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Interest rate swaps have gone from pricing in two rate cuts by the Bank of Canada before the end of the year, to pricing in another rate hike in July and no rate cuts until 2024. That would bring the bank’s benchmark rate to 4.75 per cent.Sean Kilpatrick/The Canadian Press

Financial markets have upped their bets on additional rate hikes from the Bank of Canada and U.S. Federal Reserve following blowout employment reports in both countries and higher-than-expected inflation data from the United States.

This amounts to a U-turn for bond traders and investors, who spent much of January and early February doubting the resolve of central bankers in both countries to keep interest rates at highly restrictive levels through 2023.

Interest rate swaps, which capture market expectations about future rate decisions, have gone from pricing in two rate cuts by the Bank of Canada before the end of the year, to pricing in another rate hike in July and no rate cuts until 2024. That would bring the bank’s benchmark rate to 4.75 per cent.

In the U.S., markets now see the Fed increasing its benchmark interest rate to a peak of 5.25 per cent by July, a quarter-point higher than expected two weeks ago.

Bond yields in both countries have moved sharply higher since the start of the month. They leapt again on Tuesday after the publication of the U.S. Consumer Price Index report for January, which showed price pressures easing, but not as much as anticipated.

The annual rate of CPI growth edged down to 6.4 per cent from 6.5 per cent in December. That’s well off the four-decade high of 9.1 per cent reached last June, but still more than three times the Fed’s target.

The shift in market sentiment brings market participants more in line with central bankers, who have maintained a hawkish tone about inflation even as they near the end of their rate-hike cycle. At the same time, some analysts think that markets may have swung too far in a hawkish direction, particularly in Canada.

“Two weeks ago the market was convinced the BoC would not hike in 2023 but is now pricing a full hike by July. This seems like an over-reaction based on the current information set,” Jason Daw, Royal Bank of Canada’s head of North American rate strategy, said in an e-mail.

“It is not unreasonable for the market to price a higher probability of a hike after the Canada employment report, but pricing in a full hike with the current information at hand seems like an overreaction.”

Ken Fisher: Rate hikes or none, investors needn’t sweat the Bank of Canada

After raising its benchmark interest rate to 4.5 per cent last month, the Bank of Canada announced a “conditional pause” to interest rate hikes, making it the first major central bank to signal an end to monetary policy tightening.

Bank of Canada Governor Tiff Macklem did not rule out future rate hikes entirely. But he said he would need to see an “accumulation of evidence” that inflation was proving stickier than expected, and the economy more resilient, before hiking again.

The January employment report from Statistics Canada, published last Friday, certainly added to the argument for future rate hikes. Canadian employers added 150,000 positions last month, and the unemployment rate held steady at 5 per cent – clear signs that the labour market remains tight despite repeated interest rate hikes and warnings of an impending recession.

But this single piece of data is probably not enough, by itself, to push the Bank of Canada toward further rate hikes, said Taylor Schleich, director of economics and strategy at National Bank Financial.

“Market pricing, [it’s] not taking seriously the notion that there’s a higher bar to hike now,” he said.

Mr. Macklem is unlikely to provide much guidance. Central bankers typically don’t comment on market pricing, although Mr. Macklem did push back slightly earlier this month when markets were pricing in rate cuts in 2023.

“I’m not going to validate market expectations or … try to disabuse you of them. What I will say is those market expectations move around quite a bit as data come out,” he said.

Mr. Schleich echoed this, noting that markets will likely remain volatile as long as the outlook for inflation remains uncertain.

“Things can change very quickly,” he said. “So, it wouldn’t surprise me at all if, you know, you got some weaker data, and then all of a sudden we swing back to pricing [in] cuts again.”

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