Traders in money markets over the past few days have been reassessing the odds that another Bank of Canada rate cut looms this September - and have become increasingly convinced more monetary easing is coming.
Implied interest rate probabilities in swaps markets now suggest nearly 93 per cent odds of another quarter point rate cut at the bank’s next policy meeting on Sept. 4, according to LSEG data.
Last Wednesday, the Bank of Canada cut its key overnight rate to 4.50 per cent. In the moments both before and after that decision, swaps market probabilities suggested the odds of whether there would be another cut come September was pretty much down to a coin flip.
Those probabilities have been aggressively climbing in the days since, reaching a peak today. It’s been accompanied by a steadily weakening Canadian dollar against the greenback and falling bond yields. Canada’s two-year bond yield, which is sensitive to central bank policy sentiment, today is at a two-year low of 3.53 per cent. Canada’s five-year yield, which heavily influences the fixed mortgage rate market, is at its lowest since December.
More than a full 50 basis points of additional monetary easing is now priced into markets by the end of this year.
Here’s how implied probabilities of future interest rate moves stand in swaps markets, according to data from LSEG as of early afternoon Tuesday. The Bank of Canada overnight rate is 4.50 per cent. While the bank moves in quarter point increments, credit market implied rates fluctuate more fluidly and are constantly changing. Columns to the right are percentage probabilities of future rate moves.
Usually changes in interest rate probabilities are easily explained by new economic data - from either the U.S or Canada - that arrive way off market expectations, or new commentary from central bank officials. They can also swing wildly when an unexpected event occurs, such as the pandemic or solvency difficulties at a lending institution that could represent a shock to the financial system.
That isn’t so much the case, though, this time around.
David Rosenberg, founder of Rosenberg Research, suggests the swaps repricing likely reflects market dynamics beyond Canada.
“It could well reflect the fact that commodity prices have entered a severe correction and following the tame PCE deflator numbers out of the U.S.,” he said in an email to the Globe and Mail.
The PCE, or personal-consumption expenditures price index, is the Federal Reserve’s preferred inflation gauge and came out on Friday for June. It rose 2.5 per cent from a year earlier, in line with market expectations but representing a slowdown from May’s rise of 2.6 per cent. The closely watched core index, which removes volatile food and energy prices, rose 2.6 per cent in June.
Markets are betting on a slight chance that the Fed will cut rates by at least 25 basis points at the end of its policymaking meeting on Wednesday, but they are completely pricing in a cut for the U.S. central bank’s September meeting, according to the CME’s FedWatch Tool.
Meanwhile, many commodities have been in a downtrend in recent weeks. Copper prices are down about 20 per cent from their highs this spring, and oil about 14 per cent.
Derek Holt, head of capital markets economics at Scotiabank, suggested Bank of Canada governor Tiff Macklem is being increasingly perceived to be setting a high bar for deviating from rate cuts at each future policy meeting. “Even though he said they would take meetings one by one and watch the data, most of the way in which he spoke last week makes it sound like he’s on a straight line path for a few meetings at least,” Mr. Holt said in an email.
Markets are now doing a bit of a reassessment, including on Mr. Macklem’s commentary on downside risks to the economy and inflation target, he said.
Mr. Holt, however, thinks money markets “are getting a bit carried away” with assigning such a high probability to a September cut.
“Canada’s 5-year yield at 3.15 per cent is looking pretty rich (low) to me... If more fiscal stimulus (and hence probably more debt issuance) is added late this year into early next year’s election, then that would add to supply pressures via higher yields. If one thinks something really awful is coming down the pipe toward the Canadian economy such that the BoC is cutting below the neutral rate then maybe 5s aren’t rich, but that’s not our overall belief about the outlook,” he said.
The neutral rate is where the central bank’s monetary policy is neither stimulating nor holding back the economy. The Bank of Canada currently estimates this to be between 2.25 per cent and 3.25 per cent.