Canadian investors and borrowers are on the edge of their seats as they wait for Tiff Macklem and the Bank of Canada to finally cut interest rates after six consecutive pauses.
Will Canadian inflation finally take a break? “With almost all major measures of inflation now tucked just below 3%, short-term trends even softer, and the jobless rate above 6% and rising, the domestic case for rate cuts is strong,” said a note last week from Bank of Montreal chief economist Douglas Porter.
Canada Pulling Ahead of U.S. in Inflation Battle
The situation has left Macklem to reassure Canadians that the Bank of Canada can carve its own path to lower inflation as “the U.S. case is crumbling,” Porter said.
Under normal circumstances, higher interest rates are designed to slow spending in interest-rate-sensitive sectors like housing, which cools off the broader economy, explains Morningstar’s chief U.S. economist Preston Caldwell. Higher interest rates have translated into higher borrowing costs for consumers and businesses, he says, “Yet, the US economy proved more resilient to the impact of higher rates than expected in 2023. Housing activity fell sharply, but much of the rest of the economy has been unscathed.”
U.S. Housing Inflation Lever Not Working
Fed rate cut expectations continue to melt in the face of an amazingly resilient U.S. economy and highly uncooperative inflation, said Porter.
Disinflation in the U.S. housing market doesn't seem to be helping to cool inflation and U.S. homebuyers can “only wish the Fed was in more of a rush to reduce rates,” explained Bank of Montreal senior economist Sal Guatieri in a note. “A struggling housing market suggests restrictive monetary policy is working to cool demand—at least for the 4% of GDP tied to residential construction. But unless the remaining 96% of the economy loses resiliency, as we suspect it will, policy rates could stay high for longer,” he said.
Caldwell still sees the U.S. cutting interest rates this year and continuing for around two years: “We project the federal funds rate target range to fall from 5.25% to 5.50% currently to 4.00% to 4.25% by the end of 2024, to 2.50% to 2.75% by the end of 2025, and to 1.75% to 2.00% by the end of 2026, after which the Fed will be done cutting.”
Bank of Canada Interest Rate Probabilities
We can also assess the outlook for interest rates with tools to gauge market sentiment. One way to do that is by looking at assets often seen as hedges to higher interest rates. When interest rates rise, investors may seek out the relative stability of a guaranteed financial contract.
Watching the prices of common short-term investments known as “bankers’ acceptances,” where banks guarantee payment, is one way to gauge market sentiment around interest rates. In Canada, “BAX” contracts (which track the value of bankers' acceptances) trade on the Montreal Exchange and are used to produce implied short-term interest-rate movements and probabilities for Canada.
Canadian Interest Rate Cut Expectations
BAX prices can be volatile, as economic forecasts change frequently, but as of May 8th, the metric suggests Canada is still headed for a slow and steady decline in rates, which may reflect continued expectations of a soft landing for the Canadian economy. Specifically, the prices suggest there is:
- a 67% chance of a 0.25% drop in interest rates in Canada by June 2024,
- a 33% chance of a 0.50% drop by September 2024,
- a 61% chance of a 0.75% drop by March 2025, and
- a 59% chance of a 1.00% drop by September 2025.
Compared with our last interest-rate outlook based on BAX prices, Canada interest rate cuts still appear on the horizon, albeit a little further back yet again. Also, Canada appears to have widened its lead on the U.S. for interest rate cuts, according to the CME FedWatch tool, with only a 8.7% probability of a 0.25% interest rate cut by June as of May 8th.
Despite the drop in market sentiment around lower U.S. interest rates, Caldwell remains confident in cuts ahead: “Our long-term interest rate projections are driven more by secular trends than by the Fed. Instead, interest rates are determined by underlying currents in the economy, like aging demographics, slower productivity growth, and higher economic inequality,” he explains, “These forces have acted to push down interest rates in the United States and other major economies for decades, and they haven’t gone away. Regardless of what happens in the next few years, we expect interest rates to ultimately settle back down at the low levels prevailing before the pandemic. The low interest rate regime will resume once the dust settles from the pandemic’s economic volatility.”
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