Have we hit the peak for inflation and central bank rates?

• Crude oil prices on the rise.
• Bank of Canada hits pause on its overnight lending rate.
• Canadian dollar not reflecting the price of oil.

A shorter trading week and rising bond yields had equity markets give up some gains from the week prior. Investors should be mindful that, since 1950, the S&P 500 Index has tended to have the lowest probability of a positive gain in September, compared to any other month of the year. At the time of writing, major equity exchanges in North America saw their indices contract this week. Given the strength of the equity markets year-to-date and throughout August, the volatility that we’ve seen so far in September is more the norm than the exception.

Oil prices gained for the week as U.S. crude stockpiles plunged by 6.3 million barrels to the lowest level since December last year. This drop is likely giving oil bulls more fuel to believe in a rally. The drawdown also coincided with the strongest export pace since July and reflects how little cushion is left in terms of supplies around the world. Gasoline stockpiles also fell, led by draws on the Gulf Coast, caused by a string of unplanned outages late last month.

After last week’s disappointing Canadian GDP data, it was no surprise that the Bank of Canada (BoC) decided to keep its overnight lending rate at 5%. In its statement, the BoC acknowledged weaker growth and justified it as a necessary consequence to “relieve price pressures”.  The BoC also made it quite clear that its inflation fight isn’t over, with wage growth remaining around 4% to 5%, and its concern regarding little “downward momentum in underlying inflation”. The next two CPI reports won’t make it easier on the BoC, as we will be rolling off a -0.3% and 0.1% month-over-month inflation print for last August and September, respectively. Any tick higher on the month-over-month pace in each of the next two months will push CPI above its current 3.3% year-over-year pace. 

The impact of central bank rates on mortgage interest costs (which are up 30.6% year-over-year) is contributing to higher shelter and debt servicing costs. When we remove mortgage interest costs from Canadian CPI, inflation sits at 2.6% as of July, which is within the BoC’s target range of 2% plus or minus one percentage point. The challenge for the BoC will be balancing its fight to lower inflation against the risk of pushing the Canadian economy into recession.

Looking at the Canadian versus the U.S. dollar, the loonie’s correlation to oil prices has broken down over the near term, leaving the two currencies tied mainly to interest rates. This suggests the Canadian and U.S. dollars are within fair value, based on the two-year government bond spread (as of writing, the current exchange is US$0.7311 versus the fair value calculated at US$0.7447). The near-term risk is to the downside, should market expectations price in future rate cuts by the BoC or further rate hikes by the U.S. Federal Reserve. Our view is that the current range of the Canadian dollar, based on a potential change in interest rates, is a downside risk to US$0.70 with an upside to US$0.75.

Listen to this week’s podcast for further insights.