The Canadian and US economies are tightly integrated, and tend to provide similar data for their central banks to move together. That’s no longer the case, as Canada’s economy grinds to a halt and inflation spirals back towards target. Meanwhile, the US economy continues to outperform expectations. Will economic divergence result in diverging monetary policy? At least one bank sees the Bank of Canada (BoC) cutting rates before the US Federal Reserve, as the two countries head on different paths. However, the market isn’t ready to commit to this call… yet.
Canadian Inflation Surprise May Drive Lower Fixed Rates
Canadian inflation came in much cooler than expected, helping to drive yields lower. Headline inflation was just 2.9% in January, trimming nearly half a point in a month. The BoC-preferred Core CPI, considered more stable than headline, even dropped 0.3 points over the month. The latter remains above an acceptable target range, but it’s heading in the right direction.
The decline is largely attributed to weak demand, the opposite issue seen in the US. American headline CPI remains at 3.9%, significantly above the Federal Reserve’s target rate. The country’s economy is heading in the opposite direction, leading to a divergence—at least into the short-term.
Cheaper Mortgages In Canada, More Expensive In The US
Canada is a relatively small economy and the US is its biggest trade partner. Consequently, the two countries tend to have economies that are tied very closely, including monetary policy. In fact, the BoC explicitly demonstrates this by using the US neutral policy rate as its own.
However, the market currently views the two countries heading in the opposite direction. “Canadian bond markets managed to buck the upward trend in yields this week, courtesy of a surprisingly friendly CPI reading,” wrote Douglas Porter, Chief Economist at BMO.
Porter’s observation indicates Canadian fixed rate mortgage interest costs are seeing pressure ease. Unlike in the US, where mortgage rates are heading in the opposite direction on the strength of its economy.
A divergence like this leads to the unusual consideration of what occurs when two tightly-linked economies move in the opposite direction.
“These diverging trends add to an ongoing debate since the possibility of rate cuts first came into view: Who would cut first, the Bank of Canada or the Fed?” rhetorically asks Porter.
Answering his own question, he continues “We have consistently leaned to the former, given the greater strain on the domestic economy from high rates, and a slightly cooler inflation backdrop. And the latest round of data supports that view, on both growth and inflation.”
Though Porter’s team is fairly certain, he explains the market isn’t fully sold on this idea. He estimates the market is pricing in 50-50 odds for a BoC rate cut in June.
“The lingering concern about early rate cuts in Canada is not so much about stoking a flaming equity market—no Nvidias in the TSX, sadly—but instead about fanning a simmering housing market,” he says.
