Bank of Canada Preview: Full Steam Ahead

Earlier this year, we wrote that the Bank of Canada was in a race against time to lower interest rates ahead of the mortgage renewal wall. The further cooling of inflationary pressures and rise in the unemployment rate means that central bankers need to continue cutting rates at each of their fixed announcement dates at least until the policy rate returns to a more neutral range. While that won’t guarantee a soft landing with population growth set to slow, lenders tightening credit conditions and trade wars heating back up, it offers the best shot at avoiding unnecessary pain from mortgage renewals.

The Bank of Canada’s forecast for the economy looks too optimistic. In the July Monetary Policy Report, central bankers had projected a sharp rebound in economic activity in Q3, but early indications point to a more subdued pace of increase. Rate cuts aren’t providing much stimulus to the housing market yet. This comes as little surprise to us. The combination of still-high house prices and mortgage rates means that home ownership remains out of reach for many. Upsizing has also been restrained by those same forces. Falling interest rates haven’t spurred an acceleration in consumer spending either. So far, households remain cautious, with many set to face higher mortgage or rent payments.

As rates fall further, we do expect Canadians to become less tightfisted. Outside of the pandemic, the household savings rate of 7.2% in the second quarter was the highest since 1996. That leaves a buffer for some Canadians to make higher mortgage or rent payments out of their monthly incomes. Moreover, many households still have significant sums of cash saved in their bank accounts. That money has been earning high interest. To unlock that cash and avoid a recession, the question is: How rapidly does the Bank of Canada need to ease policy? As of right now, we see 25 bp rate cuts at each of the central bank’s next six decision dates, followed by a brief pause and then a continuation down to a trough of 2.25% by the end of 2025. While that was previously seen as a very dovish forecast, the risk now is that rates fall faster to that terminal level.

Overnight indexed swaps are pricing in only a very small probability that policymakers will need to reduce rates by 50 bps in October. Given that inflation has been all but tamed, we think there’s actually a somewhat more material chance that a 50-bp rate cut will be required before the end of the year. Standard 25-bp reductions are still our base case forecast, but we can’t ignore how much the discourse surrounding the economy and inflation have changed. Central bankers around the world are now more focused on stemming the deterioration in labour markets than they are on the last mile of the inflation fight.

The July monetary policy statement contended that officials were balancing the upside risks to inflation with the downside risks to the economy. The September communiqué should place more emphasis on the latter. The labour market has continued to deteriorate with stagnant hiring and still-rapid population growth leading to a rising unemployment rate.

The danger now is that the Bank of Canada falls behind the curve if policymakers remain too focused on the slightly above-target inflation. Following previous tightening cycles, central banks have often responded too late to signs of economic deterioration.  Achieving a soft landing in this cycle is an even taller order given Canada’s vulnerabilities and the headwinds it will be facing in quarters ahead. Policymakers will need to be alert and nimble to avoid repeating mistakes of the past.

We believe central bankers are attuned to the changing dynamics and will sound more dovish next week. As a result, we see some room for rate cut expectations to build both for the near-term and further out. The implied probability of a 50-bp cut in October should increase and the policy rate expected by the end of 2025 should fall from the current 2.75% closer to our long-held forecast of 2.25%. In short, we see more expeditious policy easing than the market is currently incorporating over that time horizon. The higher-for-longer narrative is dead and it’s full steam ahead for rate cuts.