What did the BoC's January announcement tell us about future cuts?

Decision to hold came with some dovish language, analysts diverge on what the Bank of Canada will do, or should do

What did the BoC's January announcement tell us about future cuts?

As many expected, the Bank of Canada elected to hold rates steady at 5 per cent in its announcement yesterday. The most optimistic analysts had predicted the central bank to begin cutting in March, while most agree that cuts will come sometime in the first half of 2024. Nevertheless, the nature of the meeting and the insights raised may help inform advisors as to where the BoC is going, and what key developments will finally give them the green light to cut.

“The language suggests they’re interested in easing. What comes through clearly is that their main concern is wage push inflation. They’re not allowed to say ‘what we really want to see is more unemployment, it’s impolitic to say that, but what we need is a slacker labour market so that wages stop rising,” says David Baskin, Chairman and President of Baskin Wealth Management. “In many ways, they’re on the edge between cautious and cowardly. If they had any b*lls, they’d be dropping interest rates because they recognize that the Canadian economy is not growing.”

Baskin cites the fact that shelter costs have become a significant contributor to CPI, which are directly tied to high interest rates. He notes that some of his developer clients have put a hold on their projects, despite owning the land and holding the permits, because they expect that half of their prospective clients won’t be able to get mortgages at todays’ rates.

Baskin says he would like to see the BoC begin to cut rates by 25 basis points per month until prime falls from the 7.20 per cent it's at today to 5.20 per cent by the end of the summer. He would rather see inflation at three per cent with some GDP growth than inflation fall to two per cent in a recession.

The fear of inflation expectations is keeping the BoC from cutting, in Baskin’s view. Ever since inflation expectations emerged as a driving force behind inflation in the 1970s, central bankers have been working to ensure they don’t foster those expectations. They therefore set a target rate of two per cent, and if they tolerate higher levels of inflation then they are fuelling those inflation expectations. The problem, in Baskin’s view, is that the cure is worse than the disease, leaving Canada with a housing crisis and an economy in recession.

While Baskin wants to see cuts sooner, he expects the BoC won’t act until the US Federal Reserve cuts rates. If they cut beforehand, that could place significant downside pressure on the Canadian dollar as money sloshes from short-term instruments in Canada into equivalents in the US. That would, in turn, import some inflation.

Stuart Morrow, Chief Investment Strategist at Morgan Stanley Wealth Management Canada, thinks that we won’t see any rate cuts until June. His base case is that the BoC holds for longer than most have predicted and yesterday’s announcements have not prompted him to change his outlook.

Morrow highlighted that both in the language around the announcement, and the subsequent press conference, BoC Governor Tiff Macklem highlighted their awareness of the shelter inflation component in CPI, while urging investors to look through that component. He believes that before we see a cut, Macklem will want to see meaningful change in CPI, employment, and wage growth. He will also want to be confident that any cut does not spur another spike in the Canadian housing market like we saw in January of last year. There has been some acknowledgement from the BoC up until this point that rate hikes have had their desired impact, nevertheless Morrow thinks the monetary policy report that’s published after the BoC’s April 1st meeting will indicate where and when cuts may go.

Morrow and Morgan Stanley have not revised their outlooks for rate cuts and therefore have made no changes to the asset allocation benchmarks they set in their 2024 outlook published late last year. While he expects cuts to come in June, Morrow describes the April and May BoC meetings as “live” meaning we could see cuts come at either date.

Baskin, for his part, had already increased his clients’ fixed income allocations in Q4 of 2023, in part because of the attractiveness of yield right now and the prospect of gains when cuts do come. Where his clients’ base portfolios were a roughly 80/20 split between equities and bonds, that allocation is closer to 70/30 or even 60/40 in the case of his older clients. He expects that overweight in bonds to remain until yields fall below three per cent again.

As advisors communicate with their clients and contextualize the BoC’s decision, Morrow believes they need to drive home the history of inflationary periods. While many clients may be chafing at the idea of a mortgage renewal under today’s rates, there is hope for cuts on the horizon, it’s simply a question of when they arrive.

“Past instances of not quelling inflation quickly have led to complications down the road, and the more inflation gets out of hand the rougher it is to rein in,” Morrow says. “Taking a little but of short-term pain may make the long-term a little bit rosier. I think it’s certainly tough to call the timing of rate cuts or when those are going to lead through the mortgage market. I still think it’s reasonable to assume the first rate cuts are in June, with the downside case somewhere in the third quarter.”