Thoughts on the Bank of Canada plus a couple of trades

June 4, 2024

We have one of the more potentially exciting Bank of Canada meetings in a long time on tap tomorrow. Potentially exciting as they haven’t done a thing with rates in almost a year so the announcements have become a rather dull affair and potentially exciting as there is some uncertainty around tomorrow’s announcement given we’re unsure if they will cut rates or not.

Normally, the central bank likes to telegraph their moves well in advance but this time around they haven’t had much of an opportunity to do so. Instead, the weaker data has done the talking for them and the market has responded, pricing in about an 80% chance of a cut tomorrow. ?

Reasons for the Bank to be patient and wait until July:

1. They want to go in conjunction with the scheduled MPR and revised forecasts next month. They need to use tomorrow’s meeting to prepare the market and signal a July cut > I understand why people think the Bank will behave this way. Central banks like to spoon feed the market and give us all the reasoning behind any decision in advance. I think the BOC can ignore this and go tomorrow. Remember way back in January 2022, CPI was sitting at 4.8% (on its way to an eventual high of 8.1%) and the Bank of Canada was considering a rate hike at its meeting on January 26th. ?The market was pricing in about 18bps of a hike (about a 70% chance) and a hike was absolutely the right thing to do but instead the Bank of Canada took a pass that meeting. They felt the need to prepare the market and signal their intentions in front of the rate hike that came at the following meeting in March that year. It was a mistake and the one thing we are always told is you have to learn from your mistakes. In a February interview this year, Governor Macklem admitted “With hindsight, we probably could have begun withdrawing stimulus sooner” The Canadian data is telling the BOC to cut, no sense waiting and no need to spell it out to the market in advance.

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1. The Bank of Canada does not want to ignite the housing market.

• I don’t think this is sound reasoning. A 25bp rate cut is not going to set the housing market on fire, if it does it was going to happen anyways. A cut tomorrow, or no cut but telling the market you will cut in July works out to the same thing (in my opinion) when it comes to sentiment. There is very little the Bank of Canada can do to stop the housing market when Canada’s population is growing at a million a year anyways.

?

1. The Bank can’t get too far ahead of the Fed.

• There might be some truth to this one. Certainly the Bank can’t be overly aggressive with cuts and risk a significant weakening in the Canadian Dollar that would be inflationary, but a 25bp cut is not getting significantly in front of the Fed. Last I checked the BOC was independent of the Fed and last I checked the Canadian and US economies were operating on different levels:

CANADA???????????????US

Headline inflation????????????????????? 2.7%??????????????? 3.4%?????????????? ????????????????????????

Unemployment rate????????????????? 6.1% ????????????3.8%?????????????????????????????????????????????

GDP?????????????????????????????????????????? .6% ???????????????????1.3%??????????????????????????????????????????????

A look at the data makes it clear the BOC deserves to get out in front of the Fed when it comes to rate cuts.

Reasons for the Bank to cut tomorrow:?

1. The market is pretty much pricing it in (82% chance), there is an old saying “never look a gift horse in the mouth” the market is giving the BOC the gift of a rate cut tomorrow, the Bank should accept it
2. Inflation: ?

- core inflation has fallen four straight months, on a three month annualized basis core CPI measures sit at 1.6%

- the headline CPI number has now been in the BOC's target range four months running

- CPI ex-shelter is sitting at 1.2% YoY

- CPIX which excludes mortgage interest costs (which we know are driven in large part by BOC rate hikes) is running at .5% annualized over the last ?three months

Let’s face it, take out shelter costs and you might say “what inflation?”

BOC Governor Macklem has weighed in on this previously, on March 6th the Governor said: “Our message is that high rates, low rates – if we don’t grow supply, we’re not going to solve the housing problem.” Earlier, on February 1st the Governor said: “You’re not going to solve housing problems with low interest rates and you’re not going to solve them with high interest rates. We’ve tried both, and we’ve had high shelter price inflation.”

It sounds to me like the Governor has come to the realization the housing is difficult for the Bank to control. I think you can make an argument that the Bank is actually contributing to inflation by keeping rates high through elevated mortgage interest costs (which for months now have comprised about 25% of overall inflation) and is compounding shelter problems as high rates make housing projects more costly and discourage investment.

The Bank can’t do much about shelter costs, CPI ex-shelter is 1.2%, maybe it’s time for Governor Macklem to “look through” housing when it comes to setting rates. ?

3. The economy

• The unemployment rate is up to 6.1% from a low of 4.9%
• Retail sales > negative three months in a row, probably not getting a lot better as more mortgages renew at higher rates draining more disposable income from Canadians
• GDP per capita continued its downward trend during the quarter and is now 3.5% below the peak recorded at the beginning of rate hikes. A decline of this magnitude has never been seen outside of a recession.
• And here is how I think the BOC potentially justifies a rate cut tomorrow: The Canadian economy grew at an annualized rate of 1.7% in the first quarter, more than a full percentage point below the Bank of Canada's forecast in its Monetary Policy Report last April. On top of that, the last quarter of 2023 has been revised lower from 1.0% to a mere 0.1%.

I think that gives the Bank plenty of justification for a cut to help support the economy.

On May 2nd Governor Macklem testified before the House of Commons finance committee and said: “We do see renewed downward momentum in underlying inflation. The message to Canadians is, we are getting closer (to a rate cut). We are seeing what we need to see and we just need to be confident that it will be sustained”

Since then:

• Softer than expected core CPI
• Weaker than expected GDP (far below BOC estimates) with downward revisions ?

?It was a mistake not to hike back in January 2022, I think it would be a mistake not to cut tomorrow.

PRICE ACTION: Should we get a rate cut tomorrow, I think USDCAD would probably knee jerk about 30 points higher. It is mostly priced in by the market but not fully and there are still a number of analysts calling for no change so the initial move would be higher. After that it is all about Governor Macklem, I think if they cut he will go out of his way to stress:

• A July cut is absolutely not a given
• The Bank is not on a pre-determined path
• The BOC will take their time and be patient with any further rate moves
• Macklem and Co. are data dependent

I think if the Bank cuts, Governor Macklem won’t sound overly dovish and signal there is more to come in a hurry. The market has 68bps of cuts priced in for this year, if the ?Governor plays his cards right that won’t change much after his press conference. I actually think a rate cut will be ultimately seen as a plus for the Canadian economy and ultimately for the currency. Cutting earlier means a better chance of achieving some sort of soft landing (or a better chance of avoiding a hard landing) and lowers the probability of having to cut even more aggressively down the road.

Remember, the market already? has the short CAD trade on and it looks a bit stretched. CFTC net non-commercial futures positions have built the largest CAD short position since 2017. ?

• A cut is mostly priced in
• The market is short CAD already

If we get a “hawkish cut” tomorrow (I know that sounds odd, but call it a cut with no pre-determined future path for the BOC) then I think the Canadian Dollar might ultimately rally. Remember the old market rule: buy the rumour sell the fact, it might just work for USDCAD this time. ?

TRADES (as always, we have plenty more ideas and are happy to price them up, these are two quick and easy ones):

Spot ref: 1.3685

1. Long a Friday 1.3685 USD Put. Premium 45 CAD pips. Nice and simple, you also get Friday’s employment data included.

2. ?Long a 1 month 1.3650 USD Put/ short a 1.3500 USD Put AKI 1.3350. Premium 58 CAD pips. Max gain = 299 CAD pips. The AKI option is worth over 70% of the vanilla 1.3500.

Good luck,

Patric