Divergence

By Guest Blogger Ryan Lewenza

I’m a big music fan with one of my favourite bands being the UK punk band, The Clash. I was thinking of them and their great track, Should I Stay or Should I Go, when I was coming up with today’s blog topic on whether the Bank of Canada will follow the Fed and cut interest rates in the coming months (currently the market is pricing in a 100% chance of a Fed cut at its July meeting), or diverge from the Fed and hold rates steady. This week I’m talking monetary policy, so strap in, it’s about to get crazy in here!

With the slowing US/global economy and Trump’s ongoing trade war with China, central banks are reversing course faster than the Raptors’ 2020 season outlook following our disappointing loss of Kawhi Leonard to the Clippers.

In just 6 months the market went from pricing in three Fed hikes for 2019 to now pricing in three cuts for this year. I covered this in a recent blog post, and BNN interview, where I stated that the market is over-reacting to the slowdown in the economy and therefore the Fed is, at most, only going to cut once this year. Based on this outlook what does this portend for the BoC?

As seen below, the BoC and Fed historically have moved in lockstep (there’s a 90% correlation between the two) so the easy prediction is that whatever the Fed does with interest rates the BoC will just follow. I’m not 100% sure about this, at least initially.

BoC and Fed Move Lockstep Together

Source: Bloomberg, Turner Investments

Let’s first review some of the more recent Fed tightening cycles.

Over the last 25 years there have been four rate tightening cycles – 1995, 1998, 2001 and 2007. As seen in table below the 1995 and 1998 tightening cycles were quite different than the 2001 and 2007 periods.

For the 1995 and 1998 cycles the US economy was slowing so the Fed took out an insurance policy by cutting twice in 1995 and three times in 1998. This helped to provide the necessary stimulus to turn the US economy and stock market around. In both cases the S&P 500 rallied nicely following the rate cuts.

For the 2001 and 2007 cycles the US economy was on the precipice of devastating economic recessions and bear markets so the Fed had to cut much more aggressively with 550 bps of cuts in 2001 and 500 bps of cuts in 2007. We know what happened to the S&P 500 following these periods.

So investors are wondering, which period most resembles our current situation. I believe it’s the former (1995 and 1998 cycles), which is why I see few rate cuts this time (one this year and maybe more in 2020 depending on the US economy), and this is critical to what the BoC does in my opinion.

Past Fed and BoC Rate Tightening Cycles

Source: Bloomberg, Turner Investments

Because I believe the US economy is in better shape than the market currently is pricing in I believe we’re likely to see just one rate cut from the Fed this year versus the three that the market is currently pricing. Given this I believe the BoC will be more patient and very likely remain on hold for this year. Additional supports for this thesis include:

First, the Fed has already been jawboning about the outlook for rates when last week Fed Chairman Powell said “Many FOMC participants saw that the case for a somewhat more accommodative monetary policy had strengthened”. In contrast, the BoC said in its July rate announcement that “the degree of accommodation being provided by the current policy interest rate remains appropriate”. To me this clearly signals the BoC is on hold for now.

Second, inflation is running hotter in Canada at 2.4% Y/Y versus the US at 1.8%. If this continues this may force the hand of the BoC to be less dovish, keeping rates unchanged.

Inflation is Picking Up in Canada

Source: Bloomberg, Turner Investments

What are the implications of all this?

I believe this could be bullish for the Canadian stock market and our dollar.

If the Fed does cut rates I believe this will be bearish for the US dollar. With commodities being priced in US dollars, generally a weaker US dollar translates into higher commodity prices. Gold is a good example of this, and it has started to perk up in part due to the recent weakness in the US dollar. With our economy and stock market being heavily represented by the resource sectors this could bode well for the TSX relative to other markets in the coming months.

Lastly, if the BoC were to remain on hold while the Fed cut rates this year I believe this would be bullish for our Canadian dollar. The CAD versus the USD has rallied from a low of 73 cents to start the year to 76.5 cents currently. If I’m right on the Fed cutting and the BoC keeping rates unchanged this year then we could see the CAD rally up to 78-80 cents.

So start planning some trips down south if this call pans out!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.