Canada Rates Year Ahead 2023 – Bending the Knee

To state the obvious, Canadian rates underwent significant changes in 2022. And these changes were symptomatic of three forces, including: i) front-loaded rates hikes; ii) QT, and; iii) improving fiscal policy. In aggregate, these governing forces generated extreme levels of curve inversion, exerted significant downward pressure on shorter-dated swap spreads, and produced a half-year long streak of cross-market outperformance. And while QT will linger (and actually strengthen) in 2023, the impact of both monetary and fiscal policies are starting to shift. As they do, it will pave the way for incoming themes to flex their muscles, engendering material impacts across the complex that are quite different compared to this year.
In the year-ahead we see three dominant themes that will govern CAD rates. The first is the introduction of the ‘higher for longer’ regime, which reflects a longer transition period between the last BoC hike and the eventual first cut. The impact of this theme is a widening of the differential between medium-term and short-term rate expectations — a key building block of curve steepening. The second theme is reduced sensitivity to US rates, as the BoC ends it’s hiking cycle earlier then the Fed. The immediate impact as the Fed continues hiking will be the preservation of CAD richness in the early part of 2023. However, as the year progresses it will be difficult for CAD rates to maintain current cross-market valuations, particularly as the Fed stops hiking in the early part of 2023. This should generate significant CAD rates underperformance after Q1-23. The third and final theme is a shift in the preferences of structural domestic investors, including bank treasuries, LDI managers, and insurers. This will lead to a much flatter swap spread curve, but less dramatic cash steepening pressure compared to the United States.