Bank of Canada’s ‘soft landing’ scenario hits rocks in bond market

Canada’s inverted yield curve signals that the Bank of Canada could raise interest rates to a level that would trigger a recession, putting the central bank in a tough spot as it aims to rein in high inflation and organize a “soft landing” for the economy.

The yield on Canadian 10-year government bonds fell about 50 basis points below the two-year yield. It is the largest Canadian yield curve inversion in Reuters data dating back to 1994 and deeper than the US Treasury yield curve inversion.

Some analysts view curve inversions as predictors of recessions. Canada’s economy will likely be particularly sensitive to higher interest rates after Canadians borrowed heavily during the COVID-19 pandemic to participate in a booming real estate market.

“It makes sense that we’re seeing more of a reversal in this cycle than in recent ones, simply because there’s a lot more evidence of over-tightening from the central bank,” said Andrew Kelvin, Chief Strategist for Canada at TD Securities.

“That’s what happens when central banks fall behind the curve.”

The Bank of Canada, like many other central banks, deemed inflation to be “temporary” or “transitional” until the fall of 2021 and did not start raising borrowing costs until March 2022. , when inflation was more than double the rate of 2%. -cent target.

Canada’s annual inflation rate hit 8.1% in June, its fastest pace since 1983.

Investors worry that central banks around the world will not be able to ease price pressures without triggering a downturn. The Bank of England last week factored a long recession into its forecast.

Meanwhile, the Bank of Canada continued to predict that Canada will experience a “soft landing” in which the economy will slow but not tip into recession.

“Such an outcome is not totally impossible, but I don’t think they would calm down. [on rate hikes] from a recession if inflation proves persistent,” said Derek Holt, head of financial markets economics at Scotiabank.

Since March, Canada’s central bank has raised its key rate by 225 basis points to 2.5%, including a full one percentage point hike in its latest policy decision in July.

After Wednesday’s U.S. data showed inflationary pressures easing, money markets cut bets that Canada’s central bank would raise rates by three-quarters of a percentage point next month.

Nonetheless, the Bank of Canada’s key rate is expected to peak at around 3.5% over the next few months, breaking above the top of the 2% to 3% range that the central bank deems to be a neutral setting, or the level at which monetary policy is neither stimulative nor burdensome to the economy.

Such a restrictive framework would likely test the resilience of the Canadian economy, including the housing market, which has slowed rapidly in recent months.

“In Canada, investors are concerned about the impact that a slowdown in housing markets – and a cycle of longer-term household deleveraging – could have on the broader economy,” Karl Schamotta said. , chief market strategist at Corpay.

“Within the central bank’s mandate, price stability trumps short-term economic growth considerations.”

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