The week in the markets -
March 10, 2023

There’s a fork in the road ahead

The Bank of Canada (BoC) left its benchmark overnight rate unchanged at 4.5%, pausing its year-long campaign of raising borrowing costs to slow down the hot economy. The Governor of the Bank of Canada (BoC), Tiff Macklem, said in January that inflation would slow to about 3% by mid-year and potentially reach 2% in 2024. He also expects near-zero growth for the first three quarters of 2023. The current pause is conditional on economic growth and inflation slowing in line with the bank’s January forecast, and the bank is “prepared to increase the policy rate further if needed.”

The U.S. Federal Reserve chair Jerome Powell reaffirmed its position that the federal funds rate could be pushed higher in a couple of weeks, at the next rate decision meeting. Unemployment slightly increased to 3.6%, but non-farm payrolls rose by 311,000, much more than the expected 225,000. The Fed is expected to raise its overnight benchmark rate, which is bad news for Canada.

Divergence in central bank policy rates puts the Bank of Canada in a very difficult position

If we see a divergence between the U.S. and Canadian central banks in terms of rate policy, Tiff Macklem will have a tough decision to make. He’ll have one of two options open to him:

Door number one: Increase the BoC overnight rate, to keep up with the U.S. Federal Reserve interest rate policy, but this would slow the economy down further. This option would be difficult for Canadian consumers, as more of their income would be diverted to debt repayments. Canadians, compared to other developed nations, already have high balances on revolving credit and mega-sized mortgages. The household debt-to-gross-income ratio was at 182.4% as of September 2022, the highest in 20 years. Canadians take second spot in the G20 with the highest debt-to-income ratio, only two percentage points behind the Netherlands.

Door number two: Maintain the lower rate in Canada, which will drive the loonie down. A less valuable loonie would drive inflation higher. Goods and services bought by Canadians from U.S. suppliers (think your newest cell phone or favourite bottle of wine from California), end up costing the Canadian consumer more, leading to higher inflation.

The Bank of Canada insists that the rate hikes appear to be working, with the economy growing at a very slow pace in the last month. Consumption, government expenses and net exports were increasing, while inventory was keeping the gross domestic product (GDP) down. This is in line with our view that we’re in an earnings recession, an inventory recession and a real estate recession, while jobs could remain strong.