After a stubbornly dovish March FOMC meeting\u2014strong growth forecasts accompanied by a flat dot plot and no taper talk\u2014we thought a more balanced tone from the US central bank was just a matter of time. And the Fed indeed changed its tune in June, signaling rates will indeed have to rise in 2023 given strong growth and above-target inflation (a growing number of participants even see rates moving up next year). Policymakers also began discussing tapering plans and we continue to expect more details will be revealed later this summer before QE starts to be scaled back around the turn of the year.<\/p>\n
The Fed\u2019s shift gave the US dollar a boost with the trade-weighted index now up nearly 3% year-to-date. The Canadian dollar is down by about 3 US cents since the start of June even as oil prices continue to firm. Rates markets also recognized the Fed\u2019s change in tone with 2-year Treasury yields rising to their highest level in more than a year. The long end of the curve, however, has seen a surprisingly strong rally due in part to expectations that the Fed will be less tolerant of high inflation\u201410-year breakeven inflation is down by 1\/4 percent from May\u2019s highs even as oil prices have generally firmed. We think the rally at the long end is overdone and look for yields to move higher over the second half of this year as expectations for a 2022 rate hike continue to build (we\u2019re now expecting Fed liftoff in Q4\/22).<\/p>\n
Rising US yields should push borrowing costs higher in other geographies, including the UK and euro area where we don\u2019t expect rate hikes next year. The ECB\u2019s increased emphasis on symmetric 2% inflation (even if it isn\u2019t adopting average inflation targeting) suggests it will remain on the sidelines for an extended period. The RBA also looks set to keep rates on hold through 2022 but will taper its QE program later this year. We expect the BoC will continue slowing its bond buying and will look relatively aggressive with two rate hikes in 2022.<\/p>\n