Portfolio considerations as the Bank of Canada cuts rates first

Wesley Blight

June 6, 2024

Key takeaways

The Bank of Canada cut the target for the overnight interest rate to 4.75%
Canadian economic growth resumes after stalling in 2023 and inflation continues to slow
As additional rate cuts are likely, it’s reasonable to expect a further decline in the Canadian dollar and a boost for bonds with higher interest rate sensitivity

For the first time in over four years, the Bank of Canada (BoC) cut interest rates by 0.25%, bringing the target for the overnight rate to 4.75%. The Bank also confirmed that it would continue to normalize its balance sheet by not replacing maturing Government of Canada bonds that it holds. While widely anticipated, the decision to cut rates was not a sure bet.

BoC: Policy no longer needs to be as restrictive

Global economic growth of 3% in the first quarter was in line with the Bank’s April estimates. In Canada, first quarter growth of 1.7% was slightly behind. Canadian inflation continued to ease in April and three-month measures of core inflation suggests ongoing downward momentum. According to the BoC, “monetary policy no longer needs to be as restrictive” because “recent data has increased our confidence that inflation will continue to move towards the 2% target.”

Canada is the first G7 economy to cut rates, what does this mean?

While the BoC decision leads the pack, we expect similar policy easing is on the horizon for other central banks. The strength of the resilient U.S. economy is unique and, while we expect other central banks to follow Canada’s lead, the U.S. Federal Reserve does not face the same requirement to cut rates in the next few months.

From a Canadian equity and fixed income perspective, the cut provides a positive boost and is consistent with the soft-landing scenario (where the economy transitions from growth to slow- or no-growth, avoiding a recession) most were expecting.

However, with Canadian policy makers cutting rates before their American peers, we may see the Canadian dollar come under additional pressure. Already trailing other major currencies, with the exception of the Japanese Yen, a widening rate differential may add fuel to this fire. We appreciate the impact foreign exchange will have, albeit indirectly, on future policy decisions by the BoC.

Additional easing is coming, but U.S. monetary policy will be a limiting factor

We anticipate additional rate reductions from the Bank in the coming months, with a rate of 4.25% being our base case for year-end 2024. This view is supported by weakened economic growth, inflation falling in line with the Bank’s own projections, and a labour market where job gains aren’t keeping pace with labour force growth.

Further cuts are likely in 2025 as the monetary policy rate is repositioned toward neutral (estimated by the BoC to be in the range of 2.25-to-3.25%). However, the pace of these cuts will be increasingly influenced by policy decisions from the U.S. Federal Reserve. All eyes are now on the Federal Open Market Committee for further policy guidance.

Opportunities in the current environment

We’ve maintained our overall neutral view on equities, with a preference for North American equities relative to international and emerging market counterparts. Canada’s ranking in our analysis is improving due to better macro conditions and its position as the rate cut first mover. The U.S. remains remarkably resilient and relatively sheltered from Chinese and European weakness. It continues to benefit from artificial intelligence, cloud computing and energy transformation tailwinds.

With an expectation that cuts were increasingly probable, there is a fixed income opportunity to add value by increasing duration exposure (more interest rate sensitivity) on the front-end of the Canadian bond yield curve. The supporting language from the BoC confirmed our outlook that additional cuts are likely. At this time, we remain of convinced that short-term yields will continue to fall in absolute terms and relative to long-term yields.

You can read more about our short- and long-term outlooks and how we position portfolios here.

The BoC’s next interest rate announcement is scheduled for July 24^th and will be accompanied by the latest Monetary Policy Report. The U.S. Federal Reserve is scheduled to provide its latest interest rate decision and updated economic projections on June 12^th, it’s widely expected to leave rates unchanged.

Wesley Blight

Wesley Blight, CFA, CIM, FCSI, is a Portfolio Manager with the Multi-Asset Management Team of Scotia Global Asset Management. He is responsible for private asset and multi-asset portfolio solutions.

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