Curve Ball - Central bank heads of the U.S and Canada were at the podium last week

Last week the central bank heads of the U.S. and Canada were at the podium – Federal Reserve Chair Janet Yellen spoke at the semi-annual testimony to the Senate banking committee in Washington while Bank of Canada Governor Stephen Poloz delivered a speech in London, Ontario about "reinventing central banking". Unlike Yellen’s testimony, Poloz threw us a curve ball. The market was leaning heavily for another interest rate cut by the Bank of Canada at its March 4th policy meeting (didn't happen). However, those hopes were dashed when Poloz said "the downside risk insurance from the interest rate cut (in January) buys us some time to see how the economy actually responds." The CAD soared as the odds of a 25 basis point cut next week were cut from 72% to 38%. Poloz had been expected to sound a "dovish" tone but his curve ball put the central bank in wait-and-see mode.

　

Meanwhile, Yellen’s testimony was interpreted as dovish by the market even though we thought that she clarified the path to the Fed’s first interest rate hike since the 2008 credit crisis. Since the January FOMC meeting the market had come to understand that once the FOMC dropped or diluted the word "patience" from its policy statement that it could expect the Fed to raise rates after two meetings. In her testimony, Yellen further clarified this notion by saying that a rate hike could occur at any meeting after the forward guidance changed. We personally see this as a bullish development, but the market has read it as a dovish development. Most media outlets conveyed that this meant that once the word "patience" was removed that the Fed would become data dependent – duh! When hasn’t the Fed been data dependent? There is nothing new here; it will come down to a change in forward guidance and the next opportunity for the Fed to do that will be on March 18th. Thus, once patience is dropped, the count down for a rate hike will begin.

 

 

The USD has already gained considerable ground against a broad cross-section of other currencies, propelled by relatively strong U.S. growth and the divergent direction of monetary policy guidance from the Fed and the policy outlook for many other central banks. Now that the Fed has laid down the framework for a rate hike all data will be scrutinized as to whether it is positive or negative for a rate hike. Therefore, the USD is vulnerable to poor economic data and will move higher on good economic data. We had our first test last Thursday with the January CPI reading. Media headlines proclaimed that deflation had come to America with consumer prices falling by 0.1%. The decline in prices was almost all due to falling gas prices.

So this begs the question – can the Fed raise interest rates in the face of falling prices? We believe Yellen has already answered this question and took the opportunity to reiterate her position on this in her testimony by stating that the inflation impact from falling energy prices was temporary. We suspect that the plot will have a few more twists and turns with a busy data week ahead with US ISM manufacturing PMI and the non-farm payroll data.