Dollars and Sense:

The Hawk Has Landed  

Beata Caranci, SVP & Chief Economist | 416-982-8067

James Orlando, CFA, Senior Economist | 416-413-3180

Date Published: November 2, 2021

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Highlights

  • Bond yields are rising on the expectation that central banks will speed up the start of their interest rate hiking cycles. 
  • The Federal Reserve poised to take a first step in reducing its support by tapering its Quantitative Easing (QE) program as early as this week and is likely to execute its first interest rate hike in the summer of 2022. 
  • As the hiking cycle gets further cemented in market pricing, this will provide even greater upside for government yields.
Chart 1 shows the level of employment in the US and Canada from Feb. 2020 to Sept. 2021, indexed to 100 from Feb. 2021. We show that Canada has gotten back to pre-pandemic levels but that the US has not.The time has finally arrived. Central bankers have pivoted to a more hawkish tone, preparing markets for the inevitable – higher policy rates. Vaccines have supported domestic economic resilience in the face of COVID variants. Meanwhile, determination and stubbornness are highly regarded characteristics when it comes to economic progress. The same cannot be said when it comes to high inflation. This economic backdrop no longer warrants emergency-level monetary settings, pivoting central banks to speed up the timing of policy normalization. 

The Great Pivot

Several central banks have already taken their first steps down this path. Some have lifted the policy rate, while others have ceased Quantitative Easing (QE, Table 1). The Bank of Canada (BoC) was the latest to join the ranks of those ending QE, providing it the flexibility to pursue rate hikes at any point in 2022. In contrast, the Federal Reserve’s more cautious approach will leave it lagging many of its peers, risking a greater overheating of inflation, should supply-side dislocations persist for longer than expected.

Table 1: Central Banks Turning Hawkish

Source: TD Economics.
Already hiking Getting ready to hike Getting ready to cut QE
RBNZ BoC Fed
BoK BoE ECB
Norges   BoE
Banxico   RBA

Chart 2 shows the level of labor force participation (25 to 54 year olds) in the US and Canada from 2000 to 2021. We show that Canada has seen a rising participation rate over time and over the pandemic, while the US has seen the opposite.

Why the difference in approach? Much comes down to labor market conditions. Countries like Canada have enjoyed a rapid return to pre-crisis job levels, while the U.S. continues to dig out (Chart 1). This better positions the recovery to be supported by wage and salary growth. When coupled with already-high levels of savings and wealth, Canada has a trifecta of strong domestic demand forces. Federal Reserve action has also been stymied by a slow recovery in labor force participation, whereas its northern neighbor does not face the same constraint (Chart 2). The Fed has a mandate to consider not just inflation outcomes, but also the broader progress of the labor market. The latter remains a diminished representation of its former self, which the Fed has interpreted as requiring more patience relative to other central banks.

However, since the Fed acts as the central banker to the world, erring on the side of too much patience could eventually lead to a faster rate-hike path. This would impart tremendous influence over global yields that may disrupt both the domestic and the broader global economy. Waiting to strike a perfect balance between inflation and labor market health is a risky proposition, and the Fed will have to settle for ‘good enough’.

The tapering of its balance sheet will commence in the coming weeks, allowing for an end to all net-new purchases in the first half of 2022. This will open the door for rate hikes in the months that follow. By the time the Fed ends QE, the economy will likely be in excess demand. In other words, transitory inflationary forces due to pandemic-related supply disruptions will be amplified by strong demand-side forces related to domestic fundamentals. A highly stimulative zero-policy environment, implemented in response to a crisis, will not be sufficient to counter these kind of demand-push dynamics. We anticipate that the Fed will be compelled to start its rate-hiking cycle in the summer of 2022, followed by one hike every three months until the policy rate reaches 2%. This course is not set in stone. If inflation proves sturdier and market expectations begin to reflect this paradigm, the timing and speed may be pulled forward.

Yields have been on an upward trajectory from exceptionally low levels since the end of September. We expect the U.S. 10-year yield to rise another 50 basis points to 2.0% over the next six months. This would return longer term yields to levels seen in the 2014-2017 period. 

The notion of yields this high has caused some nail-biting among analysts who fret about weaker longer-term growth prospects. Some point to the compression in the UST 10-2 year spread as a cautionary signal. This angst is typical when markets must adjust to a new direction in central bank communication, but a flatter yield curve is a natural by-product of higher policy rate expectations. The current spread of 100 basis points is nowhere near levels that signal caution. In fact, this spread should continue to narrow to about 0.25% over the next two years. It’s important to bear in mind that having monetary policy set for 3-4% economic growth, when capacity can only accommodate 2% on a sustainable basis, can quickly create asymmetrical risks to inflation and asset prices. Those on the other side of the debate argue that the U.S. and other nations may already be staring down this barrel.

Bottom Line

With the durability of the economic recovery and the persistence of high inflation, central bankers around the world are moving to reduce pandemic-driven monetary policy supports. The Fed will be among the laggards, but it will begin to taper its emergency QE program soon and create the opportunity to raise interest rates from emergency levels in the second half of 2022.

The Fed is focused on employment gains, with the goal of closing in on maximum employment. But, threading the needle in an already elevated inflation environment could lead to a policy error. Central bankers are mindful that risks are two-sided. Hiking a little earlier and leaving sufficient time between policy decisions to monitor outcomes helps to mitigate the adverse impact of leaving policy rates too low for too long. 

The yield curve will continue to respond as the months roll forward, putting upward pressure on a wide array of lending rates from corporate bond yields to individual mortgage rates. The time for patience on monetary policy is ending.

Tables

Interest Rates & Foreign Exchange Rates

F: Forecast by TD Economics, November 2021; Forecasts are end-of-period. Source: Federal Reserve, Bloomberg.
Interest & Exchange Rates Spot Rate 2021 2022 2023
Nov-01 Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Interest Rates                        
Fed Funds Target Rate  0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.50 0.75 1.00 1.25 1.50 1.75
3-mth T-Bill Rate  0.05 0.03 0.05 0.04 0.10 0.13 0.30 0.55 0.80 1.05 1.30 1.55 1.75
2-yr Govt. Bond Yield  0.50 0.16 0.25 0.28 0.60 1.00 1.20 1.40 1.55 1.70 1.80 1.90 1.95
5-yr Govt. Bond Yield  1.18 0.92 0.87 0.98 1.25 1.45 1.65 1.80 1.90 1.95 2.00 2.00 2.05
10-yr Govt. Bond Yield  1.56 1.74 1.45 1.52 1.90 2.05 2.15 2.25 2.30 2.35 2.35 2.30 2.25
30-yr Govt. Bond Yield  1.96 2.41 2.06 2.08 2.20 2.35 2.45 2.55 2.60 2.65 2.65 2.60 2.55
10-yr-2-yr Govt Spread 1.06 1.58 1.20 1.24 1.30 1.05 0.95 0.85 0.75 0.65 0.55 0.40 0.30
Exchange rate to U.S. dollar                        
 Chinese Yuan CNY per USD 6.40 6.55 6.46 6.44 6.49 6.54 6.59 6.64 6.69 6.74 6.80 6.80 6.80
 Japanese yen JPY per USD 114 111 111 112 112 110 108 106 104 102 100 99 99
 Euro USD per EUR 1.16 1.17 1.19 1.16 1.17 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23
 U.K. pound USD per GBP 1.37 1.38 1.38 1.35 1.37 1.38 1.39 1.40 1.41 1.42 1.42 1.42 1.42
 Swiss franc CHF per USD 0.91 0.94 0.93 0.93 0.94 0.95 0.96 0.97 0.98 0.99 1.00 1.00 1.00
 Canadian dollar CAD per USD 1.24 1.26 1.24 1.27 1.24 1.25 1.26 1.27 1.27 1.27 1.27 1.27 1.27
 Australian dollar USD per AUD 0.75 0.76 0.75 0.72 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73
 NZ dollar USD per NZD 0.72 0.70 0.70 0.69 0.70 0.70 0.70 0.69 0.69 0.69 0.69 0.69 0.69
Exchange rate to Euro                        
 U.S. dollar USD per EUR 1.16 1.17 1.19 1.16 1.17 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23
 Japanese yen JPY per EUR 132 130 132 129 131 128 126 125 124 122 121 121 122
 U.K. pound GBP per EUR 0.85 0.85 0.86 0.86 0.85 0.84 0.84 0.84 0.85 0.85 0.85 0.86 0.87
 Swiss franc CHF per EUR 1.06 1.11 1.10 1.08 1.10 1.10 1.12 1.14 1.17 1.19 1.21 1.22 1.23
 Canadian dollar CAD per EUR 1.44 1.48 1.47 1.47 1.45 1.45 1.47 1.50 1.51 1.52 1.54 1.55 1.56
 Australian dollar AUD per EUR 1.54 1.54 1.58 1.60 1.60 1.59 1.61 1.62 1.64 1.65 1.67 1.68 1.69
 NZ dollar NZD per EUR 1.62 1.68 1.70 1.68 1.68 1.67 1.68 1.70 1.71 1.73 1.74 1.76 1.78
Exchange rate to Japanese yen                        
 U.S. dollar  JPY per USD 114 111 111 112 112 110 108 106 104 102 100 99 99
 Euro  JPY per EUR 132 130 132 129 131 128 126 125 124 122 121 121 122
 U.K. pound  JPY per GBP 156 153 153 150 153 152 150 148 146 144 142 141 140
 Swiss franc  JPY per CHF 125.4 117.4 120.0 119.4 119.1 115.8 112.6 109.4 106.3 103.2 100.0 99.4 98.9
 Canadian dollar  JPY per CAD 92.2 88.0 89.5 88.0 90.3 88.0 85.7 83.5 81.9 80.3 78.7 78.3 77.8
 Australian dollar  JPY per AUD 85.7 84.2 83.2 80.6 81.8 80.3 78.7 77.1 75.7 74.2 72.7 72.2 71.8
 NZ dollar  JPY per NZD 81.9 77.3 77.5 76.9 78.0 76.6 75.1 73.6 72.2 70.8 69.4 68.9 68.5

 

Commodity Price Outlook

F: Forecast by TD Economics, November 2021; Forecast are period averages; E: Estimate. Source: Bloomberg, USDA (Haver).
Commodity  Price 52-Week 52-Week 2021 2022 2023
Nov-01 High Low Q1 Q2 Q3 Q4F Q1F Q2 Q3F Q4F Q1F Q2F Q3F Q4F
Crude Oil (WTI, $US/bbl) 84 85 36 58 66 71 79 77 73 72 71 70 70 69 69
Natural Gas ($US/MMBtu) 5.18 16.13 2.19 3.56 2.94 4.36 5.75 5.50 3.90 3.80 4.00 4.10 3.50 3.40 3.75
Gold ($US/troy oz.) 1793 1951 1684 1795 1814 1790 1750 1675 1650 1625 1600 1585 1570 1565 1550
Silver (US$/troy oz.) 24.03 29.05 21.54 26.25 26.71 24.36 22.50 21.75 21.50 21.25 21.00 20.75 20.50 20.25 20.00
Copper (cents/lb) 445 513 304 386 440 426 442 420 406 388 381 372 363 350 350
Nickel (US$/lb) 8.82 9.51 6.87 7.97 7.88 8.67 8.87 8.85 9.53 8.85 8.62 8.28 8.50 8.28 8.50
Aluminum (Cents/lb) 123 144 84 95 109 120 130 124 122 118 115 115 112 108 109
Wheat ($US/bu) 10.80 10.77 6.51 7.41 8.53 10.28 10.75 9.75 9.50 9.25 9.00 8.70 8.50 8.25 8.00

International Interest Rates Outlook

F: Forecast by TD Economics, November 2021; Forecasts are end-of-period. Source: Bloomberg.
 Interest Rates Spot Rate 2021 2022 2023
Nov-01 Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Germany                          
ECB Deposit Rate -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50
3-mth T-Bill Rate  -0.85 -0.66 -0.66 -0.67 -0.60 -0.60 -0.60 -0.60 -0.60 -0.60 -0.60 -0.50 -0.38
2-yr Govt. Bond Yield  -0.61 -0.69 -0.67 -0.69 -0.54 -0.46 -0.40 -0.31 -0.19 -0.03 0.15 0.37 0.60
5-yr Govt. Bond Yield  -0.40 -0.63 -0.59 -0.56 -0.44 -0.36 -0.30 -0.21 -0.09 0.07 0.25 0.47 0.70
10-yr Govt. Bond Yield  -0.10 -0.29 -0.21 -0.20 0.03 0.19 0.34 0.49 0.64 0.80 0.95 1.10 1.25
30-yr Govt. Bond Yield  0.17 0.26 0.29 0.27 0.49 0.64 0.79 0.94 1.10 1.25 1.40 1.55 1.70
10-yr-2-yr Govt Spread 0.51 0.40 0.46 0.49 0.57 0.64 0.74 0.80 0.83 0.83 0.80 0.73 0.65
United Kingdom                  
Bank Rate 0.10 0.10 0.10 0.10 0.10 0.25 0.50 0.75 1.00 1.25 1.50 1.75 1.75
3-mth T-Bill Rate  0.16 0.01 0.02 0.03 0.15 0.35 0.60 0.85 1.10 1.35 1.60 1.70 1.70
2-yr Govt. Bond Yield  0.70 0.10 0.05 0.23 1.05 1.25 1.45 1.55 1.65 1.75 1.80 1.80 1.80
5-yr Govt. Bond Yield  0.84 0.28 0.33 0.55 1.11 1.38 1.60 1.76 1.85 1.88 1.90 1.90 1.90
10-yr Govt. Bond Yield  1.06 0.84 0.72 0.93 1.30 1.54 1.78 1.90 2.02 2.04 2.05 2.05 2.05
30-yr Govt. Bond Yield  1.14 1.39 1.23 1.37 1.80 2.04 2.28 2.40 2.52 2.54 2.55 2.55 2.55
10-yr-2-yr Govt Spread 0.37 0.75 0.66 0.70 0.25 0.29 0.33 0.35 0.37 0.29 0.25 0.25 0.25

Global Stock Markets

*Weighted equity index including both developed and emerging markets. Source: Bloomberg, TD Economics.
Major Market Indexes Price 30-Day YTD 52-Week 52-Week
Nov-01 % Chg. % Chg.  High Low
S&P 500 4,614 5.9 22.8 4,614 3,270
DAX 15,806 4.3 15.2 15,977 11,556
FTSE 100 7,289 3.7 12.8 7,289 5,577
Nikkei 29,647 3.0 8.0 30,670 22,977
MSCI AC World Index* 745 4.6 15.3 748 551

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