The Bank of Canada (BOC) surprised investment markets by raising its overnight rate a quarter point to 4.75% on June 8. Prior to this, the Bank of Canada had paused on its rapid hiking cycle leading some market participants to believe that we’d seen the top of the cycle and that rates might start coming down later this year or in early 2024. This additional hike dashed those hopes.
Deputy Governor, Paul Beaudry, explained the central bank’s move by suggesting excess demand in the economy is turning out to be more persistent than previously thought. While inflation has declined for several months now, it looks unlikely to return to BOC’s 2% target anytime soon. Beaudry said the central bank seeks to make Canadians better equipped for the possibility that we are entering an era of structurally higher interest rates.
The Bank of Canada’s Governing Council meets again on July 12, and markets are not counting out the possibility of another rate hike.
At Nicola Wealth we have long taken the view that, following their post-pandemic run-up, interest rates could be higher for longer. One of the Bank of Canada’s newly expressed concerns surrounds corporate pricing behaviour: are higher costs being absorbed by corporations or being passed on to consumers? The European Central Bank recently cited surging corporate profits as a source of inflation.
Meanwhile, on the consumer side of the economy, spending appears increasingly driven by excess savings and credit, leading to a further deterioration in Canadian households’ financial position. With the labour market still tight, wage growth is running at 4% to 5% and makes it hard to reduce overall inflation. In addition, there continues to be multiple inflationary forces outside the central banks’ control, from the war in Ukraine to energy politics to adverse weather events affecting food prices.
The longer we see higher interest rates in effect, the greater the likelihood of a recession. For this reason, we continue to be defensively positioned. As debts continue to roll over at higher rates, they raise the cost of financing across the economy, which is a contributor to higher costs for companies and lower profitability.
Given the steepness of the yield curve inversion, we feel investors are not being appropriately compensated for taking on the risk of longer duration. Our public asset portfolios are currently tilted towards short-duration investments, although we expect there will be tactical opportunities in long-duration plays in the future.
Keep in mind that, especially in the post-pandemic period, forecasting models for inflation have performed poorly, and there is always a lag time before the impact of higher rates is felt. There may yet be more surprises in store for the Canadian economy. We aim to be ready for them.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.
