Bank of Canada seen cutting interest rates faster as markets panic

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If you hadn’t heard of the Sahm Rule before, you’ve probably heard of it now.

Named after former Federal Reserve official Claudia Sahm, the rule holds that a recession is already underway if the unemployment rate’s three-month moving average rises half a percentage point from its low of the past year.

Friday that threshold was crossed — and everything changed.

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Coming on the heels of other weak economic data, the jump in the United States jobless rate to 4.3 per cent was the last straw,  and the market reaction has been swift and brutal.

Monday, while Canadian markets were shuttered for the holiday, the S&P 500 dropped three per cent in its worst day in nearly two years and Wall Street’s “fear gauge,” the VIX index, spiked the most on record.

Futures were climbing this morning as investors look for bargains, but analysts warn the respite may be temporary.

Weeks ago, markets were certain of a soft landing; now investors fear the Fed has waited too long to cut interest rates.

On Friday, the U.S. 10-year yield plunged 9.8 per cent from the week before. A drop this deep hasn’t happened since the global financial crisis, said Robert McLister, strategist with MortgageLogic.news. In fact such a drop has only happened three times since 1962 — and none of them were good.

Markets are now pricing in a strong chance of 1.25 percentage points of cuts from the Fed this year, when just a week ago the bets on that were about zero. Such is the panic, that at one point Monday the market was pricing in a 60 per cent chance of an emergency cut within the next week, said Bloomberg.

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All of this impacts Canada as well, and economists here are changing their forecasts.

“With the Fed expected to get a bit more forceful, this opens the door for the Bank [of Canada] to match its own dovish stance with faster action,” said Douglas Porter, chief economist of BMO Capital Markets, in a note to investors Friday.

BMO now expects cuts at each of the next four meetings, which would take the rate to 3.5 per cent by January. The cycle could wrap up by mid-2025 at 3 per cent, more than half a year earlier than expected, said Porter.

“We had warned that the risk was for sooner/faster, and a milder Fed certainly provides the cover for the bank to follow,” he said.

But just how valid are market fears.

On Friday, even the rule’s creator was skeptical.

“We are not in a recession now — contrary the historical signal from the Sahm rule — but the momentum is in that direction,” Claudia Sahm told CNBC. “A recession is not inevitable and there is substantial scope to reduce interest rates.”

Historically after the Sahm rule was triggered, equities performed poorly, safe havens gold and the U.S. dollar rose and commodities struggled, says National Bank of Canada.

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“Although interest rates are showing limited declines on a historical basis, it is important to note that the Fed had most of the time lowered interest rates before the Sahm rule was triggered in previous episodes,” it said.

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Canadian economist Harold Innis once described this country as “hewers of wood and drawers of water,” and recent data suggest natural resources still remains one of our strong suits.

The sector accounted for almost 13 per cent of nominal gross domestic product in 2022, the largest share since 2014, Statistics Canada reported last week.

Alberta contributed 38 per cent of it, 94 per cent of which came from the energy sector, said National Bank of Canada economist Stéfane Marion, who brings us today’s chart.

Exports of natural resources rose 34 per cent that year, reflecting the post-pandemic surge in demand and prices. Energy exports soared 53 per cent, minerals and mining, 18 per cent and forestry 14.5 per cent.