Canada's deep yield curve inversion adds to BoC rate hike dilemma



By Fergal Smith

TORONTO, Dec 4 (Reuters) - As the Bank of Canada considers ditching oversized interest rate hikes, it is dealing with an economy likely more overheated than previously thought but also the bond market's clearest signal yet that recession and lower inflation lie ahead.

Canada's central bank says that the economy needs to slow from overheated levels in order to ease inflation. If its tightening campaign overshoots to achieve that objective it could trigger a deeper downturn than expected.

The bond market could be flagging that risk. The yield on the Canadian 10-year government bond has fallen nearly 100 basis points below the 2-year yield, marking the biggest inversion of Canada's yield curve in Refinitiv data going back to 1994 and deeper than the U.S. Treasury yield curve inversion.

Some analysts see curve inversions as predictors of recessions. Canada's economy is likely to be particularly sensitive to higher rates after Canadians borrowed heavily during the COVID-19 pandemic to participate in a red-hot housing market.

"Markets think the Canadian economy is about to suffer a triple blow as domestic consumption collapses, U.S. demand weakens and global commodity prices drop," said Karl Schamotta, chief market strategist at Corpay.

The BoC has opened the door to slowing the pace of rate increases to a quarter of a percentage point following multiple oversized hikes in recent months that lifted the benchmark rate to 3.75%, its highest since 2008.

Money markets are betting on a 25-basis-point increase when the bank meets to set policy on Wednesday, but a slim majority of economists in a Reuters poll expect a larger move. 0#BOCWATCH

RESILIENT ECONOMY

Canada's

employment report

for November showed that the labour market remains tight, while

gross domestic product

grew at an annualized rate of 2.9% in the third quarter.

That's much stronger than the 1.5% pace forecast by the BoC and together with upward revisions to historical growth could indicate that demand has moved further ahead of supply, economists say.

But they also say that the details of the third-quarter GDP data, including a contraction in domestic demand, and a preliminary report showing no growth in October are signs that higher borrowing costs have begun to impact activity.

The BoC has forecast that growth would stall from the fourth quarter of this year through the middle of 2023.

The depth of Canada's curve inversion is signaling a "bad recession" not a mild one, said David Rosenberg, chief economist & strategist at Rosenberg Research.

It reflects greater risk to the outlook in Canada than the United States due to "a more inflated residential real estate market and consumer debt bubble," Rosenberg said.

Inflation is likely to be more persistent after it spread from goods prices to services and wages, where higher costs can become more entrenched. Still, 3-month measures of underlying inflation that are closely watched by the BoC - CPI-median and CPI-trim - show price pressures easing.

They fell to an average of 2.75% in October, according to estimates by Stephen Brown, senior Canada economist at Capital Economics. That's well below more commonly used 12-month rates.

"The yield curve would not invert to this extent unless investors also believed that inflation will drop back down toward the Bank's target," said Brown.

Like the Federal Reserve, the BoC has a 2% target for inflation.

"The curve is telling us the Bank of Canada will be forced into a reversal by late 2023, with rates remaining depressed for years to come," Corpay's Schamotta said.
Reporting by Fergal Smith; Editing by Andrea Ricci

Disclaimer: The XM Group entities provide execution-only service and access to our Online Trading Facility, permitting a person to view and/or use the content available on or via the website, is not intended to change or expand on this, nor does it change or expand on this. Such access and use are always subject to: (i) Terms and Conditions; (ii) Risk Warnings; and (iii) Full Disclaimer. Such content is therefore provided as no more than general information. Particularly, please be aware that the contents of our Online Trading Facility are neither a solicitation, nor an offer to enter any transactions on the financial markets. Trading on any financial market involves a significant level of risk to your capital.

All material published on our Online Trading Facility is intended for educational/informational purposes only, and does not contain – nor should it be considered as containing – financial, investment tax or trading advice and recommendations; or a record of our trading prices; or an offer of, or solicitation for, a transaction in any financial instruments; or unsolicited financial promotions to you.

Any third-party content, as well as content prepared by XM, such as: opinions, news, research, analyses, prices and other information or links to third-party sites contained on this website are provided on an “as-is” basis, as general market commentary, and do not constitute investment advice. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, it would be considered as marketing communication under the relevant laws and regulations. Please ensure that you have read and understood our Notification on Non-Independent Investment. Research and Risk Warning concerning the foregoing information, which can be accessed here.

We are using cookies to give you the best experience on our website. Read more or change your cookie settings.

Risk Warning: Your capital is at risk. Leveraged products may not be suitable for everyone. Please consider our Risk Disclosure.