Bank of Canada Expected to Cut Interest Rates Next Week and Beyond Amid Cooling Inflation

Over a 95% Chance of a Rate Cut on July 24

The Bank of Canada (BoC) is widely expected to reduce its overnight lending rate by 25 basis points to 4.50% on July 24, 2024. This prediction is based on recent economic data showing a cooling in inflation and a softening labor market. Short-dated interest rate swap markets predict an over 95% probability of this rate cut (as of July 19, 2024), up from 83% before the latest inflation report, as shown in the chart below. The chart also shows implied interest rates after each Bank of Canada meeting from July 24 to the year-end.

Implications for Canadians

If rates fall as expected, Canadian homeowners with variable rate mortgages will see a higher proportion of their payments go towards the principal amount. Those with variable payments will see their total payments shrink. For fixed-rate mortgages, signals from the BoC on the pace of further cuts could affect bond yields and potentially lead to lower fixed mortgage rates.

Economic Context Driving the Decision

Canada's annual inflation rate has cooled slightly more than anticipated, reaching 2.7% in June. This decline is primarily attributed to slower growth in gasoline prices. Core inflation measures, excluding volatile items, have also decreased slightly. The Canadian economy is showing signs of slowing, with unemployment edging higher.

Market Reactions and Expectations

In response to the recent inflation data, the Canadian dollar experienced a minor decline, dropping to 73.00 cents US. The bond market reaction was subdued, with Canada's two-year bond yield remaining near 3.8%. Market projections now indicate the possibility of nearly three additional quarter-point cuts by the end of the year, potentially bringing the BoC's overnight rate down to 4%.

Future Rate Cut Projections

Our analysis suggests that the BoC has entered a cutting cycle. After the anticipated July cut, the central bank is expected to pause in September before resuming rate cuts in October and December. By the end of 2024, our median expectations for the policy rate are to reach between 3.75% - 4.00%

Factors Influencing Future Decisions

While the overall trend favors rate reductions, the BoC will remain cautious due to some mixed signals in core inflation measures and wage growth. The central bank will closely monitor inflation trends, labor market conditions, and consumer financial stress when making future rate decisions. The housing market's response to rate cuts will also be a key consideration.

Economic Growth Outlook

Canada's economic growth is projected to average 1.0% in 2024 before rebounding to 1.8% in 2025. The BoC's rate decisions will play a crucial role in supporting economic stability and growth in the coming months.

Conclusion

While rate cuts appear to be on the horizon, the BoC will continue to balance the need to support economic growth with managing inflation risks. The central bank's decisions in the coming months will have significant implications for Canadians' borrowing costs and the overall economic landscape.

Disclaimer: The views and opinions expressed herein are the author's individual opinions and views and do not reflect Vanguard Investment views. These views are expressed to share insights and opinions and DO NOT constitute any financial advice. Please consult your financial advisors for any investment advice.