November 10, 2023 | 13:16
Separation Anxiety: Can the BoC Leave the Fed?
Separation Anxiety: Can the BoC Leave the Fed?
It’s widely recognized that Canada’s economic growth is now trailing well behind the U.S. pace—with the resiliency of the latter the big surprise for 2023. The reasons why are relatively straightforward and not unexpected, but there are some legitimate questions building about the Bank of Canada’s ability to steer monetary policy away from the Federal Reserve. We believe, and history suggests, that there is scope for policy to separate without creating undue anxiety, but U.S. interest rates still act as an anchor on BoC policy, especially with an already-weak loonie in mind.
Canada’s lagging economic performance is first evident in financial markets, where the TSX has woefully underperformed the S&P 500 this year (Chart 1). Canadian stocks are very slightly positive after rallying in recent weeks, but still well behind the S&P 500’s 14% advance. Some of the underperformance is technical—the TSX doesn’t have a lot of weight in what has worked, namely big tech and consumer sectors—but some of it reflects higher interest rate sensitivity that could be extrapolated to the broader economy.
Indeed, economic performance on the ground has lagged notably through 2023. Based on our current forecast, the U.S. is on pace to post sturdy 2.5% growth this year (Q4/Q4), while Canada is set for just a 0.4% advance that includes a sprinkling of negative quarters. We will again drive home the point that while Canadian growth has mostly followed the cooling script, the U.S. economy is—miraculously—on track to grow faster this year than last year, something no forecaster was anticipating at the start of 2023.
Canada’s heavy growth underperformance is all the more disappointing when considering torrid 3% population growth, a pace 2.5 ppts faster than in the U.S. In fact, per capita real GDP in Canada is on track to contract 2.3% y/y in Q3, versus 2.4% growth south of the border—so the relative growth differential might feel even more noticeable at the individual or household level.
There are a number of factors driving this wedge into relative growth. U.S. fiscal stimulus has run much stronger than in Canada and, while that probably comes with longer-term consequences, it’s juicing growth and inflation today. Canada’s productivity performance has also been famously poor. The real estate correction has been deeper, while the consumer has had a tougher time grappling with inflation and higher borrowing costs.
Rate Hikes Biting Harder
Indeed, higher interest rate sensitivity, in a cycle where the defining feature is very aggressive tightening, is probably the broadest relative headwind for Canada. While the U.S. household sector was deleveraging over the past 15 years, and housing valuations were moderating, the exact opposite was taking shape in Canada (Chart 2). Canada’s household debt-to-income ratio has just backed off an all-time high, while the debt-service ratio is bouncing around record levels despite strong income gains and many mortgages still locked into low rates. That said, the mechanics of the mortgage market will lean heavier on Canada in the coming few years as shorter-term fixed and variable-rate mortgages come to renewal, while many Americans locked in low rates for 30 years during the pandemic housing boom.
Market Expects Similar Rate Path
Despite weaker growth on the ground, a soggier outlook and what looks like a higher sensitivity to interest rates, the market continues to view near-term monetary policy in a similar light. Based on current pricing, a full 25 bp rate cut is expected from both central banks by July, while somewhat more easing is priced into the U.S. by the end of 2024 (Chart 3). For much of this year, we’ve seen an even wider disparity between expectations on the two central banks (i.e., earlier and more aggressive Fed rate cuts), which was curious given the economic backdrop. The market is now moving away from that stance but remains hesitant to assume earlier/more aggressive easing in Canada. And that begs the question: can the Bank of Canada even move away from the Fed if the economy continues to underperform?
BoC Has Separated Before
The short answer: of course the Bank of Canada can diverge from the Fed. A look back over the past 50+ years reveals plenty of periods of, sometimes, wide divergences in North American monetary policy. To be sure, it’s incredibly rare to be moving in opposite directions—although it has happened as recently as 2015—and typically the amount of daylight between the two central banks has been small (Chart 4). Over time, policies are, if anything, becoming even more tightly aligned. Following a wild ride from the mid-1970s to the mid-1990s, when Canada/U.S. spreads ranged from +500 bps to briefly -500 bps, the spread has mostly been confined to a 100 bp range over the past 20 years (Chart 5). But the point there is that even in the relatively calmer period since 2000, the Bank of Canada and the Fed have often been as much as 100 bps apart on policy (compared with the current spread of just over 30 bps). So, yes, there is plenty of precedent for the Bank to go its own way.
The Economy Drives Divergence
Not surprisingly, a divergence in underlying economic performance has driven past monetary policy divergence. A recent and stark example was in the immediate years after the financial crisis of 2008, when Canada’s banking sector fared much better and the economy rebounded more readily. As a result, the Bank of Canada was much quicker to lift interest rates away from zero, leaving a sustained period of wide Canada/U.S. spreads.
A neat method of capturing economic divergence is to simply look at the unemployment rate gap between the U.S. and Canada. It currently stands at -1.8 percentage points (3.9% vs. 5.7%), a bit off the -1.6 ppts in the first half of the year, and notably wider than the -1 ppt mean of the past two decades (which mostly reflects definitional differences; calculated on a U.S. basis, Canada’s jobless rate would be roughly 1 ppt lower than currently reported). A smoothed measure of the unemployment rate gap acts as a very good leading indicator for where relative monetary policy is headed in coming months (Chart 6). Given that we see the Canadian unemployment rate rising to a bit more than 2 ppts above the U.S. in the year ahead, this suggests that the policy rate gap could widen somewhat further in 2024.
Eyes on the Loonie
The limiter on how far the Bank of Canada can deviate from the Fed is the exchange rate. The Bank can’t cut at will without risking a serious slide in the Canadian dollar, which could easily move far beyond fundamentals and re-aggravate inflation. After all, the currency market is famous for overshooting. By the same token, the Bank could see the loonie flare higher were it to tighten aggressively on its own. Yet while the currency may somewhat limit the Bank’s independence, it also can act to reinforce whichever direction the Bank is attempting to move policy—that is, when the goal is to be relatively easy, a weaker currency amplifies the effort, much as when the goal is to be tight, a stronger currency piles on.
In fact, an economic divergence between Canada and the U.S., as captured by the unemployment gap, acts as a very good leading indicator for the exchange rate (Chart 7). Over the past 30 years, when the U.S. unemployment rate has moved well above that of Canada—classic example was after the 2008 crisis—the Canadian dollar has tended to be very strong. On the flip side, when Canada’s jobless rate was far above the U.S.—classic case was a 4 ppt spread in the early 1990s—the Canadian dollar was in the wilderness. We are currently between those two extremes, albeit tilting to a lower-than-normal U.S. jobless rate relative to Canada, and a softening currency. One wrinkle in the current cycle is that rapid population growth is pressuring Canada’s labour force and jobless rate higher, while also juicing spending and rent inflation, suggesting that the monetary policy response to a rising unemployment rate may be more muted in this episode.
Due to broader global factors, the loonie is now even weaker than one would expect given just the unemployment and interest rate differentials. (As an aside, there is only a weak correlation between the exchange rate and interest rate spreads over the past 50 years—the explanation is that a strong currency can afford the opportunity for the BoC to sometimes cut rates, or raise them less than they otherwise would have). As a result, we are not particularly bearish on the Canadian dollar at present, given that much of the relative bad news on the economic front has already been absorbed in today’s exchange rate. In fact, our broader view is that the U.S. dollar will lose altitude in 2024 against most currencies as the turn in Fed policy comes more fully into view.
Bottom Line: Given economic conditions on the ground and the near-term outlook, there is a risk that the monetary policy setting between the Bank of Canada and the Fed will diverge further, with the former pivoting to a relatively looser stance. This should keep the loonie flying at a low altitude, but it will probably take even more pronounced weakness in Canada to see significantly more downside.