News & analysis

Today’s Q1 GDP report has just killed the economic reacceleration argument in favour of the Bank of Canada holding rates next week.

Not only did first quarter growth undershoot the BoC’s forecasts of both actual and potential growth, but it has done so against a much weaker base as Q4 GDP growth was revised significantly lower, dropping  from an annualised rate of 1%, to just 0.1%. Moreover, the strong economic momentum visible at the start of the year following the end of public sector strikes has progressively dwindled as the months have progressed, with the economy ultimately flatlining at the end of the quarter. Today’s GDP report effectively confirms our long-held view that the Canadian economy remains cyclically weak, especially in the context of population growth running at around 3% per annum. Given that this is now signalled across all economic indicators, especially since April’s BoC meeting, we see no reason for the BoC to not cut rates next week. Moreover, based on the underlying trend in the data, we think there is a considerable risk that the BoC needs to embark on back-to-back rate cuts over summer, unless April’s anomalous surge in employment is a sign of an imminent improvement in economic momentum. We doubt that is the case, and as such continue to look for at least two rate cuts from the BoC over their next three meetings and crucially before the Fed meets in September, where we expect the FOMC to deliver their first cut.

Failure to do so risks maintaining an overly restrictive policy stance for too long, resulting in a more aggressive easing cycle into year-end. Our dovish outlook for the BoC and Canadian rates reinforces our bearish stance on CAD. That said, owing to the more sympathetic external environment for risk, we have marked down our 3-month USDCAD forecast from 1.40 to 1.38.

Returning to the data, the Canadian economy expanded at an annualised quarterly rate of 1.7% in Q1, undershooting market expectations (2.2%), the BoC’s forecast (2.8%), and the Bank’s estimate of potential output (2.5%). What is even more damning is that this follows on from weak growth in the fourth quarter, where the economic growth is now seen effectively flatlining (0.1%). Moreover, what strength there was in the Canadian economy largely came from the services sector, which spurred growth at the start of the first quarter due to the end of public sector strikes and heavy retail discounting.

While contractions might point to the fact that household spending on services was strong in the first quarter at 1.1%, this doesn’t look exceptional once framed in the context of population growth at around 3%.

As a result, consumption per capita remained weak at 0.1%, although this is an improvement following three consecutive quarters of contraction. It wasn’t only the expenditure-based quarterly data that reflected a weak economy. Volume measured industry data for the first quarter shows that the January rebound in the economy wasn’t the start of a sequential acceleration. All-industry growth has slowed progressively since January’s expansion of 0.7% MoM, with the economy expanding just 0.2% in February and recording no growth in March. The stagnation in the economy at the end of the first quarter was also broad based, with neither goods-producing nor services-producing industries recording growth. Furthermore, consumer-focused and thus cyclically sensitive industries proved weak. Only arts, entertainment, and recreation recorded significant growth at 0.4% MoM, but even then that didn’t reverse the 0.6% contraction in the month prior.

On the whole, the undershoot in Q1 GDP data confirms that the Canadian economy is operating with excess slack, meaning that the renewed disinflationary progress since the start of the year should persist moving forward.

Seeing as the Bank of Canada was looking for just that back in April before starting to ease policy, we see no reason for the BoC to hold rates next week. While one can never be completely sure with the Bank of Canada, given the Governing Council’s proclivity to move the goalposts at the last minute, we think it would be detrimental to their credibility to hold rates at current levels, leading many to assume that their policymaking is dominated by Fed policy.

In either case, we suspect that next week’s decision should prove bearish for the Canadian dollar. With swaps pricing only an 80% chance of a rate cut next week and a 60% probability of two cuts over the next three meetings, if our expectations are met and the Bank cuts rates by 25bps to 4.75% with the accompanied guidance sounding dovish, USDCAD should track back above 1.37 and towards our medium-term forecast of 1.38.

A continued hold from the Bank next week wouldn’t necessarily be bullish for the Canadian dollar either. Beyond the aforementioned risks to the Bank’s credibility, the decision to hold rates at 4% risks unnecessary economic scarring and a much weaker overall growth profile. This should see intermediate Canadian yields underperform, offsetting the knee-jerk reaction higher in short-term yields.

 

Author: 
Simon Harvey, Head of FX Analysis

 

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