Canada’s inflation rate increased to 2.9% in May, a higher reading than expected. Scott Colbourne, Managing Director and Head of Active Fixed Income with TD Asset Management, looks at the implications for the Bank of Canada’s interest rate strategy.
Transcript
Greg Bonnell: Canadian inflation came in hotter than expected for the month of May, and that’s clouding the picture for what the Bank of Canada might do next when it comes to interest rates. Joining us now to discuss is Scott Colbourne, Managing Director and Head of Active Fixed Income with TD Asset Management. Always great to have you on the program, Scott.
Scott Colbourne: Pleasure to be here, Greg.
Greg Bonnell: We’ve got some fresh data to go through. We know the Bank of Canada has been keeping their eyes on this one. Inflation, for several months, had been moving in the right direction. Now it moved off in the other direction. What do we make of it?
Scott Colbourne: Yeah, it was a negative surprise for the market. So short-end bonds have sold off. Canadian dollar was sort of mixed. And the markets have repriced what they expect for a July meeting. So, going into the inflation print, it was about, let’s just call it, 2/3rd of an odds of a cut in July. And we’ve moved it to maybe 1/3rd now.
So, it’s not zero odds for a July cut, but I think we are more balanced in the outlook. I mean, certainly, headline and core CPI at the upper end of that 1-3% band – the bank also looks at these sort of annualized numbers – three-month annualized, six-month annualized – and they were well below 1% going into this number. They popped up maybe 2%, 2.25%.
So, it’s not that it’s completely ruled out any possibility, but we need to see – July 16, I think, is the next CPI, and we have the meeting on July 24. So, there’s a possibility, if we get another good inflation print, that we see a cut. But right now, I think it’s reasonable that there’s lower odds.
But I think in the big scheme of the picture, the bond market hasn’t sort of repriced the destination of rates. It’s more the timing. And so, we moved it out a bit. And I know that it presents challenges for investors and maybe mortgage renewals and stuff like that. But at the end of the day, the bond market still believes that we’ll get to lower rates over the course of the next couple of years.
Greg Bonnell: Well, I looked at the details of today’s report, at services again – obviously, goods inflation was the big thing during the pandemic. Services take off after we were allowed to go out in the world and enjoy ourselves. But I guess there were worries in this rate cycle that the services inflation would prove to be sticky. Do we still have those concerns? Or we think, eventually, they’re going to start to run down as well?
Scott Colbourne: Everybody has that concern, right? We’ve had ECB, the Bank of Canada, the Swiss, Swedish – they’ve all thrown in one cut to start the process. Bank of England, I think we get it either September or November, and the same with the Fed.
And it’s the same trajectory. Growth has moderated on a global basis, specifics for each country. Inflation has moderated. But the path of easing that all these central banks are going to be following is dependent on service inflation.
We see it moving in the right direction. The labor markets are, broadly speaking, normalized – still healthy, but it’s on its way to more balanced. Wage growth is being more moderate. So, it’s this conditional focus on service inflation. And it’s a patient easing cycle and will be dependent on how sticky it is.
But, leading indicators of a lot of the sticky inflation components suggest a trajectory of, particularly on shelter, that is going to moderate. It’s just taking a little bit longer than expected. So, Canada is not unique to this. There was a feeling that we were exceptional and we’ve seen some massive outperformance in Canada. But I think this number sort of brings us and course-corrects us to the extent of outperformance relative to other central banks.
Greg Bonnell: The inflation report is, obviously, key in all this, because this has been the whole point of hiking rates so aggressively in the Western world – to try to tame inflation. We have seen it come off. But we look to the labor market, too. We look at the overall health of the economy. And I feel like in other parts of the Canadian economy, there might be a stronger case for cuts, you might be saying, especially on the economic side when you consider the robust growth in new Canadians. We’re not really keeping pace with jobs, or even economic growth, for that matter.
Scott Colbourne: Yeah, I would say that Canada, broadly speaking, has underperformed. And you saw that really evident in the data in the second half of 2023, right? We had almost zero growth and, on many, many measures it was pretty weak. The inflation data seemed to indicate that we were on a different trajectory than the rest of the world.
We’ve seen growth come back – some data surprises to the positive side, but centering in on lower growth, maybe 1.5% real growth for the balance of the year. So it’s that extent of underperformance relative to the rest of the world – massive underperformance, relative to the world, is sort of moderating. And that’s the unique position where we find ourselves as investors. Where are the opportunities for that going forward?
Greg Bonnell: You talked briefly about the bond market reaction. I want to get back to that, what this all means for the Canadian bond market. You get the disappointment today. Inflation is a little bit hotter. The destination does not change, just the path that we get there. How is the bond market sort of pricing that through?
Scott Colbourne: Yeah. At the short end of the market, today’s reaction was an adjustment higher in short-term yields – sort of in that 5-10 basis point higher in two-year yields today. So that’s the repricing in the very short term.
When you look at the path over the next 1, 2, 3 years, the destination of rates where we started at 5%, we cut to 4.75%, the market is saying over the next three years, the destination is probably between 3% and 3.25%
And that’s been relatively constant through the course of this year and last year. It’s just the path of where we ultimately get really is – what it says is that the terminal rate is higher, that we’re not going back to where we were through that sort of post-GFC environment with negative real rates and zero interest rates. We’re probably centering on 3% in Canada, 3.25%. Maybe in the States it’s 3.5-3.75%. So, we’ve got a new terminal rate.
The cost of money will be higher than what we’re used to, but we’re going to get there as the economies slow down. As the monetary policy feeds through, the fiscal policy impulse dampens a bit. And we’ll see what happens at the end of this year, because that may change everything here in terms of the narrative on inflation, fiscal impulse as well.
Greg Bonnell: Let’s jump to the end of the year then. What are you watching this, thinking if things could change?
Scott Colbourne: I think it’s very difficult to have an edge in terms of the election. We know it’s close. We’ve had some elections this year. We’ve had Mexico, and India, and South Africa in the emerging market world. And we’ve had the new election in France.
Greg Bonnell: No one was expecting –
Scott Colbourne: No one was expecting that. I would say that the reactions differed. But pundits would say, oh, it was priced into the market going in. In every case, no. And that’s my warning to investors is, don’t think it’s priced in. Be very careful in portfolio construction.
I have no edge. Most people don’t have any edge in terms of where the election is going to go. And we don’t know what policy is going to – we can handicap it now. We can think that it’s tariffs for Trump and fiscal for Biden, but we don’t know.
And that can really change the trajectory, the destination for interest rates, the term premium in the bond market. Those are all potential variables. So, it speaks to how much concentration you have in your portfolio and how to think that through.
Greg Bonnell: As we stopped raising rates in the Western world, and we had that long pause, obviously from a bond investor, one point of view they could take is, well, I’m getting the coupon and I’m waiting. I’m getting the coupon and I’m waiting. Still a bit of that story. We had the one cut already from the Bank of Canada as we await more.
Scott Colbourne: Yeah. When you look at the total returns this year in the Canadian bond market and the US bond market, you’ve gotten your coupon. And, to a certain extent, particularly in Canada, credit has really worked out nicely. Sort of a mixed picture on the interest rate, or the capital appreciation or price appreciation, and total return.
That’s OK. We’re in a world where we can get income, and that’s fine for fixed income. It’s just choosing which instrument do you want, how do you want to structure your fixed income, how much do you believe that you need some hedging vehicle in terms of more duration risk in your portfolio. Or do you want all credit? Or do you want very short-term interest rate instruments in your portfolio?
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