unsurprisingly the Omicron variant continues to weigh on economic activity. Its overall impact will depend on how the situation develops, but it is expected to be less severe than previous waves.

Inflation likely to remain elevated through 2022

The combination of strong demand for goods, ongoing supply chain disruptions and the rebound in oil prices continues to keep short-term inflation elevated in most regions.

The BoC expects inflation to decline relatively quickly from 5.0% in the first half of 2022 to 3.0% by the end of the year, then gradually move towards its 2.0% target through 2023 and 2024 as productivity increases and demand moderates. The timing and pace of interest rate increases will be guided by the bank’s commitment to achieving its 2.0% inflation target.

Similarly, the Fed reiterated that its policy decisions will be guided by its goals of maximum employment and 2% long-term inflation.

Equity markets and bond yields move higher

Overall, financial conditions remain accommodative but have tightened recently with growing expectations that monetary policy will normalize sooner than markets anticipated. This was likely a major contributor to equity market volatility we witnessed earlier in the week.

Equity markets traded higher on Wednesday as did bond yields. The Canadian dollar depreciated against the U.S. dollar throughout the day, seeing noticeable dips following both the BoC and Fed announcements.

At this time, our portfolios remain overweight equities relative to fixed income overall. Within our equity allocation, we still prefer developed North American equities versus emerging markets.

With our fixed income allocation, we are positioned for the U.S. yield curve to flatten and yields to modestly rise as the Fed unwinds its quantitative easing program. And begins raising its key lending rate.

For more information about these announcements or our positioning, please contact your MD Advisor*.

The BoC’s next interest rate announcement is scheduled for March 2.

The Fed’s next interest rate announcement is scheduled for March 16.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.

About the Author

Wesley Blight, CFA, CIM, FCSI, is an Assistant Vice President with the Multi-Asset Management team. He is responsible for the investment results of the firm’s fixed income and multi-asset products.

Profile Photo of Wesley Blight