The Bank of Canada is poised to cut interest rates again this year, but the central bank will begin to tighten rates before year-end, according to the Fixed Income and Foreign Exchange Outlook for 2004 prepared by TD Economics.

TD notes that the Bank of Canada has become less upbeat about the Canadian economic outlook, and has shifted into easing mode. It expects another quarter point reduction at the March 2 policy announcement date. “Financial markets are speculating that the easing cycle could continue beyond March. While such an outturn cannot be ruled out, we believe that the healthy state of the domestic economy, continued robust economic growth Stateside and higher commodity prices will likely convince the Bank to remain on hold throughout the spring and summer,” it says.

“And, while the current focus is on how much more easing could be in the pipeline, there is a distinct possibility of rate hikes before the end of the year,” TD argues. It notes that the Bank’s expectations for growth predict that the output gap to be “substantially closed” by the third quarter of 2005. “Given that monetary policy operates with a lag — and, given that the overnight rate should be at its neutral setting of roughly 4.75% when the output gap is closed — the implication is that the Bank will need to begin raising rates later this year.”

“Accordingly, we expect the Bank to deliver 50 basis points of rate hikes in the fourth quarter of 2004 and another 200 basis points of hikes over the course of 2005, such that the overnight rate is back at 4.75% by the Q4-05. While it is certainly possible that the Bank may wait beyond the fourth quarter of this year to launch this tightening cycle, this would be at odds with the Bank’s — and TD’s — forecasts for inflation and the output gap,” it says.

In the U.S., it predicts that the Fed is likely to have plenty of justification to start gradually rebalancing monetary policy by August. That is earlier than most observers currently expect, it allows. “Still, while the Fed could hold off until after the November presidential election or even until early 2005, such a delay is inconsistent with our forecasts for the performance of the U.S. economy — which, oddly, are not far off consensus.”

“In terms of bonds, the economic outlook suggests that U.S. yields will grind higher over the coming year. As strong economic growth reduces the slack in the U.S. economy, fixed-income markets will demand a modestly higher inflation premium. Supply pressures will also boost yields — the financial consequence of the record fiscal deficit,” it says.

TD says the rising yields on U.S. Treasuries will put upward pressure on Canadian bond yields. “However, the Bank of Canada’s expected rate cut in March, a further strengthening in the Canadian dollar and Canada’s more favourable fiscal balance will support a further narrowing in Canada-U.S. interest rate spreads.”

The bank also says that it expects to see considerable volatility in the currency, “with the exchange rate swinging in a range of 76 to 82 U.S. cents, but ending the year at close to 79 U.S. cents. ” The broad-based depreciation in the U.S. dollar is likely to remain a key theme in 2004, it predicts. “As a result, we expect the U.S. dollar to depreciate by just under 5% on a trade-weighted basis this year and next.”