MARKETS ARE UNDERESTIMATING HOW MUCH THE BOC IS GOING TO CUT RATES: CIBC ECONOMIST BENJAMIN TAL
Investors are on edge, with growing recession fears and uncertainty surrounding corporate earnings growth. These concerns, along with high valuations, are fuelling rising volatility in the stock market.
To help investors determine if the economy is normalizing or materially deteriorating, I recently spoke with CIBC Capital Markets deputy chief economist Benjamin Tal. He provided his assessment of the economy, updated his policy interest rate forecast and discussed potential implications for markets.
When we spoke four months ago, you expected the Bank of Canada to lower the overnight rate to 4 per cent by year end and to 2.75 or 3 per cent by the end of 2025. Is that still your position?
Things are basically moving as expected, but it seems that the Bank of Canada will cut to 3.75 per cent by the end of the year, so two more cuts this year. And if there is a bias to this forecast, it is that the Bank of Canada will ease more aggressively and will cut by 50 basis points at one of the upcoming meetings.
As far as what we call the terminal rate, where they will stop, our call was for 2.75 per cent. I think it’s more reasonable now that it will be in the neighbourhood of 2.5 per cent, or even potentially 2.25 per cent. The reason is the following.
When the bank is cutting now, it is not stimulating, it’s reducing tightness. You have something called the neutral rate – above this rate, you’re limiting growth, you’re tightening conditions. Below that rate, you’re stimulating activity. We are still above this neutral rate in a very significant way.
The market is expecting a terminal rate of about 2.75 per cent. Now, the five-year rate, which is impacting the mortgage rate, and the 10-year rate, which is an extremely important rate for many segments of the economy, both of them are already pricing in the Bank of Canada going to 2.75 per cent, which means that even when the Bank of Canada cuts, those rates will not be going down because it’s already expected. If you want to revive the housing market, you need mortgage rates to be lower than what it is now. Therefore, there is a need to cut more than what the market is expecting and even below what we call the neutral rate to stimulate the economy.
Speaking about a revival in the housing market, let’s discuss your housing market outlook.
The housing market in Canada is a tale of two markets.
There is a detached segment of the market, low-rise, and this market is okay, not great but okay. Prices are stabilizing or even going up a little bit, but clearly still a tight market.
The condo market is a dead market. It’s basically frozen. We have a situation in which interest rates are so high still and prices are high. Therefore, investors are in a negative cash flow position. In a paper that we released in the summer, we estimated that roughly 80 per cent of GTA condo investors with a mortgage are in a negative cash flow position. They lose money on that investment, which means that they are not motivated to buy. And in fact, they are motivated to sell so that increases the supply in the resale market.
At the same time, demand is not there. Because of that developers are not building. The economics of new development, what we call presale or pre-construction does not work, which means that you don’t see any activity.
This means that you have a window of about a year to take advantage of a weaker condo market. So, if you’re a buyer, the next year, year and a half, you have a window to actually get into the condo market because the condo market will be soft.
Now, why it’s only a window is because, as I said, developers are not building, which means that two years from now demand will still be there. We still have new immigrants. We still have demand coming, interest rates will be lower, but the supply that’s supposed to be built now is not coming because nobody’s building. So, two years from now, there will be upward pressure on prices because we simply won’t have the supply. Eventually, those extra inventories will be cleared and the market will be in shortage again because the fundamentals of the market are still very strong.
In the housing market report that you published in July, you mentioned resale condo prices have declined 12 per cent from the peak. Given the rising supply and the lack of buyers, what further downside could we see in resale condo prices in the near-term?
I suggest, at least for the next six months, there is further downward pressure on condo prices in the resale market. I will not be surprised if it continues to go down by five, six per cent over the next six months, eight months or so, and then stabilize. Then, we start going up a year and a half from now, two years from now. That’s the way I see it.
Is inflation on track to get back to the Bank of Canada’s 2 per cent target?
It seems that inflation is basically under control. In fact, if you look at inflation minus mortgage interest payments, it has been below target for the past six months or so. In many ways, we already achieved the target a long time ago.
And that’s why there’s a very interesting shift in focus. The Bank of Canada is telling you that their focus is not only on inflation above 2 per cent but also below 2 per cent.
It’s not unthinkable that at this rate, a year from now, or even six months from now, inflation will be below target. And for the Bank of Canada, the risk of inflation being below target is actually worse than the risk of being above target.
When you get into a disinflationary scenario or a deflation scenario, when prices are going down, nobody’s investing because why would you invest today if prices will be lower tomorrow? That’s something that will lead to a recession that’s very difficult to get out of, and the Bank of Canada does not have the tools to deal with it. If you have inflation that is above 2 per cent, you simply raise interest rates. That’s why I think that their fear of weaker inflation than target is justifiable and clearly at this rate inflation can go below 2 per cent.
When it comes to inflation and the speed at which the Bank of Canada is going to cut, one big thing has changed since we last talked and that is the U.S. economy.
Until a month ago, people were saying the U.S. economy is doing fine, inflation is still elevated, and they were toying with the idea of the Fed not cutting at all this year.
Since then, we have seen a significant softening in the labour market in the U.S. The unemployment rate is rising to levels that in the past were associated with recessions. The labour market in the U.S. is slowing down. The same goes for the consumer. Excess savings is basically zero now so you cannot shield the consumer anymore from the sting of higher interest rates. That’s also slowing down the economy. And investment is relatively low at this point. All those forces suggest that the U.S. economy is not in a recession, although some people toy with that idea, but it’s definitely in a soft landing scenario, very similar to what we have seen in the 1995 situation. Soft landings do happen, and I think that we are in the midst of one in the U.S.
The Fed will be engaged in monetary easing starting this month, and they will be as aggressive as the Bank of Canada over the next few quarters. Therefore, the Bank of Canada has the green light to continue to proceed with cutting without worrying too much about the Fed, that’s a big change from only a few months ago.
Have you maintained your real GDP growth forecast of 1 per cent for 2024 and 1.6 per cent for 2025?
We are at 1 per cent in 2024 and 1.7 per cent in 2025.
What data points are you closely monitoring as they could impact your Canadian economic forecasts?
There are a few things.
I will look at the speed at which the housing market is recovering. From the past, we know that we should not underestimate the ability of the housing market to recover fast. So that’s something that can trigger the question about how quickly the Bank of Canada should be cutting.
The other is to make sure that inflation moves in the right direction because that’s important.
Another thing, which is linked to the equity market, but one thing that I will be watching is the amount of money in GICs. GICs are linked to interest rates. With interest rates going down now, GICs are becoming less and less attractive. At some point, you reach a level where people say I’m going back to dividend paying stocks because I can get 5 per cent, 6 per cent yields.
I’m not talking about geopolitical issues here because nobody can predict it. But, of course, it’s in the background all the time.
When we were talking a few months ago, there was concern about the Canadian dollar falling potentially below 70 cents because of the divergence in monetary policy between Canada and the U.S. The Bank of Canada was cutting rates while the U.S. economy was still strong with the Fed not expected to cut rates in the near future. You forecast the Canadian dollar would find support at the 71, 72 cent level, which proved to be correct. What are your expectations for the Canadian dollar going forward?
I think that over the next few quarters we’ll see the currency stabilize around 72, 73 cents. But I think into 2025, we will get a cent or two beyond that. The main reason will be a general weakness of the U.S. dollar. With the Fed already clearly in the mode of cutting interest rates, I think that the U.S. dollar will weaken, generally speaking, against the pound, against the euro, and to an extent against the Canadian dollar. I think the Canadian dollar can stabilize, and even gets some momentum in 2025, just due to the general weakness of the U.S. dollar but we’re not talking about big swings here.
What will be the largest changes to your Canadian and U. S. economic forecasts if Harris wins the upcoming U.S. election? And the same question but if there is a Trump victory?
I think that a Harris is victory will not change it in any significant way. There is basically a continuation of Biden. She’s not going to reverse anything that he did. So, a Harris administration will be basically consistent with our current forecast.
Trump is much more complex.
First of all, we are adding an element of volatility. I think that the VIX [CBOE Volatility Index] will rise significantly with Trump.
The impact will be on taxes. He will make the personal tax break permanent. That’s something that will move markets. He will probably continue to cut corporate tax rates. That will force Canada to do the same as we did before. Then, he will start questioning trade policies, which is significant.
If you look at what happened between 2016 and 2020, when Trump was the president, U.S. imports from China went down dramatically, and it really was about the tariff. However, if you look at U.S. imports from the rest of the world, especially emerging markets, it went up, and that’s important. So, it’s not deglobalization, it’s reglobalization because its relocation of activity from China to other emerging markets. The big winners were Vietnam, Mexico, India, Malaysia, those countries, for example. Now, what’s interesting if you look at foreign direct investment and exports of China to those countries, it went up dramatically, which means that China is entering the U.S. from the back door.
This means that Trump will have to go after emerging markets as well. Mexico will be a victim, for example, of his policy. That’s something that is a risk. However, remember, 35 per cent of U.S. exports goes to emerging markets, which means that if you create a trade war with those emerging markets, you are really risking the U.S. export market. You’re risking the manufacturing sector. The cost to the U.S. will be significant. And those significant costs, I think, will make sure that common sense will prevail. Namely, Trump will bark but maybe will not bite, the way he did in 2016.
I think what will happen under Trump is more volatility than anything else. Clearly, one thing that will be very important is green stocks will suffer under Trump. No question about it. Anything to do with the environment will suffer. And energy will benefit, no question about it.
The recent Business Outlook Survey indicated that business sentiment remains weak. When you’re talking with CEO s and business leaders, what shifts, if any, are you seeing in their outlooks?
I think that a few things are happening. First of all, labour supply is not an issue anymore. One thing that held back productivity and the ability to grow was the lack of a labour. That’s not the case anymore.
Interest rates are punishing. The increase in interest rates has been very painful, limiting investment and the profitability of many businesses. That’s something that is still there.
I think that we’re starting to see some negative impact on profit margins. COVID enabled many businesses to increase their margins because many businesses were able to hide behind the fog of supply chain disruptions. Now, the supply chain is back to normal so that is putting downward pressure on profitability, especially in retail. Any deglobalization element that we see is also putting downward pressure on margins.
And the only solution to this is the big thing that I’m starting to see from CEOs, which makes me more optimistic. They’re starting to invest more capital in technology.
That’s why the decision by the government to limit the number of low wage foreign workers is actually positive. When you don’t have the supply of cheap labour, you have to invest in productivity. And that’s something that I believe will happen over the next year or two, and the AI revolution is perfectly positioned to take advantage of that.
The AI revolution is just starting then?
I’m positive that it is just the start. Maybe we’re exaggerating the impact in the short term, but we’re probably underestimating it in the long term.
Story by: The Globe and Mail
