BoC, U.S. Fed will ease in December then pause: Davis

Key Concepts

Economic Contraction: A decrease in economic activity, measured by GDP.
Technical Recession: Defined as two consecutive quarters of economic contraction.
Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity. This includes interest rate adjustments.
Interest Rate Cut: A reduction in the central bank's policy interest rate, aimed at making borrowing cheaper and stimulating economic growth.
Neutral Rate: The theoretical interest rate that neither stimulates nor restrains the economy.
Easing Monetary Policy: A policy of lowering interest rates and increasing the money supply to stimulate economic growth.
Structural Change: Fundamental shifts in the economy that may alter the effectiveness of traditional monetary policy tools.
Currency Weakening: A decrease in the value of a country's currency relative to other currencies.
Disposable Income: The amount of money that households have available for spending and saving after income taxes have been accounted for.
Mortgage Renewals: The process of refinancing a mortgage when the existing term expires.
Terminal Rate: The ultimate interest rate that a central bank is expected to reach during an easing or tightening cycle.
Deregulation: The reduction of government regulations on businesses.
Red Tape: Excessive bureaucracy or adherence to formal rules and procedures, which can hinder efficiency.
Trade Partner: A country with which another country conducts significant trade.
Fiscal Deficit (Deficits): A situation where government spending exceeds government revenue.
Rating Agencies: Organizations that assess the creditworthiness of borrowers, including governments and corporations.
AAA Status: The highest possible credit rating, indicating a very low risk of default.
Leverage: The use of borrowed money to increase the potential return of an investment.
Investment Grade: A credit rating that indicates a relatively low risk of default.
Basis Points (bps): A unit of measure used in finance to describe the difference between two interest rates or yields. 100 basis points equal 1%.
Inflation Protection: Investments designed to maintain their purchasing power in the face of rising prices.

Economic Performance and Monetary Policy Outlook

Canadian Economic Contraction and Recession Concerns

The Canadian economy experienced a 0.3% month-on-month contraction in August, affecting both the goods and services sectors. This follows a contraction in the second quarter, raising concerns about a potential technical recession, which is defined as two consecutive quarters of economic contraction. While the September flash GDP number showed a slight positive growth of 0.1%, the overall third quarter is still expected to exhibit only slight growth.

Bank of Canada's Stance and Future Rate Cuts

The Bank of Canada has indicated that another rate cut may not be imminent. However, Earl Davis, head of fixed income and money markets at BIM mode global asset management, disagrees. He anticipates a rate cut in December, believing the market is not adequately pricing in this possibility, with expectations for a cut not even reaching 2% until next September. Davis forecasts the core interest rate to reach 2% in December.

Rationale for Further Easing

Davis argues that despite the Bank of Canada's assertion that they are happy with current rates due to a structural change in the economy where low rates may not stimulate borrowing if people are not investing in new projects, the central bank must still facilitate this adjustment. The primary mechanism for this is a weaker currency, which is achieved through continued monetary easing. He believes current economic conditions, as evidenced by the GDP figures, warrant moving beyond neutral policy into the high end of easing territory.

"Free Money" Era and Mortgage Renewals

If the core interest rate is brought down to 2% with inflation also around 2%, it would essentially create an era of "cheaper money" in real terms, though not entirely "free." A significant factor influencing future economic conditions is the 2026 mortgage renewals. Many individuals will be renewing mortgages taken out at ultra-low rates (around 2%) at significantly higher rates, leading to reduced disposable income. This impending pressure on household finances is seen as another reason for the Bank of Canada to ease monetary policy.

Bank of Canada's Strategic Communication

Davis commends the Bank of Canada and Governor Jeff Mlin for effectively managing market expectations and preventing them from getting ahead of policy decisions. While currency and housing are not explicitly stated mandates, Davis believes they are crucial decision criteria influencing the Bank's actions, leaning towards another easing move by year-end.

Terminal Rate Expectations

If the Bank of Canada does ease by the end of the year, Davis suggests the terminal rate (the ultimate Bank of Canada rate) could be 1.50%. This contrasts with current market expectations, which discount a terminal rate of 2.10% by the end of 2026, driven by concerns over weak GDP numbers. Davis anticipates a need to stimulate growth heading into next year.

Contrasting Economic Prospects: Canada vs. U.S.

Brighter U.S. Economic Outlook

The United States is projected to have brighter economic prospects, driven by two key factors:

Tax Reductions: Significant tax cuts for both corporations and individuals are expected to boost spending.
Deregulation: The ongoing move to reduce regulations and red tape is seen as removing friction from the economy, aiding the growth of small and medium-sized businesses and job creation.

Impact of U.S. Strength on Canada

While Canada is on the opposite end of the economic spectrum, a strong U.S. economy is beneficial for Canada due to their significant trade relationship. Approximately 65-70% of Canadian trade is with the U.S. Therefore, improved U.S. economic performance is expected to positively impact Canada.

Canadian Dollar Outlook and Government Fiscal Policy

Weaker Canadian Dollar Forecast

Davis anticipates a weaker Canadian dollar in the year ahead, though not dramatically so. He forecasts the loonie to remain in the range of 0.70 to 0.74 U.S. cents, potentially dipping into the high 60s, but not reaching the lows seen in 2025. A weaker currency would benefit Canadian companies by making their exports cheaper.

Government Deficits and Credit Rating

The Canadian government plans to run tens of billions of dollars in deficits in the upcoming budget. Davis believes the government has room for this increased spending, as other developed markets are spending more. The key concern is how rating agencies will perceive this. He believes Canada will retain its AAA status, which is crucial for maintaining lower borrowing costs. However, he stresses the need for a plan to eventually reduce these deficits and for spending to be targeted well, with current infrastructure and buildout plans appearing to be so.

Currency Weakening through Debt

Increased government debt is another factor that can contribute to a weaker currency, alongside lower interest rates. This aligns with the need to support the economy through structural changes.

Investment Recommendation: First National Financial Bond

Bond Offering Details

Davis recommends a bond from First National Financial, a large non-bank lender. The offering provides a yield of 4.7% on a five-year bond, which is a full percentage point above government bonds.

Rationale for Investment

Davis has followed First National Financial for about 10 years and considers it a very good and well-run company. The company was recently acquired by private equity, which is issuing more debt to leverage the firm, leading to this bond issuance. The bond is tripleB investment grade. While the company has a fair amount of leverage with this issuance, Davis believes it is a profitable and well-managed entity with the ability to manage its debt. The primary goal of bond investing is the return of capital, and this bond offers an attractive interest rate, providing inflation protection and contributing to portfolio growth.

Conclusion

The Canadian economy is facing headwinds with recent contractions, but the Bank of Canada may be poised for further interest rate cuts to stimulate growth and manage structural changes. While the U.S. economy shows brighter prospects, its strength will benefit Canada. The government's fiscal plans for deficits are manageable, provided they maintain their credit rating. For investors, a specific bond offering from First National Financial presents an attractive yield with a focus on capital preservation and inflation protection.