Three On A Match: US Tax Reform, ECB And Bank Of Canada Meetings

There are many economic reports that will vie for investors’ attention. The flash PMI readings for the eurozone may be the most contemporaneous data, while the UK and US are the first G7 countries to report Q3 GDP. Japan will provide September CPI figures, and the both Sweden’s Riksbank and Norway’s Norges Bank hold policy meetings.  

Spain’s reassertion of its authority over the secessionist-minded Catalonia will draw attention, and investors will digest the results of the Japanese national elections. Abe’s gamble with a snap election appears to have paid off, and the government is seems set to have retained its super-majority. Japan’s election concludes an unlikely twelve-month period where all of the G5 countries held national elections. The Czech Republic election results seem consistent with the shift to the right by the Visegrad Group, as well as many countries in western Europe.    

We focus on three developments that may have the broadest impact. The first is the Bank of Canada meeting, which is not often thought to have global implications, especially given that policy will remain on hold.  However, the reason we think it is important is that the Bank of Canada with two rate hikes this year as seen as the epitome of “end of divergence” meme that seemingly became consensus.  

The Bank of Canada hiked the overnight lending rate by 25 bp in July and again in September. Initially, the market moved to price in a hike on October 25. As recently as mid-September the market was discounting more than a 50% chance of a hike at this month’s meeting and a nearly 75% chance of a hike by the end of the year. 

Guided by official comments and some softer data, the market has reconsidered. Interpolating from the Overnight Index Swaps, Bloomberg estimates that the market is now discounting less than a one-in-five chance of a hike in the week ahead and a little more than a one-in-three chance of a hike this year.  

The rate hikes that were delivered were not the beginning of a monetary tightening cycle like the Fed has entered. The two rate hikes were the taking back of the precautionary cuts delivered in 2015 as the economy coped with the drop in oil prices and the terms of trade shock. 

If the Bank of England hikes rates early next month, as the market expects (~80% probability), it will look more like the Bank of Canada’s move than the Fed’s. The Bank of England cut rates, and eased policy in other ways, around last year’s referendum. With the economic activity moderating, and price pressures expected to peak soon, and the significant pass-through of higher rate to households, a sustained campaign to normalize monetary policy does not appear to be at hand.  

Canada illustrates another broader issue, and that is the significance of interest rate differentials, which is a way to quantify a dimension of divergence. On a purely directional basis, the US dollar-Canadian dollar exchange rate is highly correlated with the two-year interest rate differential. Over the past 60 sessions, the two move in the same direction a little more 90% of the time.  

The US dollar fell against the Canadian dollar from early May’s high close to CAD1.38 to near CAD1.21 in early September. The greenback has recovered in recent weeks and moved toward CAD1.2625 before the weekend. About a week after the US dollar peaked in early May, the US two-year premium peaked near 65 bp.  As the dollar was tumbling, the differential swung to a discount of 25 bp by early September. The US premium, now a little more than 11 bp has been restored, and the US dollar appears set to recoup its earlier losses.