With Inflation at 2.0%, Canada Can Now Pick Up the Pace of Interest Rate Cuts

The United States saw strong economic growth during the first half of the year, but recent indicators have been a little less encouraging. Meanwhile, the latest data suggests that the outlook is improving in other parts of the world, particularly in Europe and Japan. It also seems that the labour market slowdown is more pronounced in North America, as other leading economies have only recorded a slow rise in unemployment (graph 1). That said, problems persist in Germany, where the manufacturing sector continues to struggle, and in China, where economic woes remain widespread. In addition, inflation is proving to be more stubborn overseas, and stickiness in the eurozone could give the European Central Bank reason to maintain its cautious stance.

Leading up to the US Federal Reserve (Fed) meeting on September 18, opinions among investors and forecasters were divided on just how big of a rate cut was on the way. In the end, the central bank decided to go big. The decision wasn't a sign of panic and shouldn't be interpreted that way. Rather, it was an acknowledgement that the US may have waited a little too long to start its easing cycle. Plus, the Fed clearly doesn't plan on maintaining this pace. Its officials expect the federal funds rate to come down by another half point before the end of 2024, which is consistent with two more 25‑basis‑point cuts. Since US inflation eased to 2.5% in August, the Fed now seems more concerned about jobs than price stability.

After remaining stubbornly above target for more than three years, Canada's inflation rate finally fell back to 2.0% in August. Efforts to stabilize inflation didn't significantly affect economic growth, as real GDP continued its upward climb in the second quarter, growing at an annualized rate of 2.1%. But Canadian households seem to have paid the price. The job market weakened abruptly under strong population growth and unemployment edged up, reaching 6.6% in August. At the same time, elevated interest rates pushed the household debt service ratio to record highs (graph 2). And for many Canadians, the pain will likely get worse in the coming months as mortgages taken out at ultra‑low rates during the pandemic come up for renewal. 

Now that inflation is back on target and the job market is seemingly more balanced, it's becoming increasingly difficult for the Bank of Canada (BoC) to justify maintaining a restrictive monetary policy. Even though the policy rate has already been trimmed three times, it's still at 4.25%, which is substantially higher than what's considered to be the neutral rate. For this reason, we believe the Bank may follow in the Fed's footsteps and announce a 50‑basis‑point cut in October. This would speed up the move to the neutral rate, which is estimated to be between 2.25% and 3.25%. Once neutrality is in sight, the BoC could see reason to tap the brakes and ease its way to the lower bounds of the range with smaller adjustments.

Anyone hoping for a dramatic drop in retail rates may be disappointed. Based on our observations, 5‑year fixed mortgage rates have already fallen more than  170 basis points compared to their recent peak. In fact, they could even start edging back up in 2025 as the outlook for the Canadian economy improves. Variable rates will come down in proportion to policy rate cuts. But given their significantly higher starting point, variable rates probably won't end more than 50 points lower than the current 5‑year fixed rate even when the policy rate reaches its anticipated low of 2.25% (graph 3). The reason is simple: since the BoC's policy rate cuts have been widely anticipated, the reductions have already been priced into fixed mortgage rates. 

Not too long ago, the US's robust economy and sticky inflation seemed to suggest that the Fed would diverge from most other central banks by holding back on interest rate cuts. But the situation is changing, to the detriment of the US dollar (graph 4).

The US dollar doesn't typically gain strength when the economy is doing well. In fact, it tends to thrive in times of economic uncertainty thanks to its reputation as a safe haven currency. But investors will likely feel reassured by the Fed's decision to cut interest rates in hopes of reducing recessionary risks.

If the United States succeeds in avoiding a recession, that would be good news for Canada and the Canadian dollar. But the Canadian economy can still expect to face significant headwinds brought on by slower population growth and mortgage renewals that remain costly despite falling interest rates. These reasons have tempered our optimism for the Canadian economy and will likely hold back the Canadian dollar's potential to appreciate.

Rising commodity prices could also help the loonie, as could narrower interest rate spreads with the United States. While the loonie is currently trading at CAN$1.36/US$, we expect the exchange rate to settle around CAN$1.33/US$ next year (graph 5).

Things Are Looking Up for European Currencies and the Yen

Conditions may remain favourable for European currencies and the yen over the short term. Since inflation is proving to be persistent across Europe, central banks in the region can't keep pace with monetary easing in the United States and Canada, though this is likely to change in 2025.

The contrast is even starker in Japan, where the central bank has finally started raising interest rates after leaving them unchanged throughout 2022 and 2023. This should continue to buoy the yen.

The markets often experience a chill in September, and the trend proved true once again this year just after Labour Day. But then summer weather made comeback in Eastern Canada and the global markets warmed in the days that followed (graph 6). The Fed meeting initially sparked a negative reaction, but this was followed by a major bump the next day. This indicates that investors aren't sure what to think about the current situation. On the one hand, investors are optimistic because it looks like a soft landing is possible for the US economy. But on the other hand, they're acutely aware that a soft landing is crucial for justifying the current valuations of S&P 500 stocks. And any gains driven by anticipated rate cuts may have already peaked.

We've been concerned about S&P 500 company stock valuations for months. In many cases, the ratios reflect the anticipated productivity gains and exponential growth prospects for companies that develop and adopt artificial intelligence. But if we look beyond the high‑tech sectors, nine of the eleven S&P 500 industrial sectors now have high average price‑to‑earnings ratios compared to their historical values (graph 7). Sure, artificial intelligence could spur productivity gains in a number of sectors, but until these gains translate into improved corporate earnings, it makes sense to take current valuations with a grain of salt. 

The S&P/TSX has performed well recently, pushing its 2024 gains up to nearly 13.0%. Canada may be facing economic challenges, but this weakness has already been priced into Canadian stock valuations. Plus, things are looking up for Canadian stocks now that inflation is back on target and the key interest rate is coming down quickly. Not only do lower interest rates help stimulate the Canadian economy, but they also make dividend payouts more attractive—and S&P/TSX companies already offer relatively high dividends. The opening of the Trans Mountain pipeline (TMX) also seems to have shielded the Canadian energy sector from losses related to falling oil prices (graph 8). 

Unlike its counterparts in North America, the European Central Bank can't yet justify a faster pace of rate cuts. That said, the economy seems to be picking up across the eurozone after several difficult quarters in 2022 and 2023. European corporate earnings expectations have also improved recently. And since the ECB's monetary policy is now less restrictive than before, there's reason to be relatively optimistic about Europe's outlook for 2025. Meanwhile, Asian markets are still facing higher risks. This is especially true in Japan, where the central bank is expected to continue with monetary tightening. However, the outlook for the economy and corporate earnings is good.

Long‑term bond yields shrunk in early September, reflecting increased recessionary fears. Yields then improved after the Fed announced that it would be cutting interest rates by 50 basis points, as this decision reassured investors about the economy. This suggests the stock markets are now less sensitive to bond yields and more attentive to the economic outlook. As a result, the correlation between stock and bond returns is back to negative (graph 9). And since investor expectations have already priced in a series of interest rate cuts, attention could remain focused on economic forecasts for the next few months. The negative correlation between these asset classes could therefore be around for a while yet.