BeiChen Lin was surprised by Governor Macklem’s focus on inflation over growth, argues we still shouldn’t see a hike this year
The decision by the Bank of Canada (BoC) to hold its interest rate steady yesterday was greeted by an uptick in Canadian bond yields by between five or six basis point. It’s a move that BeiChen Lin, Director and Head of Canadian Investment Strategy at Russell Investments, attributes to the relatively hawkish tone struck by the BoC. He argues that the BoC’s primary focus on inflation, rather than risks to GDP growth brought on by new US tariffs, have markets viewing the BoC as more likely to hike than cut in the near future.
Despite the slight surprise he saw in the BoC’s hawkish tone, Lin believes that there are still a host of growth related headwinds that policymakers will continue to consider. In addition to the likely negative impacts on GDP growth brought about by US tariffs, he notes that Canada is still running in a negative output gap between one and two per cent, meaning there is slack in the economy. A rate hike in that situation would likely be even more damaging to growth, Lin says.
“We continue to expect that given the weak economic conditions in Canada at the moment and given the lingering uncertainty with respect to the trade scenario, we expect that the Bank of Canada will likely not raise interest rates for the remainder of this year, notwithstanding the hawkish tone that the Bank of Canada has taken today,” Lin says. “Of course, they’re going to remain data dependent, which means that if we do in fact get to a situation where inflation does start broadening out beyond just energy and gas prices, then at some point the BOC might be forced to respond. But if they are forced to respond while the economy is still weak, that means that any rate hikes they do make might need to be followed with and offset by steeper rate cuts down the road in order to restabilize economic growth.”
Why the BoC took a hawkish tone against supply-side inflation
The primary drivers of inflation at this point in time appear to be energy prices connected to the conflict in the Middle East and the looming onset of retaliatory tariffs on US imports. Both of those forces are distinctly supply-side, meaning monetary policy’s capacity for demand destruction shouldn’t have much of an impact in curtailing that sort of inflation. Despite that, the BoC has offered somewhat hawkish messaging around inflation. Lin says that is likely a product of the persistent nature of inflation since the end of the COVID-19 pandemic.
People, including policymakers, tend to draw on their most recent experiences and view new stimuli in the context of past events and Lin believes that the BoC’s tone is informed by their multi-year battle with inflation. He adds that unlike the US Federal Reserve, the BoC technically has only one mandate: controlling for inflation. However, Lin says that this hawkishness should be viewed in the context of the BoC’s core goal: anchoring medium-term inflation expectations around two per cent. Monthly inflation spikes will factor less into the BoC’s approach than what that medium-term expectation rests at.
What to watch to see what happens next
The BoC’s approach, Lin says, will remain data dependent. Given how uncertain the state of the Canadian economy appears to be right now, with the impact of tariffs on both growth and inflation still unknown, leading indicators of economic health may be instructive. Lin says that consumer spending data can offer some immediate insight. He contrasts studies of the Canadian consumer with their US counterparts, noting that while both face higher energy prices, Canadians are pulling back on other spending in a way that Americans are not.
Lin says that if we see continued deterioration in the volume of goods Canadians are buying, even if nominal dollars spent increase, then it would be a sign of greater weakness among Canadians and a need by the Bank of Canada to provide additional support. The labour market, he says, will also be an instructive metric.
What Canadian fixed income investors can do now
The BoC decision comes amid a global increase in developed market bond yields. While global bond yields tend to demonstrate relatively high correlations over time, Lin argues that there are core differences in Canada’s fiscal situation that should continue to make its bond market attractive. Notably, Canada carries a far lower government debt burden as a per centage of GDP than other developed markets, especially the United States. Lin expects that Canadian bonds ought to rest at yields around 50 basis points lower than their US equivalents, and that Canadian bonds should be looked at more favourably given the larger spread between Canadian and US yields we currently see.
While Lin believes there are risks in Canadian bonds, largely connected to either the global rise in yields or the chance the BoC does hike rates, he argues those risks are relatively low. The economic struggles Canada still faces should force the BoC into more accommodative policy, which should be good for bond investors. One of the keys to success, Lin says, is to look for active fixed income strategies that can weather volatility better than index strategies.
Amid all the fear and worry that tariffs, conflict, and bond market volatility can induce, Lin says that advisors should offer a balanced view to their clients, reminding them of the strength we see in many financial markets, especially equities, and how that strength has improved their overall financial wellbeing.
“I think one helpful approach would be for advisors to press the replay button, rewind the clock back to 2025, think about how much people were worried at the time,” Lin says. “And yet the TSX was up double digits. And not only that, it was actually one of the best performing markets in the developed market universe.”
