Two central banks face different economic circumstances, but share exposure to energy shocks
Each month at WP we take a deep dive into a topic highly relevant to Canadian financial advisors. This April we’re focusing on fixed income.
Both the Bank of Canada (BoC) and the US Federal Reserve (Fed) elected to hold their key interest rates steady yesterday, albeit with a 1.25 per cent delta between the two central bank rates. Each economy faces its own set of hurdles. The United States has shown strong GDP growth, decent jobs growth, and stubbornly sticky inflation. Canada has been in a much weaker place, at least in terms of GDP growth and its labour market. Canadian inflation had been brought below the BoC’s target of two per cent, until an energy shock sent CPI higher again.
Both central banks showed how they view the oil shock caused by the outbreak of the US-Israeli war with Iran. Energy shocks can be challenging for central banks, as they put upward pressure on inflation and downward pressure on economic growth. Both the BoC and the Fed highlighted the dual risks posed by this energy shock, while trying to forecast the path forward in rates in the face of different outcomes.
“That neither central bank is in a hurry to do anything. Right here, right now both are definitely acknowledging that headline inflation is going to move higher because of energy prices, but they’re trying to separate that from what they think is happening underneath the surface with inflation,” says Neil Shankar, Economist at CI Global Asset Management. “The takeaway is that both of the banks are just clearly in this wait and see mode amid this elevated uncertainty around the outlook.”
Are markets mispricing bonds?
The Bank of Canada, Shankar notes, was more explicit in calling out how the direction of energy prices might impact inflation. At the moment, they see the impacts as somewhat limited but said that if the conflict goes on longer, we may see more sustained inflation across other categories, which could necessitate interest rate increases. The BoC also highlighted downside risks to growth from US tariffs and CUSMA renegotiations in June, which could necessitate interest rate cuts.
That more even-handed view of this inflation spike, expressed to some degree by both the BoC and the Fed, runs contrary to some of the pricing seen in fixed income markets for both countries. Canadian bonds, in particular, saw as many as four interest rate hikes in 2026 priced in at one point. While those forecasts have come down, the expectation on markets remains that the BoC will hike at some point this year.
Rachel Siu, Managing Director and Head of Canadian Fixed Income Strategy at BlackRock argues that the market consensus of a BoC rate hike this year is incorrect.
“We continue to believe the BoC will maintain their data-dependent stance on future decisions, but our base case remains for the BoC to likely keep rates unchanged this year, assuming the move higher in energy prices does not lead to persistent second round inflation effects,” she said.
Shankar agrees with Siu, highlighting the BoC’s explicit statement that the economy is in a state of excess supply, which should keep this inflation spike somewhat contained. Moreover, he argues that bond markets have overstated the impact of the energy shock on core inflation and understates the risks to GDP growth and employment should CUSMA renegotiations flag or fail.
Fed independence and regime change
While Shankar saw many of the same narratives around war-induced inflation risks implied by the Fed, the overarching narrative for what was likely Jerome Powell’s final FOMC meeting as Fed Chair shifted quickly to Fed independence and his designated successor, Kevin Warsh, who was approved by the Senate Banking Committee on Wednesday.
Shankar highlighted that the FOMC decision came with four dissents, highly unusual for that body. He sees that as underscoring a growing internal disagreement around the path of interest rate policy. Despite those signs of disunity, Shankar doesn’t expect an immediate shift in the Fed’s reaction function. Governance by committee and consensus should keep the FOMC focused on underlying data when it comes to the future path of policy decisions.
When Warsh takes over at the Fed, Shankar says he’ll be watching for changes in the tone and framework coming out of that body. He’ll watch for further dissents from FOMC members and the potential that Warsh changes how the Fed frames US inflation. Shankar notes that Warsh will be able to control how much weight is placed on underlying or headline inflation and how broad economic uncertainty is communicated to markets, which can shape market pricing even if policy remains unchanged.
As markets react to narratives of an energy shock, Canadian growth risks, and Fed regime change Shankar believes that it’s advisors’ job to keep level heads.
“The key message for clients is, ‘don’t don’t overreact to headlines.’ Instead of focusing on headlines that highlight these big swings in energy prices or geopolitical developments that are so fast moving, it’s important to stay anchored to the underlying economic backdrop,” Shankar says. “Energy prices will continue to move inflation around for month to month. But central banks, bringing it back to the decisions today, are still going to focus on the underlying trends. And I think that’s ultimately what will determine the path for interest rates going forward. And that’s, I think, what advisors should keep clients anchored to.”
