It’s Starting to Smell like a Recession

There’s no need for provincial premiers to persuade the Bank of Canada to stop hiking. As we saw with the Q2 economic accounts, the data makes a compelling enough case. Not only did GDP growth miss the Bank of Canada’s forecast by a wide stretch, but it registered a 0.2% contraction, the second in the last three quarters. Worse, Q1 growth was downwardly revised from 3.1% to 2.6%. Ironically, the consensus had penciled in a 2.5% outcome ahead of that release. This is noteworthy, as the seemingly robust Q1 figure was a pivotal factor motivating the Bank’s decision to resume hikes in June.

So has the recession begun? It well may have, as once we factor the flat July flash estimate into our real-time GDP tracking, it points to another negative in Q3. And GDP wasn’t the only piece of bad news this week. The recent Canadian bank earnings reports were downbeat, and not just because banks are increasing their provisions for credit losses, hampering their ability to meet analyst expectations. Lenders are increasingly focusing on optimizing their spending. It’s no coincidence that within the finance and insurance sector, job vacancies dipped below their pre-pandemic averages in June, as per StatCan data released on Thursday. This is a trend worth monitoring, especially in Ontario and the Greater Toronto Area (GTA), where the financial industry has the biggest presence in Canada.

But the job market is also showing signs of weakness beyond the interest-sensitive financial industry. Economy-wide weekly Employment Insurance claims have surged by 34% since mid‑June (graph). Considering the strong growth in the working-age population, it’s reasonable to assume that the 0.5 percentage point increase in the jobless rate between May and July was just the beginning. This suggests that a Beveridge curve miracle – a phenomenon recently observed in the US where job vacancies were falling without a significant rise in the unemployment rate – might be elusive in Canada.

This leads us to the intriguing question of how the markets are currently pricing the Bank of Canada’s policy rate trajectory compared to the Federal Reserve’s. Somewhat overlooked through all the talk of “higher-for-longer” interest rates this summer is the fact that a “higher-for-longer” outcome is being discounted more aggressively in Canada than in the US. As of this writing, investors were anticipating US rate cuts starting in Q1 2024, while they didn’t expect the Bank of Canada to ease until mid‑2024.

This is noteworthy given Canada’s substantial exposure to mortgage rate renewals, an issue we have thoroughly analyzed, and which reappeared during the recent bank earnings season. Lenders reported another increase in the share of their mortgage portfolios featuring amortization periods exceeding 25 years. It’s almost unheard of for buyers to extend their amortizations in the US, where Canadian-style variable-rate mortgages are uncommon. This means that the impact of higher interest rates is primarily felt by potential borrowers in the US, who can still opt to avoid entering into an expensive mortgage arrangement.

By contrast, in Canada, the repercussions of higher rates also extend to existing borrowers, who can’t opt out of higher interest costs. In effect, a financial instrument once synonymous with promoting forced savings has now become associated with forced belt-tightening due to rising rates. That’s why we are seeing consumers start to buckle, with even services consumption coming in flat in Q2. And for the Bank of Canada, it’s a simple waiting game as the number of borrowers grappling with this situation continues to mount each month. The bottom line here is that there exists a noteworthy disparity in mortgage debt dynamics between Canada and the US, and markets may not be fully appreciating this distinction.

So where does this leave us ahead of Wednesday’s decision? Assuming that the Bank of Canada places greater emphasis on economic activity and employment trends rather than relying on lagged indicators like sticky core inflation and wages, it’s hard to justify pressing on with rate hikes. This is particularly true once we consider that the market has already tightened conditions significantly, as we can see from the 5‑year Canadian bond yield recently reaching its highest level since 2007.