Bank of Canada's inflation fight made harder as bond yields fall

Governor of the Bank of Canada Tiff Macklem walks outside the Bank of Canada building in Ottawa, Ontario, Canada June 22, 2020. REUTERS/Blair Gable/File Photo

TORONTO, Dec 15 (Reuters) - The Bank of Canada likely faces a challenge in 2023 convincing markets not to expect a swift reversal in its interest rate hiking campaign, as the recent decline in bond yields already works to lower some domestic borrowing costs.

The central bank sets short-term interest rates but longer-term borrowing costs, such as for businesses and some mortgage rates, are determined by the bond market.

Canadian bond yields, like U.S. bond yields, have tumbled since October as investors anticipate that the tightening cycle is nearing an end and the central bank is poised to shift to cutting rates next year.

Bond yields, along with other measures, such as the strength of the stock market and the currency, help determine financial conditions, or the availability of funding in the economy. If they loosen, it could prevent activity from slowing enough to ease inflation pressures.

"To the extent that the markets start to anticipate the end of central bank hikes, and even the possibility of cuts, it makes the central banker's job that much more difficult," said Doug Porter, chief economist at BMO Capital Markets.

"If markets rally too much and are too healthy or too robust, it's going to be tougher to actually squeeze inflation out of the system."

The BoC says that the economy remains overheated despite evidence that tighter monetary policy has helped cool interest rate-sensitive sectors of the economy, such as housing.

Still, it has opened the door to moving to the sidelines at its next policy decision on Jan. 25, after raising rates at a record pace of 400 basis points in nine months to 4.25%, its highest level in nearly 15 years.

In contrast, the Federal Reserve on Wednesday said it would deliver more hikes next year.

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There are no signs yet that the housing market will roar back, but a potential peak in rates could help stabilize activity.

"Demand hasn't changed, people have just been sitting on the sidelines while this transition from ultra-low rates to the new rate equilibrium happens," said James Laird, co-founder of mortgage rate comparison site Ratehub.ca.

Its data shows that the lowest available fixed rate for five-year mortgages, the most common term in Canada, has fallen half a percentage point from its peak in November to roughly 4.70%.

Variable rates have continued to climb.

Money markets are pricing in a high point for the Bank of Canada's policy rate of 4.40% in March, with rates then expected to fall to roughly 3.9% by the end of 2023.

Since October, Canada's 5-year yield has tumbled nearly 100 basis points and the Toronto stock market (.GSPTSE) has rallied 11%.

The Canadian dollar has fallen nearly 7% against its U.S. counterpart since August and even further against some other G10 currencies, in a potential boost for exports.

Inflation eased to 6.9% in October after peaking at 8.1% in June but is likely to be more persistent than previously thought after spreading from goods prices to services and wages, where higher costs can become more entrenched.

Central bankers "should avoid doing anything that fans this market narrative" of rate increases soon reversing, said Derek Holt, head of capital markets economics at Scotiabank.

"Otherwise, we could be on an inflation and rates roller-coaster for years to come that is biased toward higher average inflation."

Reporting by Fergal Smith in Toronto and Steve Scherer in Ottawal; editing by Jonathan Oatis

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