The central banks in the US and Canada both significantly increased interest rates over the last year, but more recently their paths are diverging. Canada’s inflation rate is lower than the US, and the Bank of Canada (BoC) expects to get core inflation to 3% by mid-year.
As expected, the BoC left the overnight rate unchanged at 4.5% last week. The economy has been evolving largely as the Bank has expected, and these economic factors support a conditional pause in interest rate hikes.
The employment report on Friday showed that the Canadian labour market remains strong with 22,000 new jobs added in February. The unemployment rate remained unchanged at 5.0%, and the participation rate held steady at 65.7%. While this data shows strength in the labour market, the Bank noted that it was expecting a softening in the labour market in its policy statement earlier in the week. While wage growth in February accelerated to 5.4% year-over-year, most of this was due to the impact of rehiring lower paid service workers during the post-COVID reopening in the previous year.
Meanwhile, in the US, Federal Reserve Chairman Jerome Powell’s testimony to Congress focused on the strength of recent economic data “which suggest that the ultimate level of interest rates is likely to be higher than previously anticipated.”
The markets reacted with the 2-10s spread widening to 100 basis points before narrowing to 90 basis points by the end of the week. This closely monitored figure – which is simply the difference between the 10-year US Treasury yield and the 2-year US Treasury yield – has historically been a strong indicator of a recession. The current 2-10s spread is the deepest inversion since 1981.
Equity markets were also in a risk-off mindset. The collapse of SVB Financial Group added to these concerns with the Dow posting the worst week since June. While there is still more data to come before the Fed’s March 21-22 meeting, the market’s expectation for a 50 basis point rate increase is still around 40% as of last Friday.
The turmoil that swept through the banking sector over the weekend has dramatically changed expectations about what the Fed might do. To prevent a panic, Federal regulators announced an emergency lending program to help provide cash to banks facing losses on their liquidity reserves because of the change in interest rates.
Both the Bank of Canada and the US Federal Reserve have been focused on tight labour markets as a source of wage pressure. The tightness of the labour market has been viewed as a sign of economic strength; our view is that it reflects constrained labour supply. Both in the US and Canada, an aging population has reduced labour participation. To eliminate wage pressure will not be easy. For Canada, our high level of immigration helps to mitigate this need by increasing the labour force. For the US, it is more likely that a recession may be the solution.
The employment report on Friday saw the US economy add 311,000 jobs in February. This was well ahead of the consensus forecast of 225,000. While the Job Openings and Labor Turnover Survey, or JOLTS, show the labor market was cooling in January, the continued imbalance between worker supply and demand persists, and the labor market remains tight.
The Bank of Canada is expecting economic growth to wane in the coming months as the impact of higher interest rates take hold. “With weak economic growth for the next couple of quarters, pressures in product and labour markets are expected to ease. This should moderate wage growth and also increase competitive pressures, making it more difficult for businesses to pass on higher costs to consumers.” The Bank reiterated its focus on price pass-through from the business sector in the Senior Deputy Governor’s speech the day after the Bank’s policy meeting.
Canadian consumers have high debt loads and the shorter-term nature of Canadian mortgages makes consumers more sensitive to higher rates. It is expected that most variable rate mortgage borrowers will have hit their trigger rate, which should lead to increased interest payments for these households.
Right now, the Fed’s policy goals are in conflict. The Fed is charged with a mandate of fostering stable inflation, and it is also responsible for maintaining the stability of the financial system. With uncertainty in the banking system, the expectation is that the Fed will move more cautiously. This could mean anywhere from a quarter point increase to a quarter point cut.
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