Chief Investment Strategist breaks down common motivations and diverging paths forward for central banks
On another central bank double feature Wednesday, both the Bank of Canada (BoC) and US Federal Reserve (Fed) elected to cut interest rates by 25 basis points. While the BoC cut from a neutral rate and the Fed cut from a more restrictive position, both decisions were motivated by the same core factor according to Philip Petursson.
Petursson, Chief Investment Strategist at IG Wealth Management, cited deterioration in the labour markets of both Canada and the United States as core motivations for the cut decisions. He weighed in on what the future path of interest rates might be for both countries, where that leaves incentives for the asset mix in Canadian securities and how threats to Fed independence might impact bond market reactions to this and possible future US rate cuts.
“They're both cutting because we've seen a softening of the labour market, both in Canada and the United States. I think that is really the connection between the two moves,” Petursson says. “Over the last year, the Bank of Canada has moved further than the Fed, and the Fed had been hesitant. Nut now it seems that they're somewhat on the same path, even though that the Fed is still going to be above the BOC in terms of the absolute level of rates and probably the terminal rate.”
The BoC’s unwritten mandate
Labour weakness is an explicit motivator for the Fed to cut, because of their dual mandate to maintain price stability and employment. The BoC, however, is only explicitly mandated to deal with inflation. Petursson, however, argues that the BoC has an unwritten mandate to help ensure a healthy backdrop for the Canadian economy. He cites BoC Governor Tiff Macklem’s own comments following Wednesday’s decision that while monetary policy can’t directly impact trade policy, a policy chance can potentially support businesses negatively impacted by tariffs.
Given the BoC was already resting at a neutral rate of 2.75 per cent before the 25 basis point cut, Petursson believes that this will not mark the start of a sustained easing cycle in Canada. There might be cause for one more 25 basis point cut this year, but Petursson believes the BoC will remain data dependent. Inflation, in his view, may not be that big of a factor going forward, but jobs and GDP growth will weigh on the potential for that final cut.
Petursson notes that the BoC might not be under as much economic pressure as headlines might make it appear. GDP growth was negative in Q2, but tariffs played a significant role in that downturn as they did in the unexpectedly high positive growth rate seen in Q1. Jobs numbers in July and August were weak, but using his team’s preferred metric of a rolling 12-month average, Petursson notes that Canada is averaging 17,000 jobs created. That may be the lowest number post-COVID, but it's not yet disaster territory. The BoC, therefore, may not have to shift into an overly accommodative state right away.
From an asset allocation perspective, Petursson notes that beyond the bump in bond prices a cut will bring, Canadian fixed income is now offering returns in the mid-single digits. That may not be overly attractive and coupled with long-term positive tailwinds for equities from cheaper capital, these cuts could see the Canadian asset mix appear more favourable for equities.
A US easing cycle under political clouds
Petursson believes that the Fed’s cut represents the start of a more sustained easing cycle for the United States. He caveats that by noting the terminal rate for the Fed might end up higher than Canada’s, but nevertheless it appears that the Fed is willing to move steadily out of restrictive territory. He expects quarter-point cuts over the next three to five Fed meetings.
Overhanging this and future Fed decisions is the apparent willingness of the Trump administration to interfere politically in the Fed. As seen in the attempted firing of Governor Lisa Cook and the appointment of governors who explicitly favour faster rate cuts. In assessing the role of politics in future rate cuts, Petursson believes bond investors will assess what the Fed is doing, what Fed policy rates should be in accordance with economic data, and what noise is coming from the administration. If the Fed cuts deeper than 3 to 3.5 per cent, then Petursson believes bond investors will react by pushing long-term yields higher and steepening the yield curve.
There are potential threats to the data informing US Fed policy, too, following the firing of the Bureau of Labour Statistics Chief, Erika McEntarfer. Petursson notes that analysts can safeguard their own decisions by cross-referencing datapoints from various independent sources.
For advisors seeking to make sense of both central bank decisions for their clients, Petursson notes that some care should be taken around language. Cuts can sometimes come with the tone of a real growth scare, but weakness in the labour market and 25 basis point cuts are not necessarily reason to panic.
“Weakness in the labour market doesn't mean that we're in or headed towards a recession, and we don't believe that we are headed there at this point in time,” Petursson says. “These are cuts to perhaps balance out economic growth, balance out what we're seeing in the economy, and we see them as a positive, not a negative. This will contribute to corporate profitability in terms of lower cost of capital.”
