Canada’s economy grew faster than expected in the second quarter, data showed on Friday. But the report also pointed to economic weakness over the summer, keeping an interest rate cut next week by the Bank of Canada clearly in view.
Implied interest rate probabilities in swaps markets now suggest an 80% chance of a 25 basis point rate cut Sept. 4, and a 20% chance of a larger 50 basis point cut. Less than 24 hours ago, money markets were pricing in under 10% odds of a 50 basis point cut next week.
Money markets are fully pricing in 75 basis points of cuts by the end of this year, largely unchanged from prior to today’s GDP data.
Here’s a breakdown of those implied probabilities in swaps markets, according to data from LSEG as of 945 am ET. 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.
Below the main table is a breakdown of probabilities for the Sept. 4 Bank of Canada meeting.
Economists are also fully expecting at least a 25 basis point BoC cut next week, and some are now not ruling out a 50 basis point cut. Here’s what they are saying.
Stephen Brown, Deputy Chief North America Economist
Although second-quarter GDP growth surprised to the upside, the downgrade to GDP in June and preliminary estimate that GDP was unchanged again in July imply that third-quarter growth will be much weaker than the Bank is forecasting. That leads us to think that we are now close to 50/50 in terms of the chance of a 50bp cut or a 25bp cut next week, whereas markets currently put the chance of a 25bp move at 80%.
The 2.1% annualised rise in second-quarter GDP was admittedly bang in line with the preliminary estimate implied by the monthly GDP data. But after the monthly data consistently overstated growth in previous quarters, the consensus estimate was for a 1.7% gain and the Bank’s forecast was 1.5%. The slowdown in household consumption growth to just 0.6% annualised will concern the Bank, although domestic demand growth still rose by 2.4% thanks to a much stronger 6.0% rise in government spending and an 11% jump in non-residential structures, machinery & equipment, which was led by a rebound in aircraft & transportation equipment investment. That helped to offset a renewed 7.3% decline in residential investment, which continues to be dragged down by higher interest rates. Otherwise, net trade was a modest drag as exports fell by more than imports.
The big disappointment was that monthly GDP in June was revised down to be unchanged from May, and the preliminary estimate for July points to another unchanged reading. That’s a surprise given the potential boost from the recent completion of the Trans Mountain pipeline expansion, which has pushed energy export volumes much higher. Even if GDP rose strongly in August and September, quarterly growth would be on track to be less than 2.0% annualised, well below the Bank’s forecast of 2.8%. The odds still just about favour a smaller 25bp cut next week, but we wouldn’t be surprised by a 50bp move and there is now a good chance of a larger move at the October meeting, when the Bank will update its economic forecasts.
Royce Mendes, managing director and head of macro strategy, Desjardins Securities
The Bank of Canada’s forecast for the economy looks too optimistic. In the July Monetary Policy Report, central bankers had projected a sharp rebound in economic activity in Q3, but early indications point to a much more subdued pace of increase. Rate cuts aren’t providing much stimulus to the housing market yet. This comes as little surprise to us. The combination of still-high house prices and mortgage rates means that home ownership remains out of reach for many. Upsizing has also been restrained by those same forces. Falling interest rates haven’t spurred an acceleration in consumer spending either. So far, households remain cautious, with many set to face higher mortgage or rent payments. ...
Overnight indexed swaps are pricing in only a very small probability that policymakers will need to reduce rates by 50bps in October. Given that inflation has been all but tamed, we think there’s actually a somewhat more material chance that a 50bp rate cut will be required before the end of the year. Standard 25bp reductions are still our base case forecast, but we can’t ignore how much the discourse surrounding the economy and inflation have changed. Central bankers around the world are now more focused on stemming the deterioration in labour markets than they are on the last mile of the inflation fight. ...
The danger now is that the Bank of Canada falls behind the curve if policymakers remain too focused on the slightly above-target inflation. Following previous tightening cycles, central banks have often responded too late to signs of economic deterioration. Achieving a soft landing in this cycle is an even taller order given Canada’s vulnerabilities and the headwinds it will be facing in the quarters ahead. Policymakers will need to be alert and nimble to avoid repeating mistakes of the past.
We believe central bankers are attuned to the changing dynamics and will sound more dovish next week. As a result, we see some room for rate cut expectations to build both for the near-term and further out. The implied probability of a 50bp cut in October should increase and the policy rate expected by the end of 2025 should fall from the current 2.75% closer to our long-held forecast of 2.25%. In short, we see more expeditious policy easing than the market is currently incorporating over that time horizon. The higher-for-longer narrative is dead and it’s full steam ahead for rate cuts.
Derek Holt, vice-president, Scotiabank Economics
Q2 GDP growth came from government spending that contributed 1.3 ppts to q/q SAAR GDP growth in weighted contribution terms. Further, government capital investment added another 0.4 ppts. All combined, government accounted for about 80% of Q2 GDP growth. This reliance on the public sector is disconcerting. For the most part, governments do not create wealth. They can set positive or negative conditions for growth and transfer riches around, but it’s the private sector that creates wealth and the private sector was weak during Q2.
Where did all this government spending come from? Largely via retroactive wage increases given to their workers at various levels of government which counts as government expenditure in the GDP accounts. Statcan noted that retroactive wage increases by the Federal government played a transitory role in boosting gov’t spending. ...
So, bring on momentum toward the Federal fall economic and fiscal update. Freeland & co will treat this as evidence that gov’t spending is the main game in town and gosh it couldn’t possibly go away now could it. That’s exaggerated in a trend sense and it’s just one quarter, but still, an election year beckons and the free spending Trudeau-Singh-Freeland team will probably prime the pumps especially given their awful polling. ...
The BoC will take this overall report as justification for a widely expected quarter-point cut next Wednesday and ongoing dovish bias that defers to the October decision with its full forecast update. I would think they are likely to revise down their Q3 GDP estimate of 2.8% q/q SAAR from the July MPR in the October MPR, but for now, they will wish to monitor the pent-up demand arguments. Uncertainty toward whether stalled consumption in Q2 after strong Q4 and Q1 gains is an emerging trend, or a temporary one if pent-up demand gets unleashed, should keep them guarded against up-sizing cuts among other reasons for not doing so that I’ll write in my weekly later today.
An added inflation caveat for the BoC is that Q2 labour productivity in the business sector (next Thursday) is looking awful. Real wage growth is climbing while productivity is tanking which reinforces inflation risk. Business sector output looked very weak in Q2 alongside a large gain in hours worked which means productivity problem fell significantly.
Douglas Porter, chief economist, BMO Capital Markets
This is a clear case of there being less than meets the eye for growth. While the headline advance of more than 2% for Q2 is certainly welcome, it comes with a wide variety of “yes, buts”. Briefly, the growth relied heavily on government spending, it still marked a drop in per capita terms, and the flat June/July readings give a weak handoff to Q3. (Other than that, Mrs. Lincoln thought the play was not bad.) These results probably don’t change anything significantly for the Bank of Canada next week—for example, we are maintaining our estimate of annual GDP growth for both this year (1.1%) and next (1.8%). A third consecutive 25 bp cut is expected next week. However, if Q3 comes in far below the BoC’s forecast and the jobless rate continues to forge higher (August data out next Friday), that could open the door to potentially more aggressive cuts later this year—especially if the Fed is also tilting that way in the Fall.
Andrew Grantham, senior economist, CIBC Capital Markets
Growth in the Canadian economy was modestly better than expected in Q2, but weak momentum heading into the third quarter gives ample reason for the BoC to continue cutting interest rates. The 2.1% annualized growth rate in Q2 was slightly higher than a 1.8% consensus estimate and also above the 1.5% the Bank of Canada had penciled into its July MPR. However, the composition of growth wasn’t particularly impressive, with consumer spending almost stalling (+0.6% annualized) and government spending being the largest contributor. Business investment was also a positive, albeit mostly offset by a decline in residential structures. Momentum heading into Q3 was much weaker than anticipated, with June GDP printing flat on the month (consensus +0.1%) and the advance estimate for July pointing to a further stall that month as well. That leaves early tracking for Q3 at around 0.5% annualized, allowing for modest growth in August and September, which would be well below the 2.8% forecast from the Bank of Canada’s MPR. Because of that we still see the Bank of Canada reducing interest rates by 25bp at each remaining meeting this year.
Robert Both, Canadian macro strategist, TD Securities
The Q2 number was a little bit stronger than we’d expected but the details were quite a bit softer than that, even with the positive surprise. .... The strength (in household spending) we saw over Q4 and Q1, that’s not likely to be sustained over the rest of 2024 and 2025. With the consumer accounting for such a large share of total economic activity, that does reinforce that there is a limit to how quickly the economy is going to expand over the second half of this year.
Matthieu Arseneau and Alexandra Ducharme, economists with National Bank Financial
Beyond the fact that growth was slightly better than expected, the details of the report do not change our view that interest rates in Canada remain too restrictive. Once again, economic growth was not enough to reverse the downward trend in GDP per capita, which has continued its freefall since 2022. This shows that the economy is still growing below its potential (estimated at 2.5% by the central bank) and that excess supply continues to grow. What’s more, the contraction in GDP per capita in Q2 would have been much more pronounced had it not been for the government’s substantial contribution. Indeed, private final domestic demand grew by only 1.0% in the quarter, illustrating the paralyzing effect of monetary policy on the private sector. While economic growth in Q2 exceeded the 1.5% forecast by the BoC in July, the 2.8% it predicted for Q3 now seems virtually unattainable in light of this morning’s figures. The Canadian economy stagnated in both June and July (preliminary data) according to the monthly GDP data, and a recovery seems unlikely. Despite the start of interest rate cuts, households renewing their mortgages continue to face a significant interest payment shock. Household consumption may also be affected by weak private sector hiring, which is expected to continue. Indeed, corporate profits are struggling to recover and there are increasing signs of widespread overstaffing. Companies don’t just seem to have an excess of workers, their inventories also seem overfilled. Inventory accumulation has softened the economic blow in recent quarters, but the opposite could happen if companies now choose to liquidate them. Whether in manufacturing, wholesaling or retailing, the inventory-to-sales ratio appears excessive, and is approaching the levels seen in recent recessions. In conclusion, this morning’s report does not change our view that the Bank of Canada should cut interest rates sharply in the coming months, including by 25 basis points at next week’s decision.
Charles St-Arnaud, chief economist, Alberta Central
With the preliminary GDP estimate suggesting that economic activity was flat in July, growth is expected to be modest in the third quarter and is likely to be around 1.0% q-o-q ar.
Today’s GDP confirms that the Canadian economy is struggling, with most of the growth coming from the government sector and GDP per capita contracting for a fifth consecutive quarter. Moreover, consumer spending is weak, with another decline in spending per capita increase. Nevertheless, Today’s number is unlikely to have a major impact on the BoC’s rate decision next week, with weak growth confirming the need to ease monetary policy now that inflation is in line with the target. We think the BoC will cut its policy rate by 25bp next week and again in October and December, bringing the policy rate to 3.75%.
Bryan Yu, chief economist, Central 1 credit union
Despite the elevated pace of growth in Q2 the third quarter is likely to drop off and fall well below the Bank of Canada’s 2.8 per cent forecast. Industry GDP showed a flat June monthly reading more than the same in preliminary July data with resources declining. Add in the short but impactful rail stoppage in August and we forecast growth of about one per cent for the quarter. We see a cut in September, and further cuts at its remaining two meetings for 2024. The pace of reduction will slow in 2025 and reach 2.75 per cent in Q3/Q4.
Abbey Xu, economist with Royal Bank of Canada
Although slightly above expectations, the details behind the Q2 GDP increase are softer than the headline growth rate and per-person output continues to decline. Employment has declined for two consecutive months, and the latest unemployment rate is up almost 1% from a year ago. Recent economic data indicates that inflationary pressures have broadly eased, with breadth of goods impacted by abnormally high inflation narrowing to pre-pandemic levels, and the softening economic backdrop should reinforce the Bank of Canada’s view that the economy has softened enough to keep inflation on a downward trajectory. We continue to expect the BoC to follow up cuts to the overnight rate by another 25 bps in September.