Retail Rates Are Already Coming Down and Policy Rates Will Follow

Economies around the world grappled with weakness in late 2023. In the fourth quarter, the eurozone saw its real GDP stagnate after falling in the previous three months, while the United Kingdom and Japan both recorded a second consecutive quarterly decline. The US economy is still faring the best, though its growth will likely slow in the beginning of 2024. Because of the widespread economic weakness, inflationary pressures are easing and central banks may be ready to start cutting key rates by early summer (graph 1).

Unsurprisingly, the Federal Reserve (Fed) kept interest rates unchanged at its meeting on March 20. The accompanying press release was practically the same as the previous one and the median estimate from Fed officials is still for three rate cuts this year. The latest data shows that the US economy remains resilient and that inflation may be a little stickier than expected. The Fed therefore has no need to signal imminent rate cuts. The first could come this summer, but the pace of subsequent cuts may be slower in the United States than elsewhere in the world.

Canadian real GDP was up 1.0% in the fourth quarter of 2023, significantly exceeding the Bank of Canada’s forecast. However, this result obscures a pullback in domestic demand as households continue to struggle under high interest rates. In 2023, real GDP only increased 1.1% while the population grew by 3.0%. Without a doubt, these are challenging times for the Canadian economy. Job creation has also struggled to keep pace with population growth over the past few months, and this is driving up unemployment (graph 2).

The Bank of Canada (BoC) refrained from sending definitive signals at its meeting on March 6. Stronger-than-expected growth at the end of last year gave the central bank reason to remain cautious. However, progress on inflation and signs that wage pressures may be easing boosted Governor Tiff Macklem’s confidence that “monetary policy is working largely as expected.” The latest inflation figures also surprised to the downside, which could open the door to an initial rate cut in June (graph 3). Weakness in the Canadian economy could then prompt the BoC to subsequently make multiple rate cuts.

Falling yields on long-term government bonds have already had a cooling effect on the interest rates offered on savings and loans at Canadian financial institutions (table 1). Stronger investor risk appetite is also making it cheaper for lenders to raise funds, pushing rates down further. That said, there are still risks for both the Canadian and global economies. Bond yields are expected to stay on a downward track, but if investors become more risk averse, financial institutions could prioritize accumulating deposits over credit growth, limiting how much retail rates come down in the coming months.

Changes in interest rate spreads continue to have a significant effect on exchange rate movements. And the various data that influence central bank decisions also tend to influence exchange rates. Inflation tops the list. In recent weeks, the fact that US inflation didn’t come down as much as expected temporarily buoyed the greenback, which remains fairly strong relative to historic levels (graph 4). Inflation was also more stubborn than expected in the eurozone, bolstering the euro in early March. Canada was one of the few countries where inflation surprised to the downside, and this momentarily weighed on the Canadian dollar. While it’s true that interest rate spreads between Canada and the United States have widened, the loonie is being lifted by rising prices for oil and other commodities. Low investor risk aversion is also helping many currencies.

We were interested to see how the yen would react to the recent monetary policy pivot in Japan. Despite the country’s first interest rate hike in many years, the yen depreciated, finishing comfortably above ¥150/$US. Since investors don’t expect to see multiple rate hikes in Japan, rate spreads with the United States continue to weigh heavily on the yen.

Changing expectations for monetary policy could still shake up the currency market in the short term. Currencies could weaken in the countries expected to cut interest rates more quickly. This could very well be the case for the Canadian dollar. Even though prices for oil and other commodities could edge up a little in the coming quarters, interest rate spreads will probably hold the loonie back and prevent it from pushing past US$0.75 (graph 5).

Financial market news has remained largely focused on enthusiasm for artificial intelligence technology and the spectacular performance of a handful of companies with high exposure to this sector. The S&P 500 and the Nasdaq are both heavily influenced by the tech sector and have soared in recent months thanks to its strength. In March, they surged even higher, especially after the Federal Reserve meeting (graph 6). However, as investors become more cautious about this high-flying sector, stock market returns may once again become sensitive to economic fundamentals.

Earnings expectations are up for companies on the S&P 500 thanks to the US’s unfettered economic growth and further signals from the Fed that rate cuts are coming. However, the improved outlook is mainly attributable to a few sectors (graph 7). Despite the information technology sector’s optimistic prospects, its average price-to-earnings ratio is now higher than the peak recorded during the pandemic. In addition, the tech sector’s weight in the S&P 500 is also at a record level of more than 30%. This poses a significant risk for the index’s overall returns.

Even though Canada’s S&P/TSX Index isn’t riding quite as high on the optimism surrounding the information technology sector, the tech craze has still given it a boost. The Canadian economy’s resilience and improved outlook also contributed to the Index’s performance. More stable oil and commodities prices could also push returns higher. With many risks still weighing on the Canadian economy, S&P/TSX valuations are much lower than those of its US counterpart. However, low valuations translate into attractive average dividend yields and better growth potential as interest rates fall. The Canadian markets will probably have to contend with more volatility throughout 2024, but the S&P/TSX could offer good returns if a deeper economic pullback is avoided and interest rates come down as expected.

Central banks around the world have been making changes. One notable case is the Bank of Japan, which has finally ended its negative interest rate policy. This could pose a risk for the Japanese stock market, which recently surpassed its peak from the 1980s. Higher interest rates in Japan could strengthen the yen and hurt the profitability of many Japanese companies (graph 8). So far, the Bank of Japan has reassured the markets that its monetary tightening measures will be limited. But the yen’s fate will be determined by changes in US interest rates over the next few quarters. In Europe, the Swiss National Bank opened the door to interest rate cuts. This makes sense considering that the country’s inflation rate has already been below 2% for a while. The Bank of England and the European Central Bank are maintaining a more cautious approach, much like the Fed and the Bank of Canada.

While it’s very likely that key interest rates will start to come down in 2024, bond yields may decline a lot more gradually. After two years of monetary tightening, the yield curve remains highly inverted, reflecting well anchored expectations of key rate cuts. The inverted yield curve should flatten and become positive again once inflation returns to target and the economy normalizes, which will limit the drop of long-term yields (graph 9). Unless growth is much slower than expected, bond market gains will remain constrained by the more gradual pace of declining yields.