Stability of economy would be challenged under a constrained environment
The inverted yield curve in Canada is warning that the Bank of Canada may hike interest rates to a point that sparks a recession. This puts the central bank in a difficult position as it attempts to control excessive inflation and orchestrate an economic soft landing.
The yield on the 10-year Canadian government bond has fallen 50 basis points below the two-year yield. According to Reuters statistics, that is the largest and deeper inversion of the Canadian yield curve going back to 1994, and more pronounced than the U.S. Inversion of the Treasury yield curve.
Since many Canadians took out large loans during the COVID-19 epidemic to participate in a booming housing market, the Canadian economy is expected to be particularly sensitive to higher interest rates.
Andrew Kelvin, chief Canada strategist at TD Securities, said: "It makes sense that we should see more of an inversion this cycle than we have in the last few just because there is so much more of a central bank overtightening component to this.
"That's what happens when central banks fall behind the curve," Kelvin added.
Along with many other central banks, the Bank of Canada maintained that inflation was "temporary" or "transitory" through the fall of 2021. It did not begin raising borrowing costs until March 2022, when inflation had grown to more than twice its 2% objective. June saw the fastest annual inflation rate in Canada since 1983 at 8.1%.
Investors have expressed concern that central banks throughout the world won't be able to reduce pricing pressures without sparking recessions. Earlier this month, the Bank of England predicted a protracted recession. The BoC has kept up its forecast that Canada will have a soft landing where the economy will slow but not enter a recession.
In its most recent policy decision in July, the Bank of Canada brought the benchmark lending rate up 1% to 2.50%, 225 basis points above its previous level of 0.25% in March.
Money markets decreased their bets that the Bank of Canada would raise interest rates by another three-quarters of a percentage point next month after U.S. data showed a softening of inflation pressures.
Despite this, the BoC's policy rate is anticipated to increase to a height of roughly 3.50% in the upcoming months, going over the top of the 2%-3% range that the central bank considers to be a neutral setting, or the level at which monetary policy is neither encouraging nor burdening the economy.
The constrictive environment is set to test the adaptability of Canada's economy, notably the property market, which has slowed drastically in recent months.
