Poor economy means Bank of Canada has to keep cutting rates

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“Overall, recent data suggest the economy is still operating in excess supply.” Bank of Canada press release, June 5, 2024

That is all anyone needs to know. The beauty is that the market is only priced for two Bank of Canada rate cuts between now and the end of the year. We think the central bank will be cutting at all four remaining meetings.

This is not really about “easing” per se, but rather removing the excess restraint. The Bank of Canada first openly discussed the fact that the Canadian economy morphed into a position of a disinflationary output gap at the April 10 meeting. Why it didn’t start the rate-cutting process back then is truly anyone’s guess — outside of a case of “once bitten, twice shy” because of the shame of missing “transitory” in 2021 and 2022.

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There’s no sense crying over spilled milk. In actuality, the Canadian economy moved into “excess supply” last summer, and yet governor Tiff Macklem and crew raised rates two more times, to five per cent from 4.5 per cent. That was a classic policy overshoot. Whenever the Canadian economy is in this state of “excess supply,” the policy rate typically is under three per cent, not at 4.75 per cent (where it is today).

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There are some pundits who believe that the Bank of Canada will end up re-igniting the housing market, but that is hardly going to be the case with mortgage credit availability drying up as banks record a ton of loan loss reserve provisions on their income statements.

The issue is that the supply of credit is subsiding at a far faster pace than the reduction we are seeing in the cost of credit, and the central bank has a long row to hoe to push interest rates down to a low enough level that can end up being described as stimulative.

It seems lost on those who believe the Bank of Canada is playing with fire that mortgage volume growth has completely evaporated over the past year — for the first time in nearly half a century.

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To reiterate, all the central bank is doing now is damage control, pure and simple. And while the governor kept his cards close to his chest when asked about the prospects of future rate cuts, the historical record shows that all central bankers sound hawkish or cautious after the first rate reduction. There is nothing new here. They simply don’t want the markets to front run them and price in an entire easing cycle the day of the first move.

And then there are others who think the Bank of Canada should be concerned about the fallout on the dollar. The thing is, a weaker loonie is (sadly) what the domestic economy needs right now, considering that industrial production (minus 1.6 per cent) and manufacturing employment are both negative on a year-over-year basis.

The production sector has virtually no pricing power at all, with core producer price index (PPI) inflation flirting near one per cent year over year. Prior periods of Bank of Canada policy divergence with the United States Federal Reserve saw the Canadian dollar beat a retreat to around 70 cents U.S. We are actually almost there, but the primary risk ahead is Canadian dollar weakness as the central bank continues to cut with the Fed dragging its heels.

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There are two developments worth considering as to why the Bank of Canada is justified in cutting rates with the Fed on hold. For one, there is no fiscal stimulus in Canada, but there is still a ton of it lingering stateside. Second, there are no 30-year fixed-rate mortgages in Canada; the economy here resets to higher interest rates much faster than is the case in the U.S.

There was nothing like the US$2-trillion stimulus checks handed out in 2021, as was the case under Bidenomics, a gift that has kept on giving to the U.S. energizer bunny consumer. And the proof of the pudding is in the eating, with the year-over-year trend in Canadian real gross domestic product (GDP) running at 0.5 per cent compared to nearly three per cent south of the border. And in contrast to the Bank of Canada, I doubt anyone at the Fed would be characterizing the U.S. economy as being in “excess supply.”

That is an enormous difference that justifies the Bank of Canada’s go-it-alone stance. But don’t worry: the Fed will be following this global trend towards policy rate cuts in September, once Jay Powell sets the table the month before at the Jackson Hole Symposium.

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The bottom line is that the Canadian economy is either in a recession or on the verge of slipping into one. The unemployment rate has climbed 140 basis points from the cycle low of 4.8 per cent to 6.2 per cent currently. Over the past six decades (and this covers five recessions), not once was a recession avoided with this sort of increase in the jobless rate from the trough.

To reiterate, the market is priced for only two cuts at the next four meetings. But consider this: the 6.2 per cent unemployment rate compares to 5.5 per cent just before COVID-19 entered our lives in early 2020. Back then, the CPIX, which is the most important core inflation rate since it excludes the eight most noisy and volatile components, was sitting at 1.8 per cent. Today, it is 1.65 per cent.

There was no “excess supply” going into 2020, but there is today — those are the Bank of Canada’s own words. Where was the policy rate in early 2020? Try 1.75 per cent.

It may not be a stretch at all to think that the central bank has a whole lot of work — as in pressing the rewind button — ahead of it. No matter how you slice it or dice it, rates are still far too high when benchmarked against where activity and inflation reside.

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Historically, the Bank of Canada has kept the policy rate roughly 50 basis points above the inflation rate. Using that as a benchmark, that means the policy rate should be closer to three per cent right now. And seeing as many measures of the core rate suggest we are on course for the two per cent midpoint of the range, I doubt this cycle ends before the overnight rate touches two per cent — and that actually is a conservative estimate.

And yet we have several Bay Street economists who believe the central bank should not have cut at all or that it is one-and-done. That truly is laughable.

So, what falls out of all this analysis?

• Look to the swaps market for maturities that do not have enough easing priced in.
• Trade around a steepening of the Government of Canada bond curve.
• Be long the Government of Canada bond market outright as the declining “cost of carry” acts as a gravitational pull for the entire curve. The best potential returns will be at the midpoint of the maturity spectrum.
• Trade the Canadian dollar from the short side, at least until the Fed begins to tilt away from its current “higher for longer” narrative.
• As for the stock market, have a barbell between industrials (weaker Canadian dollar) and utilities (lower yields).

David Rosenberg is founder and president of independent research firm Rosenberg Research & Associates Inc. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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