Expert explains why markets are pricing in a cut and what might happen if Macklem cuts or holds
It’s finally here. Tomorrow the Bank of Canada (BoC) will announce their key interest rate decision following what has been called the first “live” meeting of the year. While 2024 began with expectations for multiple interest rate cuts in both Canada and the US, stubborn inflation data and resilient GDP growth has prompted investors to revise their schedules further and further out. While the US Fed remains unlikely to cut at their upcoming meeting next week, markets are pricing in a high likelihood that the BoC cuts tomorrow.
Shailesh Kshatriya, director of investment strategies for North America at Russell Investments, explained why markets are now pricing in a roughly 80 per cent probability that the BoC cuts. He outlined the datapoints underpinning that likelihood and explained what could happen to markets if BoC Governor Tiff Macklem announces another hold. He explained that the likelihood of a cut has risen somewhat dramatically in just the past week.
“The market started last week with the probability around 60 per cent that the BoC would cut interest rates by 20 basis points. The market was holding the door open for the BoC if they chose. By the end of the week we were around 80 per cent,” Kshatriya says. “A big shift in terms of market probabilities. And it happened because of the soft-ish GDP numbers that we saw last week as well as a somewhat soft personal consumption expenditures (PCE) price index print from the US last week. Those had an impact on yields moving lower for the week, which can get worked into those probabilities.”
Kshatriya explains that this high probability of a cut brings Canada closer to what was expected somewhat earlier in the year. He says that Canada still has a roughly 50 per cent chance of slipping into a mild recession, in large part because the economy is more interest rate sensitive than its US counterpart.
If we do not get a cut tomorrow, Kshatriya expects that to come with a very dovish tone. He believes that if Macklem doesn’t drop rates by 25 basis points tomorrow, he will lay the groundwork for a cut at the July meeting.
One factor that some say has kept Macklem from cutting earlier, or at least signalling a cut earlier, has been the housing market. Given the state of housing affordability and shelter inflation, there are concerns that a telegraphed cut may reintroduce speculation and froth into the Canadian housing market and drive prices up higher. Kshatriya accepts that concern, but notes that the core issue is one of supply, and the BoC has no control over that. Moreover, while a cut may increase real estate prices, it will also serve to lower some of the inflationary pressure around shelter costs.
One area that may give the BoC pause, however, is wage inflation. While the BoC’s goal of “further and sustained” easing seems to be on course across most major datapoints and metrics, wage inflation remains elevated. However, there has been a relatively large spike in unemployment over the past year or so, rising from 5 per cent in 2023 to 6.1 per cent in 2024. Kshatriya believes that should provide enough cover for Macklem to cut.
If Macklem chooses to hold, Kshatriya says that the market reaction will be determined in large part by the language that accompanies a hold. While any hold would be greeted as hawkish at this point, if the language really sets the stage for a July cut, the market reaction may not be so severe. If they cut, too, the language will be key. The BoC may do what Kshatriya calls a “hawkish easing” where they cut but signal that cuts will be far fewer and shallower than the market expects.
“Language is going to be very important. The Bank of Canada has recently been using terms like “further and sustained easing” to gain confidence in a cut. How that language changes will be very important,” Kshatriya says. “I think their stress on data dependency will be there, but if that language starts to shift and signals that they are gaining confidence in the trends they’re seeing, that opens the door for perhaps more than the markets are pricing in right now.”
