Bond markets might be over-anticipating recession risks in Canada versus the U.S., says investment strategist
For many businesses and consumers crushed under the weight of rising interest rates, the Bank of Canada’s recent indication of a pause in its tightening likely brought some measure of relief. But they shouldn’t breathe too easily either.
Coming up to Wednesday’s announcement, many observers were expecting one last hike from the central bank. That’s exactly what the BoC came out with, announcing a modest 25-basis point upward adjustment to 4.5%.
The central bank said it expected to hold the policy rate at that level, though it reserved the right to start hiking again as it watches out for risks in job numbers, inflation levels, China’s quick lifting of COVID-19 restrictions, and the continued uncertainty from Russia’s war on Ukraine, among other factors.
“The Bank of Canada has been quite consistent in saying that they would prefer to err conservatively and focus more on upside risks to inflation,” David Stonehouse, senior vice president and head of North American and Specialty Investments at AGF Investments, told Wealth Professional.
While policymakers aren’t projecting any dovish turns in the near term, Stonehouse says the market is anticipating two rate cuts by the end of 2023. That disjoint between investors and the BoC, he says, comes down to a tug-of-war in economic outlooks.
“Bond markets are starting to reflect the possibility of recession, and the Bank of Canada was fairly sober and clear about that risk,” Stonehouse says. “They expect the middle quarters of this year to result in GDP growth of either side of zero, and full-year growth of 0.5% to 1%.”
The BoC’s latest decision also comes almost a week ahead of the Federal Reserve’s first policy rate announcement for 2023. The U.S. central bank has clearly telegraphed that it’s likely to also hike by 25 basis points next week.
“I would expect that [the Fed] will leave the door wide open to the potential for another rate hike in March at their next meeting,” Stonehouse says. “They have not been nearly as close to signalling the potential of a near-term end to their hiking as the Bank of Canada has.”
The Canadian and U.S. economies have generally run on parallel economic tracks, but the two countries have begun to diverge in several important ways. To Stonehouse, the biggest differences lie in how extended consumers in Canada are, as well as the severe chill in the Canadian housing market.
“We've seen a more precipitous drop-off in activity and a somewhat faster and slightly larger decline in prices from the peak in Canada than we have in the U.S.,” Stonehouse says.
Given the weakness in the Canadian consumer’s balance sheet compared to the U.S., there’s an expectation for slower growth in 2023 in Canada, as well as a greater possibility of GDP touching recessionary levels. That gives the Fed a little more room to tighten compared to the BoC.
“The bond markets are reflecting that in the way of lower bond yields across the board in Canada than in the U.S.,” Stonehouse says. “The markets looked more similar in the first half of last year, but since then the Canadian bond market has really latched on to the notion of deteriorating economic prospects to a greater extent than the U.S. bond market.”
The weak outlook on Canada could change on a couple of wildcards. Greater-than-expected resilience in the resources sector, coupled with an uptick in global activity, could turn the economic tide. The considerable influence of immigration in Canada relative to the U.S., Stonehouse adds, could prop up housing demand at the margin as well as economic growth.
“That’s where I think the two bond markets could converge to some extent, and the market might be over-anticipating Canadian weakness relative to U.S. weakness in 2023,” Stonehouse says.