E40 – Framing the Bank of Canada

When we look at history as far as how the central banks behave, what we notice is when there's big common shocks that happen both in the positive and negative direction, policy cycles tend to be very aligned. And there's not a big common shock like COVID in and out, GFC, before and after, or tech bubble in 2001. When there's not these issues that are surrounding the market, whether it's a big economic event, or crisis or liquidity event, then you see the Bank of Canada willing to deviate from the Fed, and sometimes fairly meaningful. Hello everyone and welcome to the 40th episode of the Open Outcry podcast. I'm your host, Pippin' Rye. Here at BMO Global Asset Management. Now there's been some developments since our last episode a couple of weeks ago. In the US, we did get the June non-farm's print and that came in below expectations. And also, the April and May numbers were also revised lower. Now, of course, the focus for the Fed has shifted to inflation, especially in light of the last statement from newly minted Fed Chair Kevin Worsh. But our print to like last Friday's non-farm's number should be at least somewhat concerning for the dual mandate central bank. And at the very least, it implies that there's no need to rush into hiking rates at this point. Although we do still think that the nice move from the Federal Reserve is a hike. There's clearly no need to rush into things. And so far as the meeting later this month is concerned. Now, markets, specifically to the US Dollar Swaps market, is currently pricing at 18 beeps for the September FOMC at a full hike by October. Now, we will get our guests thoughts on that in a bit. In Canada, the April GDP number came in last week. And that came in a bit above expectations as well. The advance print for May suggested that the Canadian economy expanded modestly as well. Now, that leaves Q2 GDP tracking north of 2%. Of course, that is an improvement from the Q1 GDP number. But it still implies a bit of economic slack as well. In addition to that, earlier this week, we also received the updated business outlook and Canadian survey of consumer expectations. Both of those are very important inputs into the bank Canada's calibration process. Of note, near term inflation expectations did increase markedly. But most of the responses for these surveys were recorded just before the recent ceasefire between the US and Iran and Israel was announced. Elsewhere AI CapEx is obviously at the center of nearly every investment team out there. But there's also some degree of thanks with the amount of spend that's going into the space relative to forward looking demand. And as a result of that, we are seeing a bit of divergence in terms of how the different layers of AI are performing with hyper scalers, clearly under performing over the last couple of months, relative to upstream AI players. That includes, of course, chip and high bandwidth, memory, manufacturer. So a bit more of an active theme that's developing the AI space as opposed to the passive theme that we've all become accustomed to over the last couple of years. All that aside, we're here today to talk about Canada, cat rates, and also developments in the United States as well. And who better to bring back to the podcast than Jason Doff from RBC? And before we begin, happy birthday Jason. I understand it's your birthday today. So feel free to chime in with your thoughts, but also, you know, happy birthday. What's going to happen? Welcome to the show. Thanks a lot, Bipin. It's great to be back. You mentioned the 40th episode. I wish I had a forehand along my age still, but unfortunately, we passed that number. So again, great, great to be on and looking forward to your discussion. Let's start off very, very broad. I mean, I ran through a couple of the recent data, developmental points in Canada. I mean, what do you make of where we stand from a fundamental perspective in Canada? Yeah, it's a good question. I think the difficulty with assessing where the economy is right now is that we've had pretty choppy data over the past year. And it's really hard to read too much into some recent data prints. So yes, as you mentioned, Q2 GDP looks like it's tracking quite good, closer to 2%. The last labor market report was exceptionally strong. But the reality of the matter is from Q125 to Q126. The Canadian economy didn't grow at all. The GDP growth rate was zero. The good aspects where the consumer did good. Government spending investment was generally positive over that one year horizon. But other sectors were definitely lagging and contracting for the most part. So it does look like we're maybe on better footing right now. At least our expectations are, you know, we get GDP growth rates on a quarterly basis. Somewhere around 1.5% in Q2, Q3, and Q4. So hopefully that's the way it plays out. But it's been very difficult to get an accurate read of the economy. And again, the data has been very choppy. It really does feel like it's a muddled picture fundamentally speaking Canada. As far as the data is concerned. Now you mentioned, you know, 2% handle for Q2. And let's say we do get those, you know, 1.5%. I think I heard you correctly. For Q3 and Q4, you guys are expecting 1.5% quarterly annualized for Canada, is that right? Yeah, that's correct. Basically, what a round 1.5% plus minus Q2, Q3, and Q4. When are you as expecting a slack to be fully absorbed? That is that looking like a 2027 story? Well, I think when you think about the Bank of Canada, it's less important to assess when slack is absorbed versus when it's starting to be absorbed. So you don't have to get to a next-sense situation for the Bank of Canada to possibly hike interest rates. But I think if we did have quarterly growth rates around 1.5% that is starting to reduce the excess slack. And at least, directionally, that would be more consistent with rates going up at some point in the future rather than coming down. So, yeah, we have the Bank of Canada on hold in 2026. I think that probability is high and rising. The chances of them doing anything from a rate cut or rate hike standpoint. Those probabilities are very low and shrinking. And 2027 seems like a reasonable expectation as far as at least some adjustment style hikes coming into the system. If we are GDP north of 1%. Let's say. Let's talk about the Bank of Canada because obviously there is a meeting next week. Kathy Damper, we're recording this on Tuesday July 7th. You know, there's one more label for a survey print ahead of the next decision, which is on Wednesday July 15th. And I will expect in the bank to do much here. But within the MPR and the statement, is there anything in particular that you're looking for? I think in general, the Bank of Canada has played it kind of quite down the middle the last few meetings. And I don't think they necessarily want to rock the boat. But if we're looking for where there could be some surprises kind of in either direction, you know, even though Q2 is tracking, you know, reasonably well given some of the problems we've had over the past year or some of the volatility and the data, it's still unclear whether we're on a sustainable growth rate going forward. So if there's any risk, it's probably for growth numbers to come down a little bit for 2026 in the MPR and even possibly given where oil prices are now and everything seeming a little bit more quiet on the Middle East front that maybe inflation forecasts come down a little bit. So there could be a little bit of a dovish undertone from that angle. But then on the other side, you know, they may mention maybe not in the MPR, maybe in the press conference. They may mention something about the currency. It is quite weak or they probably get questions about it from the press corps. I would say that, you know, historically, they've talked about it. They've mentioned it. The market is generally overreacted to that or given it too much importance versus what it's actually been worth for policy decisions. But if there's anything that comes out more on the hockey side, it would be the currency being weak and maybe that adding a little bit to inflation pressures going forward. Now, outside of the currency, let's say, and outside of inflation because obviously those are two very important factors and to interrelated to an extent. Now, what are the data points do you think matter for the bank account at this point? I mean, are we talking jobs, wages, housing? What else are they looking at to get a fully formed picture of the economy or its headed? I think if they're looking at everything, to be honest, the labor market is going to be a critical input, I would say, in the sense that we've been in this low hiring, low firing type of job market, low break even, low trend, employment. But that's still allowed the consumer to do okay over the past year. As long as we're not getting layoffs happening, then the chance of the bank account of cutting interest rates, I think, is pretty low. And then it's holistically what's happening with the growth picture. If we are getting to a sustainable growth rate above 1%, then that's going to be something that they're going to be interested in. And yes, inflation expectations, as long as those are benign and they're not worried about any second round or fee-to-effects happening from either commodities or just growth in the economy, it does give them a long runway before they need to, before they need to act. We know that the USMCA is going to feature prominently in next week's communications from the bank. I mean, can you remind our listeners what sets stake here and what the correct framing of the eZ upcoming talks should be. Just thinking about it from the standpoint of how the Bank of Canada has been looking at it over the past few months, they've said that if there were more tariffs, more trade disruptions, then they may need to cut interest rates. That's not what's happened, right? We're in the status quo type of an environment, so that's not a sufficient trigger for them to do anything. I think it was their expectation, it was widely believed in the market, political circles, that July 1st was never going to be met, right? There was no way that Trump, the US administration was going to sign on to the current deal. So, we're left in a situation where, for the economy, it's very status quo versus what we've seen for the past three months, for the past six months. I wouldn't expect any more unilateral tariffs on Canada, maybe not even any global tariffs that the US puts in place that would tangentially affect the Canadian economy. So, we're left in a situation where, yes, it's still a period of uncertainty. The US is going to try to extract concessions from both Canada and Mexico. I think that was widely expected, but at least in our opinion, how talks or, I guess, flare-ups publicly have been pretty minimal in general, and generally what the US is asking for, that there does seem like there is a path to a solution, whether that comes before midterms, open question, it's maybe in Trump's best interest for that to happen before then. Maybe it's a longer time horizon, but it does seem like there is a path. And I think it's really important to understand how the US administration has been behaving over the past year. And I think the situation in the Middle East really kind of highlights it where you can have small wins that get characterized as big wins. And as long as Canada and Mexico are willing to give something, then that does seem like there is a path to a good outcome occurring over some unknown time horizon. After investing, just got easier with our BMO SPDR or SPIDER select sector index ETFs. For the first time in Canada, investors can access all 11 sectors of the S&P 500, available in both hedged and un- hedged versions, empowering investors to cost effectively gain or reduce US dollar exposure. To learn more about sector ETFs and access additional resources, visit our website at BMOGAM.com. How does the Canadian Business Secretary act just something like this? I mean, obviously, you don't want to be in a situation where we're reviewing things on an annual basis. And it feels like that's one of the risks that we're up against. Right? I mean, it sounds like you're veering towards something more comprehensive that'll last a while so that we're not in that scenario where we're constantly reviewing or constantly having annual reviews of the trade agreement. Is that the right framing of your looking at things? Yeah, I think the eventual outcome is that there is a revised deal that is then extended for another 16 years. I don't see us in annual reviews all the way to 2036. Your Trump is going to strike a deal, claim a victory, or absolute worst-case scenario. Once Trump's term ends, I think it would be a pretty low bar to getting something done with either the Democrats or the Republicans in the US because it does seem like there's widespread appetite in political circles in the US for there to be a solution or a resolution. And this is more of maybe a Trump thing rather than a broader political issue. It is debatable how much this has caused problems for the Canadian economy and I'll give two examples. One, the labor market, trade-related employment, so manufacturing, wholesale, and transportation. There's not been a layoffs over the past year. That employment growth has been zero. It has lagged the broader economy. So there's been an impact, but maybe not that significant. And second, business investment in Canada on a real basis has been zero for the past year. It's been zero for the past three years and has been zero for the past 10 years. So some of this goes beyond just trade uncertainty. So I'm not sure that a resolution necessarily just unlocks a whole bunch of animal spirits necessarily. Let's play the hypothetical. Let's say we're in a situation where we don't have a comprehensive agreement. We have annual reviews, let's say, up until 2036. What does that look like from the bank cannabis perspective? Are they entertaining the notion of more cuts in that environment? All else equal? Maybe, but it's going to depend on a lot of other factors. I don't think that that in itself would be a reason for them to cut because I think as we progress over time, you will start to see export diversification that does start to limit the damage a little bit. Switching gears a little bit, let's talk about the US in particular. What's your take on the Fed from here? I mean, clearly the focus is now on inflation, but what's RBC thinking in terms of what the Federal Reserve will do over the course of 2026 and 2027? Yeah, like right now and for the past couple of months, our view has been there on hold. It's a low conviction view, obviously given what Worsh and the Fed said, you know, kind of at the last meeting, but that does seem like the most likely scenario. And yes, there has been a number of F.R.O.M.C. members that have their dots pointing to a hike. And the data will have to be realized for that to kind of occur, but at least right now, we're still comfortable with the Fed being on hold. If they did start to move, then we may be willing to kind of change our view on where we think Terminal is going to be. But there is a lot of moving parts. How the labor market is going to play out is the who's from AI going to continue to last. Are there going to be enough inflation pressures for them to be worried about? Obviously, those are going to come off the boil a little bit next week, given oil prices have come down. So there still is a lot of patience, but the challenge with the Fed and their new communication strategy is markets are not going to be able to fully price policy outcomes leading into meetings. It's more volatility. It'll be much more like what we see in Canada, right? The market could be probably 60 percent and the bank of Canada could do either. You know, right? All of a sudden, it's going to make for a much more interesting Fed-watching experience going forward. Let's switch gears again. Let's talk about markets and how you're reading your interpreting things right now. So from a cross-market perspective, I mean, CAD rates have outperformed the US for most of this year. In fact, if not all of this year. I mean, we're close to extreme levels in terms of two-year and ten-year spreads. First question, what's behind this move? And I guess the follow-up to that is, do you think this is structural? What's behind the move? Well, the vast majority of the move has been the big shift in Fed pricing, right? So we go back to before the war on February 26th, the market was pricing around 50 basis points of rate cuts over a one-year horizon. Now it's pricing 1.5, 35, 40 basis points of hikes over the next six months. So there's been a dramatic shift in expectations related to the Fed. The bank of Canada side rates have gone up a little bit versus where they were pre-war, but they haven't matched what's happened in the US. So the vast majority of the delta that we've seen in the cross-market spread, as you mentioned, has come from the US leg rather than specifically the Canada leg. So over the next one to three months, more from a tactical standpoint, there's probably more room for government of Canada bonds to outperformed the US. And that's spread that even go a little bit more negative from where it currently is. That could happen from some negative data surprises. That could happen from inflation coming off to boil a little bit. That could happen from just generally the Fed expectations coming down a little bit. Because ultimately, the market's pricing around 50 basis points, 60 basis points of rate hikes in Canada over the next year, and at least based on current fundamentals, inflation and growth, that seems a bit too high. So there is still room for there to be more adjustments in Canada further out the curve on a relative basis over the next little while. Now when we go beyond the next one to three months, let's say, if, and it's a big F, if we get to this above trend growth phase in Canada for the remainder of the year, then the stage is set for the B.O.C. to move in 2027. So if there is any O performance now, I think there's a reversal of that closer to the third quarter, fourth quarter of this year. And I think you touched on, you know, a very important point as far as is there something structural going on? There's a great article from the St. Louis Fed from earlier this year that looked at GDP growth in the US in the first three quarters of 2025. And on their assessment, AI was responsible for around 40% of your US growth. That's a big number. So there is structural things going on. The US is the tip of the sphere in AI. They're seeing it from a growth perspective. Canada, we're not necessarily seeing it. I always like to say that the US is the tip of the sphere and we get more of the echo effect of that. So then, I mean, extending on that thought, is there a chance that the bank Canada will deviate from the Fed? It doesn't have to mean, you know, having diametrically opposed paths for each country's policy rate, but could this be a situation where the both central banks be hiking, is just the Fed is going out a much faster clip than the bank Canada's. I'll answer that in two ways. One, given the starting point of where the US policy rate is versus Canada, the US is obviously at a much higher rate. The chance of the Fed raising rates significantly more than Canada, like let's say two or three hundred basis points in the B.O.C. only does a hundred. That's maybe, you know, unlikely. It's not impossible, but does seem a bit unlikely. Is there a possibility that we're wrong? And the Fed embarks on a adjustment style hiking cycle of 50 hundred, maybe even more. And the bank Canada does nothing. Yes, there's a possibility for that also. When we look at history as far as how the central banks behave, what we notice is when there's big common shocks that happen, both in the positive and negative direction, policy cycles tend to be very aligned, like COVID, in and out, GFC, before and after, tech bubble in 2001. When there's not these issues that are surrounding the market, whether it's a big economic event or crisis or liquidity event, then you see the bank of Canada willing to deviate from the Fed and sometimes, you know, fairly meaningful, right? Some examples were in 2003 we were raising interest rates. The Fed was cutting. Then the Fed went on hold and we started cutting in them. We both central banks started raising interest rates for multiple years. In 2010, Bank of Canada raised interest rates. The Fed was on hold. 2015, Bank of Canada lowered interest rates. Fed was on hold that basically zero bound. And then the experience of COVID, you know, in and out, the Bank of Canada was an early mover in both of those cases and really wasn't taking a cue from what the Fed was doing to decide what to do with monetary policy. So they will rely on fundamentals domestically. If there is a big shock, then stuff becomes aligned, but other than that, they can deviate. 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Well, I think when you think about the yield curve, there's a lot of factors people like to talk about as far as supply, term premium, you know, different things as far as how auctions are growing, so on and so forth. When you boil it down, you know, the main reason that yield curves move is because of what's happening with front end interest rates. Right? And, you know, the US curve flattened a lot, as you mentioned, for a couple of months and flattened significantly and outflattened a lot of countries around the world because there was this adjustment that was happening in Fed pricing. The yield curve in Canada was pretty unchanged, you know, during that same period. And then as you mentioned, yes, you had a little bit of steepening recently. The steepening recently, that's being more driven by the front end. It's also been a reversal in a big move that we had post-fed meeting last time in the long end. So I think it is a little hard to read into it right now, especially, you know, we're now into the summer, you know, liquidity's lower, positioning sizes by clients is lower, conviction levels are lower. It seems like most people have resigned themselves now that we are into the summer period, into a low volatility period, where carry trades are attractive. And in that environment is the front end in most markets. And when you translate that into a curve trade, steepeners are positive carry. So I think it's really hard to read from a fundamental standpoint. I think it's people positioning, you know, as we get into summer. If you could express only one ratio for today, whether it be duration curve or relative value for both Canada and the US, what would you like to go with? Well, I think in the US, from a directional perspective for duration, we're back, you know, kind of close to the highs that we've had in 10 year bond yields around 450, close to the highs we've had in 30 year bond yields around 5%. So I think at these levels, you are at attractive yields that if you're looking for an investment over a six or 12 month horizon, that there's probably more likelihood that yields in the 10 to 30 year sector in the US or at least stable or come down rather than go up significantly from here. And can I'll take a bit more of a shorter term, you know, kind of aspect to, you know, how markets could behave over the next three months. I think the front end of the yield curve in Canada probably offers good risk rewards, stuff like the two year bond yield, for instance. It has good carry characteristics. There's probably still room for the market to chip away at what's priced in for the BLC to year end for rate hikes and even a little bit for 2027 over the next couple of months. And just given the positive carry in these structures, it does, you know, allow a good risk return profile over a few months period. Is there any place you're seeing a large disconnect between how investors are positioned and the underlying fundamentals? Not necessarily at the moment. Like you look at a lot of markets around the world, places like Europe, the UK, the large rate hikes, expectations that were built into the market a couple months ago, those of now come off and it looks at more of a realistic point. The Fed, possibly raising interest rates, you know, that's hard to argue against right now. I think there's less justification to even say that it's 50/50 that the Bank of Canada will raise interest rates by the end of the year. So maybe there's a little bit of disconnect in the Canadian market and I think that's a result of where the market's pricing the Fed. You know, it was a situation where the market was pricing no hikes for the Fed. Then I don't think we'd be pricing any chance of a BLC hike this year and we might actually be pricing a small probability of cuts. So there is a bit of a misalignment. I would say in the front end of the Canada curve versus fundamentals that we see right now and that's being influenced by the US market. Forecast time, let me do you have your forecast. Andy, if ready you? Jay? Putting me on the spot with forecast, you know, just to be kept on forecast reporting for, you know, austerity. Yeah, listen, it's always difficult. I would say that you know, based on our forecast on a buff trend, you know, that the market probably pivots a little bit more strongly to 2027 hikes by the Bank of Canada as we get closer to the end of this year. We have the two year yield in Canada 310 and the 10 year yield at 360. So a little bit higher they are now not significantly, but directionally, I think there's a greater chance between now and year end that they're higher rather than more for the US. I mean, for context today, we're sitting here, the two year yield is at 415 basis points and the 10 year yield is at 452 basis points. What do you see both by December 31st to 2026? Yeah, so we see the two year relatively unchanged from where it is now and the 10 year yield a little bit lower and the reason that we see it a little bit lower, so we see the 10 year at 435 is because our base case is still that the feds on hold this year. Some US rates outperformance relative to Canada sounds like it's the play from our BC then. I think over a six to 12 month rise in the Nesta Wright trade, maybe not the next one, the two months, but I think beyond that, the stage is probably something that I guess. Thank you so very much, Jay, for joining us today. We covered a lot of topics here, not just talking about Canadian fundamentals, but also talking about the direction of travel for both the Bank of Canada and the Federal Reserve. Also, what to watch for with respect to the USMCA and also in terms of how to frame it from a market's perspective. So thank you so very much, and happy birthday again. We'll love to have you back on some time soon. Thank you everyone. Thank you to RBCs Jason Dough for joining BIPIN on the Open Outcry podcast, presented by BMO Global Asset Management. For additional commentary and insights, check out BMO's ETF Center at BMO eTS.com. That's BMO, ETFs.com. The viewpoints expressed by the portfolio managers represent their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. 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