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Hikes On The Horizon

2021-12-17, Clement Chiang

As we near the final pages of 2021, and begin anticipating the next chapter, we want to share some thoughts on what we see as a material shift in the macroeconomic backdrop. As we know, central banks acted quickly in 2020, deploying almost every policy tool at their disposal to stave off deflationary forces arising from an unforeseen pandemic shock. But now that economic growth has rebounded and employment and inflationary pressures have recovered, these emergency levels of monetary stimulus are no longer needed.

As a result, the Bank of Canada has fully tapered its quantitative easing (QE) program. However, the U.S. Federal Reserve is still tapering its asset purchases and announced this week they will be doubling their current pace to conclude QE a few months earlier (March 2022). But tapering is not tightening. Slowing down its monthly rate of asset purchases means the Fed is still growing its balance sheet, just at a lower rate. Monetary policy remains highly accommodative. Likewise, policy rates are still held at the zero bound and after accounting for current inflation, the real Fed policy rate has rarely been this low since the 1970s. The Economics and Strategy team at National Bank illustrate this extremity below.

Note: Based on 3M mov avg for smoothing purposes
Source: NBF Economics and Strategy (data via Bloomberg)

The Fed has been quite vocal that their criteria for policy liftoff would require both the rate of inflation and market expectations for inflation to sustainably trend above their 2% target. As well, the Fed also wants the economy operating at full employment before considering rate hikes. With inflation exceeding their required levels for some time now (U.S. CPI 6.8% y/y and Canada’s CPI 4.7% y/y for November), it is the employment picture that remains outstanding.

The North American labour market made big strides in 2021. Reported unemployment rates for November are now closer to their pre-pandemic lows than their elevated levels at the beginning of the year.

Source: Bloomberg, QV Investors Inc.

If the current pace of job formations continues, Canada and the U.S. could arrive at full employment in very short order and fulfill the final criteria for rate liftoff. On Wednesday, the Fed also revised its economic projections for 2022 that now include consensus expectations for three policy rate hikes next year and another three in 2023. The market had already been expecting this and had been pricing these expectations into rate markets, shown as dashed lines in the chart below. It is our base case that market expectations are correct and that rate hikes are back on the table, but there are always risks to this forecast that we need to consider.

Note: Solid lines are past policy rates. Dashed lines are market-implied expectations as of Dec 17, 2021.
Source: Bloomberg, QV Investors Inc.

The key risk that remains front and center is the evolution of the virus and its influence on economic activity and global health. We are currently navigating around a new variant of concern and should this or another variant lead to further economic restrictions, it is likely that central banks would backtrack from their hawkish tone and redeploy supportive monetary actions quickly. There is no hiking playbook during a global pandemic for modern society to refer to, so this scenario should not be easily dismissed.

However, on the other hand there is a convincing case for central banks to turn decidedly more hawkish. As mentioned, the employment backdrop in North America is strong. The labour market is tight as employers are finding it difficult to fill job openings. This is one factor that has led to high wage inflation (U.S. average hourly earnings 4.8% y/y in November) and we have not experienced pay increases like this in decades. Should this level of wage growth persist, there is a risk that it could lead to a demand-pull type of inflation that is more persistent in nature and more challenging to arrest. The chart below shows that it has been a long time since the Fed has hiked into inflationary pressures this high, not to mention from such a low policy rate base. It is plausible that central banks are late in timing their rate hikes and as a result they may need to hike quicker and higher than what we have experienced in recent cycles to tame elevated price pressures. A scenario like this is not priced into rate expectations and could be quite disruptive to investments that are dependent on the lower for longer rate narrative.

Note: Based on 3M mov avg; policy rate is Fed Funds upper
Source: NBF, Bloomberg

As it is important to consider other risks, these scenarios are not our baseline. We do expect this upcoming hiking cycle to be measured, flexible and well telegraphed. But as we have learned in recent years, tail scenarios may be more probable than we think. More importantly, those investors that have recognized the assets and sectors that have long been beneficiaries of zero interest rate policies and that have had the fortitude to be positioned defensively, could be rewarded with attractive opportunities should these supports be removed more aggressively than expected. We believe our equity, bond and balanced strategies have the flexibility and are prepared for what could be bumpier markets ahead. Our focus on risk management and quality franchises purchased at attractive valuations continues to be our North Star and so we look forward to what 2022 may bring.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Clement Chiang | VP & Portfolio Manager, Fixed Income

Clement oversees QV’s investment process and makes portfolio decisions for the fixed income strategies.