The US Federal Reserve just scrapped the transitory narrative, and it was felt in Canada. Reserve Chairman Powell candidly dismissed the transitory inflation explanation. This immediately began to flatten Canada’s yield curve, according to BMO. The bank’s chief economist, Douglas Porter, highlighted this point to clients in his latest research note. His analysis shows the last time the yield curve flattened to this level, Canada was ready to hike rates.
The US Federal Reserve Says Inflation Is NOT Transitory
The US Federal Reserve shocked the market by dismissing transitory inflation. “Fed Chair Powell’s blunt remarks that it was time to retire ‘transitory’ and that it was ‘appropriate to consider wrapping up taper a few months sooner’ predictably steam-rolled the Treasury curve,” said Porter.
The US accelerating its timeline for a rate hike caught the market off guard. This means cheap growth and high inflation are coming to an end in the not-so-distant future. Now short-term yields are surging, increasing pressure to raise rates.
“What really caught the market off guard was the change in tone given the emergence of concern over the economic outlook amid the newest variant, said Porter. “Short-term yields edged higher, even on a deeply down day for commodities and equities, while long-term yields fell heavily.”
Canada’s Yield Curve Is Flattening Very Fast
This isn’t just an American issue — it immediately spilled over to Canada. “As a result, the gap between 10s and 2s fell to just 57 bps for the GoC curve. Aside from a one-day plunge on the day of the most recent BOC Statement, this is the flattest curve since the opening week of the year,” said Porter.
The “10s and 2s” refers to the Government of Canada (GoC) 10-year and 5-year bond yields. Typically a 10-year bond should have a yield higher than short-term bonds. Longer outcomes have more uncertainty and should therefore carry a higher risk premium. As short-term bond yields get closer to long-term ones, the curve is said to be “flattening.” This is bad news since the bond buyer thinks the economy will be worse off in the future than it is today.
BMO highlighted the yield spread because of how Canada responded last time it hit this level. “Notably, looking back to the prior cycle, this is about the slope of the curve in the summer of 2017, just before the BOC began to lift rates again.”
Of course, it’s a little different this time. Canadian interest rates were 100% higher, and inflation was at half the rate this time. Porter stopped short of saying whether he thinks this means Canada will accelerate its schedule. It is a point to consider though, with the US looking to tighten policy sooner than they had expected.