Mackenzie's chief fixed income strategist outlines how markets greeted yesterday's CPI print and the likelihood of further Bank of Canada cuts
Inflation fell to more manageable levels in June. While still above the Bank of Canada’s target rate of two per cent, yesterday’s published June CPI data saw the topline inflation number drop to 2.7 per cent. Fixed income markets reacted immediately with yields falling over 20 basis points, spurred somewhat by the subdued sentiment in the business outlook survey published on Monday.
Dustin Ried explains that the fall in yields means markets are pricing in an 80-85 per cent likelihood that the Bank of Canada cuts interest rates after its July meeting next week. The chief fixed income strategist at Mackenzie Investments outlined why he now sees a cut as very likely, what that means for future cuts, and the opportunity set that falling inflation opens up for fixed income investors.
“The June numbers were a lot friendlier than the May numbers released last month, and I think it helps solidify the Bank of Canada going for back to back cuts in June and July,” Reid says. “The question now for myself and the market is, are they going to go back to back to back? Will it be June, July, and September cuts. I haven’t made my decision yet.”
Reid says that these tamer inflation numbers, as well as the negative sentiment in the business outlook survey, support a more favourable outlook for interest rate cuts. That would be further supported if the US Federal Reserve begins to cut interest rates in September, which markets have begun to price in a likelihood of.
Two areas may yet give the BoC pause before it embarks on another cut: the labour market and divergence from US Fed policy. Reid, however, does not think either factor should inhibit BoC Governor Tiff Macklem too much right now. While the labour market is still quite strong by historical standards, we are now seeing a meaningful uptick in Canadian unemployment, driven by both an increase in the labour supply and a downturn in demand. That should support another cut.
Divergence from Fed policy has been an area of some significant noise since the Bank of Canada elected to cut rates last month. Concerns have been raised about potential damage to the Canadian dollar as a result of that divergence. Reid, however, says that Macklem appears comfortable with as much as a roughly 1.05 per cent divergence from US policy, which should be positive for a cut.
The reaction on fixed income markets to the CPI print was broadly positive, Reid says, with Canadian duration outperforming US duration yesterday. He is broadly constructive on the North American duration trade, with the expectation that we are now at the start of a rate cutting cycle in both the US and Canada. He expects Canadian bonds to continue to do well vs their US counterparts, at least until the US begins its own cutting cycle.
Within that play, Reid sees better prospects on the shorter end of the yield curve simply because he has greater confidence in predicting where those rates will be in two years time. He sees the five year bond as indicative of cyclicality, that cuts may not come as quicky as some expect. 10-year bonds, he says, offer an interesting prospect but one that comes with more unknows — such as the likelihood of a Trump victory in the 2024 US election.
It's notable that while markets greeted the news of a 2.7 per cent inflation rate warmly, that rate is still well above the BoC’s target of two per cent. Reid believes, however, that inflation will likely rest structurally higher in the medium to long-term. Whether it rests in the 2.5-2.7 range or in the 2.1-2.3 range is still a question, but he expects higher inflation to continue. At the same time, he notes that slowdowns in the broader economy, the labour market, and weakening consumer and business sentiment should be enough to prompt further interest rate cuts.
Reid does not think that structurally higher inflation prevents the bank of Canada from cutting rates, but it may prevent and will delay a quick cutting cycle that brings us right back to a neutral interest rate.
As advisors try to make sense of this move for their clients, tempering expectations and outlining opportunities, Reid says that a focus on the outlook for further cuts, and the factors that could complicate them, can be a useful base for conversation.
“The Bank of Canada thinks that rates are restrictive, or at least somewhat restrictive. We’ve already seen one move and we are probably going to see another one or two moves this year,” Reid says. “The Bank is recognizing that rates may still need to be closer to neutral. The market is in the process of repricing what could happen. But rates in Canada don’t move in a vacuum, and the US story is going to be very important. Those looking for a big move lower in rates are going to be disappointed.”
