Why the Bank of Canada might not cut again unless Canada falls into a recession
Two decisions from two central banks on two sides of the border mirrored each other somewhat on Wednesday, with both the Bank of Canada (BoC) and the US Federal Reserve (Fed) electing to cut interest rates by 25 basis points. Where they diverge, however, is in the place they’ve cut from and the overhanging concerns weighing on each central bank. The BoC has now cut rates to the low end of neutral, with further cuts likely stimulatory, despite inflation slightly above two per cent. The US Fed has cut amid a government shutdown that leaves key employment data unpublished and unknown.
For Soami Kohly, fixed income portfolio manager at MFS Investment Management, the pair of decisions point to potential weakness in the United States and the limits on Canadian central bank policy. Kohly highlighted the long-term trends of correlation between the two economies and how they might play out in a situation where monetary policy is still far apart between the US and Canada. He explained, too, how advisors can add appropriate context around these decisions and explain what they mean for Canadian investors.
“One of the biggest takeaways I had from the Fed was a change in the wording of their statement around unemployment, saying that ‘downside risks to employment rose in recent months,’ which suggests they may have access to some data on employment that we don’t right now. And why that matters in Canada is that, generally speaking, our labour markets move together,” Kohly says. “My interpretation of that wording is that you have weakness in employment in the US, which could spill over to Canada. At the same time the Bank of Canada is saying that there’s weakness in the economy, but it’s twofold.”
The BoC, Kohly explained, differentiated between cyclical and structural weakness in its monetary policy report. Cyclical weakness is the kind of issue that rate cuts and monetary policy can help deal with. Structural weakness, however, is more exposed to trade policy overhangs and the BoC’s own monetary policy report published Wednesday explained how little a central bank can do to actually address that issue. Kohly’s view, therefore, is that the BoC won’t cut interest rates again unless Canada falls into a recession.
Kohly describes the BoC’s position as challenging, noting that despite some growth overhangs, the bank has a single mandate of controlling inflation. Even if structural weakness is now a factor in the economy, the BoC has to stay focused on CPI, which does appear to stay somewhat higher.
“The most recent Canadian Survey of Consumer Expectations suggests a negative impact on consumer spending from high prices of goods and services and economic uncertainty, while firms’ investment expectations remain subdued amid a soft sales outlook, excess capacity, and limited ability to pass on higher costs,” said Kathrin Forrest, Equity Investment Director at Capital Group.
While Kohly sees challenges to any future BoC cuts, he thinks the Fed has plenty of room to cut. In part because they’re operating from a higher benchmark rate, but also because of the political pressure from the Trump administration to cut rates further. Moreover, Kohly sees the disconnect between the BoC and Fed benchmark rates as likely unsustainable in the long-term, agreeing that the likely reason the wide delta has not yet wreaked havoc on the Canadian dollar is largely a result of the secular decline in the USD that emerged from the onset of US global tariffs. He believes the economies remain highly correlated despite trade tensions and that US fed policy will gradually work its way down to a point within one per cent of BoC rates.
If Kohly’s prediction holds and the BoC can’t cut to undo structural weaknesses in the economy, then fiscal policy must play a role. Next week the Carney government will release its first budget since the election and Kohly expects a large deficit. He says, though, that not all spending will be unwelcome. Signs of productivity investment and capital expenditure may be greeted warmly, as would cuts or efficiencies on the operations side of government. He notes, too, that Canada has fiscal room to spend compared to our OECD peers, though he caveats that by saying it’s something of a ‘race to the bottom.’
Amid a cutting cycle underlined by softening economic conditions on both sides of the border, Kohly can see why some investors might feel concerned. He notes, though, the sheer quantity of macro shocks that markets have digested only to keep moving higher. For advisors and their clients, keeping that view in mind can help temper even the most pessimistic among us.
“you still overweight risk because long term you're going to outperform, but you don’t want to be at the full end of the risk spectrum,” Kohly says. “You want to sit with some risk, because we've been in this environment now for a while of high news flow, uncertainty in the market, tariffs going on, changing governments, both U.S. and Canada, and the equity market's gone up.”
