Advisor outlines why he thinks the BoC is "between a rock and a hard place"
The Bank of Canada will make its first key interest rate decision of 2024 tomorrow. Investors and analysts have already priced in interest rate cuts from the BoC later in the year, perhaps as early as March or April. However, January has already presented mixed data around inflation and unemployment that could challenge those expectations. While most analysts predict the BoC will hold rates steady at this announcement, we may begin to see some indication of where Governor Tiff Macklem will take rates in the months to come.
“I think they’re stuck between a bit of a rock and a hard place right now,” says Josh Sheluk, portfolio manager at Verecan Capital Management. “It should be pretty simple for them because their sole mandate is to control inflation. If you believe that, then it seems the data is telling you very firmly that interest rates should not be cut. However, I’m not naïve enough to think that they don’t look at anything else aside from inflation. If you look at they broader economic picture, there’s definitely some shoots of weakness in there. On the one hand, they probably shouldn’t even be thinking about cutting yet. But, on the other hand, the economic weakness is probably nudging them a little bit more in that direction.
“I would expect that there’s no cuts [tomorrow], and I think that’s pretty firmly priced in at the moment, but I think there might be a little bit more stickiness in interest rates than the market is currently pricing in.”
The case for cuts largely comes down to the signs we’ve seen since the back half of last year: slowing GDP growth, weakening employment, and declining consumer and business sentiment on surveys. However, inflation remains stubbornly above 3 per cent — after falling from its 2022 highs relatively quickly — and wage growth has stayed high. While Sheluk says that January numbers alone shouldn’t shift expectations hugely, they’re part of a trend that points to inflation remaining higher and rates potentially remaining higher as well.
Central bank announcements typically come with a lot of language parsing and semantic analysis. Sheluk believes that investors and advisors need to look beyond that tendency somewhat. Often you’ll see announcements from the BoC or the US Federal Reserve that generate a huge volume of discourse around language choices, only to have the central bank walk back their language.
Rather than specific language choices, Sheluk thinks that we might be able to infer some direction from the datapoints the BoC chooses to highlight around CPI, employment, and GDP growth.
Markets have priced in a hold for this announcement and Sheluk agrees with that assessment. He also says it is more likely than not that the BoC begins to cut rates by June. However, he notes that some swap markets have priced in a 99% probability of a cut by June, which he thinks is too optimistic.
Given his outlook for the BoC, Sheluk and Verecan are adopting an asset allocation model that’s a little overweight bonds and underweight equities. Despite the mixed signals he and Verecan see economic weakness and the possibility of cuts this year. In that environment they expect bonds to do quite well.
Geographically their equity exposure is relatively evenly split between Canadian, US, and international markets. Tweaks to that allocation are more tied to specific valuation than any economic outlook. Their fixed income holdings are about half in Canada and half in global markets, which remains largely static over time. He does think a Canadian bond holding looks attractive given the relative weakness of the Canadian economy compared to the US and the likelihood of steeper cuts from the BoC to deal with that.
While tomorrow’s announcement will grab headlines and capture client interest, Sheluk advocates for caution and stability. Too much uncertainty remains on the market right now to declare the beginning of a cutting cycle, and advisors should focus on ensuring their clients are prepared for a range of eventualities.
“We would very much encourage our clients not to focus too much on this one interest rate announcement,” Sheluk says. “We can go back 12 months ago, at that time, the market was pricing in a high likelihood of recession and a high likelihood of cuts throughout 2023. And none of that came to fruition. For most of our clients, it's just about managing behaviour, keeping them on an even keel, and understanding that a lot of this stuff is unpredictable. And even the Bank of Canada doesn't know a ton about what's going to happen three months or six months from now. They're going to be reacting in real time just like the rest of us. So putting too much impetus on what they say is likely going to lead you down to some paths that could potentially lead to some wrong decisions.”
