For more than two years, the question on everyone’s mind was how high would interest rates go and when would they start to come back down. Well, the first part of that question was answered last summer, when most central banks took their official rates to the cycle’s peak and then shifted into pause mode. The second part of the question, at least for some of the major central banks in the world, has been answered this quarter. Switzerland kicked things off in April, followed by Sweden in May and then our own Bank of Canada and the European Central Bank (ECB) this week. The moves were modest and delivered with intentional vagueness as to what the future course of policy would be.  We still have not heard from the Federal Reserve, which meets next week, and the Bank of England, which convenes June 20th.  For investors, the focus now is on what type of easing trajectory we can expect?

 

First, we need to be careful when we talk about the term “easing”.  While it’s common to refer to decreases in policy rates as easing, in reality central banks are only easing when they are cutting rates to below their equilibrium level. This is always a moving target, but if we are talking Canada or the U.S., equilibrium is probably around 2.5%. Given that we are still well above that mark, whatever the central banks are doing with rates today is not considered easing, but simply a shift to a less restrictive stance.

 

 

Another common belief is that once a central bank starts to cut rates, it continues to do so in a gradual stepwise manner. This was the case with cycles when Alan Greenspan presided over the U.S. Federal Reserve and, if the economy was in dire shape, then rates would be brought down swiftly. Think 2007-2008 and 2020. If we see inflation figures evolve the way central banks want, we may see a steady decline in rates but not necessarily the predictable quarter-point per meeting pace that we were once accustomed to. Instead, the coming months are more likely to see adjustments to rates on as needed basis and completely dependent on the data.

 

Thursday’s ECB announcement and statement was an interesting example. While the bank determined that lowering rates was appropriate based on developments on the inflation front, it also revised its forecasts for inflation in 2025 and 2026 higher. Yes, higher. Even though Europe has outperformed Canada and the U.S. in terms of the degree of disinflation achieved, it has hit a floor just north of its desired 2% target as the chart below shows.

 

Source: Factset Research Systems

 

If an extended period of higher rates hasn’t been able to return inflation to zero, then the argument for a rapid succession of cuts starts to fade. And it’s not that there is widespread evidence of economic malaise. The unemployment rate for the EU fell another notch in April to 6.4% - another record low and almost half of the peak seen in 2013.

 

As I noted on Wednesday, the Bank of Canada was more forthcoming about guidance as to future rate decisions. The economy is showing more signs of stress than south of the border and the path to victory on inflation appears for now to be more realizable. After all, core inflation hasn’t gotten as “stuck” as in the U.S. or Europe. For five straight months it has declined, reaching 2.6% in April. That was clearly enough for the Bank of Canada and, as Tiff Maklem mentioned, there is room for rates to head even lower provided inflation remains on this path.  Still, we are not talking about a quarter-point cut at each of the Bank’s remaining four meetings this year. I think we might get one or two more.

 

Source: Factset Research Systems

 

As I have discussed before, this transition in monetary policy is going to be different than in past cycles since it is not going to be reactive to a significant deterioration in economic activity, but merely adjusted to less restrictive levels as inflation and indications of excess demand abate. Assuming both occur, then rates can return to equilibrium, albeit a new world one. The pace of that adjustment may be too slow for some, but the only way you get a speedier version is by the economy cracking.  That might get you a Bank of Canada rate target of 2% or lower, but you won’t like the outcome for equities. Better to get to 3% over the space of the next 18 months, with growth weakening but not turning negative. That way you can get a continued ascent in equities and total returns for bonds in the 5-10% region.

 

If that is the base case scenario, what are the riskier alternate ones? Well, there is always the possibility that Canada’s progress on inflation is a head fake and we also see a floor before we get to 2%. Certainly, a weaker Canadian dollar and continued fiscal pump priming could create the conditions for that. The U.S. has the benefit of a stronger dollar to dampen imported inflation, but its fiscal situation is in even more disarray. All of which might restrict the degree to which rates can come down, even at a snail’s pace. The strategy in that case would be to tilt away from government bonds into corporates and maintain equity exposure, leaning more towards value.

 

The counter argument is that the lags with which policy works on the economy have become longer and we have already kept rates too high and for too long, making an economic downturn all but inevitable. That would be the classic example, where the economy enters a recession and pushes central banks into emergency easing mode. In that case, the strategy would be to move entirely into long duration government bonds and pull back on equity exposure and lean more into quality stocks.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle

 

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The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.