Dovish language and cuts offer respite for bond investors, but may be too late to prevent weakening consumers, economy
Yesterday’s 25 basis point cut by the Bank of Canada (BoC) came with some language and messaging that most would interpret as dovish. While the cut was well signalled and largely priced into the market ahead of the meeting, BoC Governor Tiff Macklem’s particular focus on the weakening Canadian consumer was a notable aspect of his press conference. This more dovish stance, focused more on downside risks than inflation, could set the stage for more cuts this year. Grant Connor, however, thinks that this whole cycle has come too late.
Grant Connor is vice president and portfolio manager at CI Global Asset Management, primarily covering the Canadian bond market. He accepts that central banks have a tough job to do, but says that per capita indices and the rapid weaking of Canadian consumers mean that Macklem should have begun his cuts earlier. He offered some insights into what the future outlook for cuts may be, what opportunities this opens up on the bond market, and how advisors should talk to clients in a weakening environment.
“It seems like there’s a big of a shift now, which you’d expect at the start of a rate cutting cycle. They’ve telegraphed that if the economy and inflation proceed as expected, expecting more cuts is very reasonable,” says Connor. “We’ve got slightly higher odds that we get two more cuts this year, I could also easily see them going three more. I think they should cut at each of their next meeting, whether they do or not will depend on the data.”
Connor says that his outlook even at the start of 2024 was that the Bank of Canada needed to adopt its dovish stance much sooner. He backs that up with per capita numbers that paint a dismal picture of the Canadian economy. While the policy report today notes an expectation that real GDP per capita will rise, Connor notes that they did not mention the fact that real GDP per capita is currently sitting at around the levels it was at in early 2017.
At the same time, inflation is up over 22 per cent. The poor retail sales report published recently, Connor says, is evidence of a consumer feeling the painful pinch of inflation and higher interest rates. The Bank of Canada’s own consumer surveys are finding elevated financial vulnerability among Canadians.
Canadian consumers are worried about missing their debt payments, they’re worried about the impact of both inflation and higher rates, they’re going to be on the lookout for the next twelve months as they pull back on spending. Canadians have a tough year ahead, as mortgage renewals from 2020 begin, taking a wrecking ball to monthly balance sheets. Connor notes that despite this pressure, the bank of Canada’s cuts so far have not resulted in the meaningful fall in mortgage rates that Macklem may want to see.
Connor accepts that the incentive structure for central banks results in more reactive than proactive decision making. Fear of re-igniting inflation with a cut will keep central bankers from cutting until they are sure the economy is slowing down. The trouble there is that a slowdown can turn into a recession rapidly. Moreover, in these circumstances the per-capita data may be more instructive than it otherwise would be, with the significant rates of immigration supporting business in the short term but contributing to that meaningful drop in per-capita GDP. As consumers weaken, Connor sees a set of growing headwinds for Canadian businesses that will compress their margins and could tip the country into recession.
Recessions are broadly bad news, but there could be more opportunity in the Canadian bond market as more cuts and more evidence of slowdowns come. Connor currently sees a particular opportunity in the middle of the yield curve, where you have some reactivity to cuts and short-term datapoints, without the volatility at the short end. If economic news gets more dire, the longer end of the curve should move higher in value as well.
Currently, the opportunity set looks better in the Canadian bond market than the US bond market, because of the relative weakness in the Canadian economy. However, as the US economy also shows more signs of a slowdown and the US Federal Reserve moves towards a cut, there may be a pivot point where US fixed income allocations offer more promise.
As advisors look for opportunities in the fixed income market, Connor says that they need to be offering appropriate context around this decision for their clients and preparing them for an economy that may be in a more challenging moment than we realize.
“As advisors are talking to clients, the things that I’ve seen that might make people miss things is that equity markets have generally done well, and the US market specifically,” Connor says. “We often see equity markets do really well before a recession, until it’s clear we’re going into that recession. I think the miss could be if you don’t have enough duration in your portfolio with core long-term bonds that will perform well and offer some protection.”
