With Canadian activity sliding and the Bank of Canada (BOC) winning its tenacious campaign to wrestle inflation back toward its 2% target, it can afford to hold its policy rate at 5% for the third straight month when it meets this week.

Indeed, Canadian GDP growth has declined for four straight quarters and markets already are starting to price in rate cuts from the second quarter next year.

Even with little or no growth projected in the fourth quarter of this year and a projection of annual growth slowing to below 1% next year, the BOC is likely to hold the line on rates.

The Bank has said while it is comforted with the direction of inflation, it remains concerned about price persistence and will hold rates steady.

Monday Morning Notes, 10/23/23
Third quarter GDP arrives on Thursday, and markets expect it to be a whopping 4.3%. Numbers on the high side will increase the probability that the Fed’s latest SEP projection is too low, and market participants will likely price in a greater probability of a December hike. See below why I think we should fade such a move.
The Fed is in a dramatically different place than a year ago. In retrospect, I think there was an unwritten strategy to keep raising interest rates until rates were higher than inflation and a disinflationary trend was established. Having reached that point, the Fed can now shift to an extended pause and wait to observe the progress toward price stability. In this phase of the cycle, policy is resilient to some elevated inflation prints.
Faster than expected growth in the second half of the year by itself does not push the Fed back into a rate hike at the December FOMC meeting.

The political, market, and geopolitical news cycles have entered a new phase of enormous risk and volatility. But from a policy perspective, the upcoming meeting of the Governing Council of the European Central Bank on October 26 will be held in “calmer waters,” a phrase we have heard used more than once by ECB officials.
That does not mean traders and investors will have no interest in the meeting.
ECB officials will review the latest data against their forecasts at the two-day meeting next week. While inflation last month dropped more than markets had expected, and the next print is expected to show continued improvement, the numbers are, by and large, within expectations.
To that very important point, it appears some analysts are already straight lining this trend to a first half of 2024 ECB rate cut, some even calling for a cut in Q1. This flies against what the ECB expects it may do next year.

Raising the Bar


Bottom Line: The stage is being set to pass on another rate hike at the December meeting. Waller provided us with the conditionality around that meeting, and it raises the bar for a hike relative to the September SEP. Federal Reserve Chair Jerome Powell won’t close off a December hike, and could tomorrow repeat Waller’s guidance, but I think the risk here is that Powell can deflect from any real direction beyond November and appear a notch more hawkish that Waller. That would help solidify some market pricing of non-trivial but less than 50% odds of another rate hike in December.

In the countdown to its October policy meeting, the potential for another adjustment in Yield Curve Control (YCC) is live as the Bank of Japan lays a path to an exit from negative rates policy that could come as soon as March or April next year.

While all that might sound a little early right now and we are mindful events can push decisions into later months, reasons for a more aggressive timeline, partly motivated by politics, are stacking up.

The Data is Telling the Fed to Hike, But Doves Resist That Message

Bottom Line: At a certain level, this is all very simple. The economy has outperformed expectations and threatens to continue to outperform. The Fed does not expect it to continue to outperform, and a contingent within the Fed is fighting to make policy based on that forecast and forego further rate hikes. That contingent has yet to get significant pushback. We have key speakers coming up that can provide that pushback or suggest that rise in the long end of the curve is enough to complete the job. If that turns out to be a bad bet, then the Fed will eventually have to come back to the table with an additional hike, but in my opinion if that happens it will be more than one hike. I still think that yields can’t come down without sharply slower growth, and the evidence for that has been slow to emerge.

The Fed is behaving as if it is done hiking, and I can’t say that it won’t choose to forego a rate hike in December even if it appears likely to hit the September SEP economic projections. Once the Fed skips two meetings, it will be “restarting” rate hikes, a shift that would seem to imply a higher bar. To be sure, Fed signaling could be dovish only because the outcome of the November meeting is already certain, and speakers don’t want to say anything that puts that back into question. But it feels as if speakers have gone further than necessary to achieve that goal. The hawks have all but given up the stage, which seems odd because presumably they were among the 12 participants anticipating another hike this year and the data should embolden that group.



...Arguably the data since the September meeting has already been sufficient to allow the Fed to hike rates at the upcoming FOMC meeting. GDP growth in the third quarter could top 5%, more than enough to put the Fed’s latest growth projection at risk barring an unlikely sudden stop in the fourth quarter.

On the back of increased stimulus, and a bump in consumption including through the Golden Week holidays and bolstered by the Asian Games that will conclude this weekend, officials in Beijing expect to be able to ride a consumption rebound, even if modest, through the fourth quarter of 2023 and hit their 5% GDP target for this year relatively easily.

Published on October 3, 2023
The move in long rates further argues against a Fed policy rate hike at the next meeting. Quite simply, the Fed will recognize that financial conditions have tightened meaningfully and expect a subsequent hit to growth. In other words, the Fed will anticipate that the move in longer-rates offets the need for additional policy rate hikes. I don’t think the Fed will risk aggravating the market at this juncture to push for a rate hike in November. There is limited upside for such a move unless inflation rebounds. This is a very different situation from this past spring when the Fed was determined to keep hiking despite the SVB collapse. Now rates are in restrictive territory, and perhaps sufficiently restrictive, which wasn’t the case at the March FOMC meeting.

A collapse in growth and precipitous drop in inflation could of course make the earlier rate cut bets pay off, but for now the assessment at the ECB, which we would tend to agree with, is that tentative signs show that Europe’s hardest hit sectors in Germany could be bottoming out.
The German IFO sentiment indicators for example are not good, but they have stopped their steep descent. Likewise, the survey indictors from China, which is so vitally important for German manufacturers.

The Bank of Japan’s (BOJ) October policy meeting is shaping up to be a watershed event; a forecast round wherein improved inflation projections for 2024 and 2025 should open up an early 2024 window for a positive policy rate for the first time in seven years.

By the time of the October 30-31 BOJ meeting, officials expect to have price data and preliminary guidance on the outcome of next year’s Spring wage negotiations that provide a crucial piece of evidence to confirm the central bank has met its price and wage goals.

Bottom Line: As we have written repeatedly, the improved growth outlook has upended the expected drift downward in yields typical at the end of the cycle. The Fed’s place in this story is just as we expected before the FOMC meeting. It sees enough in the employment and inflation data to hope that it hiked rates in July for the last time, but it intends to respond to faster growth with at a minimum of more “higher for longer” and even higher rates if needed. We need to see weaker growth to change this story.

While Ueda’s comments last week did not exactly fling the door open to a rate hike this year, his guidance represented a sharper tilt by the BOJ toward higher rates than at any time in almost 25 years.
And, though we have consistently written this year that a rate move is not likely until next year, equally we have flagged the need to be on guard for signals from Ueda that could point to a BOJ pivot that could come before the second quarter of 2024.
Even if Japanese politics sideline BOJ rate action this year, we continue to caution clients not to dismiss the possibility that the BOJ brings forward a move to end negative interest rates which are at minus 0.10 bps.
When asked about the timing of a possible interest rate adjustment, Ueda said: “It is not impossible that we will have enough by the end of the year to anticipate (wage hikes next spring).”

That said, Powell will still note that faster growth could slow the return to price stability and, if it continues, that could warrant another rate hike. I think the Fed will want to see if the third quarter growth spurt sustains momentum in the fourth quarter before deciding if another rate hike is necessary. Such data likely won’t be available until the December FOMC meeting at the earliest. I also expect the usual hawkish talk about the job not being done and a reminder that inflation progress could reverse as seen more than once in this cycle.
I think the Fed retains another rate hike in the 2023 dots. The balance of risks favors some downward drift in the distribution of the 2023 dots, but I think the improved growth outlook will justify retaining that last rate hike in the SEP. The risk is that the last dot disappears, although that would be akin to a declaration that the cycle is definitely over.
The improved growth outlook all will reduce the number of projected rate cuts in 2024 compared with the June SEP. The easy way to think about this is that the Fed’s forecast will simply push forward the slowing that was anticipated for the second half of 2023. If the Fed pushes it back three months, it probably delays the timing of the first rate cut in the next cycle by a quarter, which then translates into 75bp of cuts for 2024. If the Fed pushes forward the slowdown by six months, the risk is that the Fed will then expect only 50bp rate cuts in 2024.

The ECB has every reason to convey a far more tempered stance at this juncture, and a hope that this could be it for rate hikes, and that time, especially if inflation eases and thus real rates stay tight, will now be on their side.
But we suspect that our “hawkish lean” still lurks as well in the Governing Council very close beneath the surface.
With just one inflation print between now and October, that meeting will clearly be a hold. But we doubt that the decision at hand by December will be whether and when to cut, but rather an assessment of whether the ECB has done enough, as Lagarde said today, “to reinforce” the trajectory of easing inflation that it has penciled in for 2024 and through 2025.

Markets are still favoring a pause and are pricing a European Central Bank rate hike this week at less than even odds.

But we are switching our expectations for the ECB interest rate decision this Thursday from a pause to a 25-basis points hike.

The more we re-run in our minds what we have heard from ECB officials, wargame their tactical choices, and analyze the data and risk management dynamics that will be debated at the Governing Council meetings tomorrow and Thursday, the less comfortable we are with our briefly held, and highly unusual for us dovish call that they will pause at this meeting.

The forecasts, as characterized by ECB Vice President Luis de Guindos, are likely to show a lower growth trajectory than expected in June, and an inflation outlook that is “more or less” as expected in June.

Putting a finer point on that inflation outlook, analysts expect that is likely to translate into a slightly higher figure in the near term, and perhaps a small tweak lower to the 2.2% outlook for 2025 due to slower economic activity. But even a small revision to 2025 inflation, if it does show up in the numbers, will be insufficient progress for ECB hawks, and the leadership, to hang their collective hats on.

Bottom Line
It’s always risky to shift a position on a call where the market odds are sitting at 50-50, and perhaps even risky ahead of a CPI report. It’s a space where it is easy to find yourself on the other side of your own call with each new data point. After all, the odds are 50-50 for a good reason. The data is stronger than expected and the Fed has highlighted that stronger than expected activity could lead it to hike rates again. At the same time, however, lower inflation reduces the urgency to hike rates again, and the Fed is balancing policy against these two considerations. While my optimism hasn’t change, and indeed the data flow has supported the growth story, the tone of the conversation now leads me to believe that even with growth coming in faster in the third quarter, as long as core inflation stays low in these next two prints, the Fed will believe it can wait past the Oct/Nov meeting until it has much more visibility on the fourth quarter to decide if it needs to push rates up another notch.

The Canadian and Australian central banks, either finishing out or done with tightening, are turning their attention to how to fend off growing speculation that rate cuts will be brought forward – in Australia’s case, to early next year.

In Canada too, where the Bank of Canada (BOC) has not yet declared its 2% inflation goal in sight let alone attained, markets are assuming that with a headline CPI inflation rate at 3.3% in July, the BOC has topped out at a cycle peak of 5% and are expecting the BOC to cut rates by the summer of 2024.

This is notwithstanding important data in the interim including Friday’s release of second quarter GDP, forecast to have grown an annualized 1.2% in the second quarter from 3.1% a year earlier. If it fails to show growth moderating in line with the BOC’s projection of an annualized 1.5% rate, it could raise the odds of another hike sometime this year.
To be clear, while we see 5% as the BOC’s policy peak, the BOC noted in July persistent excess demand, reflecting its intention to hold rates higher and for longer than markets are pricing.


...The Canadian and Australian central banks, either finishing out or done with tightening, are turning their attention to how to fend off growing speculation that rate cuts will be brought forward – in Australia’s case, to early next year.

The RBA is just as cautious regarding the path to 2% inflation, notwithstanding this week’s stark slowing in July inflation data that has markets already tipping the RBA is done at its 4.1% cash rate.
While we agree the RBA won’t move rates again at its September 5 policy meeting, it is more likely than Canada to finish out its cycle with a final 25bp-hike, to 4.35%, though not until its November 7 policy meeting, a few days ahead of the November 10 release of the upgraded economic projections.

Battlelines Drawn Heading into Powell’s Speech
Bottom Line: The Fed wants to be done as every rate hike increases the risk of a hard landing. I don’t think the Fed was committed to an Oct/Nov rate hike at the July FOMC meeting, but that’s because it had a very pessimistic outlook for growth at that time. And I think participants were very confident in that outlook, but incoming data has shaken that confidence. Reiterating our outlook, our baseline going into Powell’s speech is that he wants to say, “policy is in a good place,” but he can only really be confident this will hold at the September FOMC meeting. Thinking beyond September, I think he will recognize that the possibility of an upside surprise to growth means the Fed “may have more work to do.” It doesn’t make sense to take that option off the table now given that the Oct/Nov meeting is still a long time away and in theory the data could cut decisively either direction by then.

Many economists and analysts, however, are sticking with their calls for another ECB rate hike. They point to the underlying price components of the PMIs that do not paint a pretty picture and reinforce concerns over the durability in particular of service sector inflation.
Expectations in the forecasting community are that the preliminary Eurozone August CPI figures that will be released next week will paint a similar picture of stickiness in core prices, with most forecasts showing just slight improvement from July’s 5.5% reading.
While they may be right on the data, we no longer agree with the call for a September hike and now expect that the ECB will take a pass and leave rates unchanged at 3.75% at their upcoming meeting