FICC Market Review: Rate Expectations

While central bank rate cuts are widely anticipated, particularly in the U.S., a closer look suggests a different reality for borrowers. North American markets have seen significant volatility in the past six months, driven by evolving geopolitical events. Despite expected policy easing, the actual cost of longer-term borrowing may remain stubbornly high, shaped by broader currents and factors beyond the central banks’ direct control.

The mood and the pricing - Rate cuts are expected
Financial markets are calling for a reduction of 25 basis points (bps) in Canada and 50 bps in the U.S. from current interest rate levels. Those expectations have been dwindling since the initial announcement of global U.S. tariffs. In the graph below, one can see how the current expected paths for policy in both countries (green and red lines) are higher than they were on April 4 (yellow and blue).

Today’s CPI report doesn’t change our view that the Bank of Canada will hold this month. While headline inflation is under 2%, core inflation remained stubbornly high last month and the latest jobs report was stronger than expected.

Relative to Canada, the U.S. market continues to believe that a greater amount of policy easing is ahead (the differential between a Government of Canada 2-year bond yield and the equivalent U.S. Treasury bond has moved from -150 bps to -109 bps in just a few weeks). What expectations are driving this? What developments could corroborate this current view? What should you look towards for clarity ahead?

What to look for ahead - Absent a growth shock, “real” rates matter
In Canada (first chart below), the policy rate is a little above headline CPI (85 bps) and very close to the current core CPI reading. In the U.S. (second chart below), policy has remained fairly significantly above both inflation measures (core CPI and the Personal Consumption Expenditures (PCE) price index) as the Federal Reserve has been more reluctant to cut rates than the Bank of Canada. And why is this important? Well, because it influences the extent to which rates could realistically be expected to be lowered ahead. Absent a real shock to Canadian economic growth that would weigh on the inflation rate heavily over time, it limits the extent that the Bank of Canada can ease rates. As Governor Tiff Macklem said recently, “If the recent firmness in underlying inflation were to persist, it would be more difficult to cut the policy rate.” Essentially, The Bank of Canada rate cuts of 2024 have not been met with a proportionate reduction in the measure of Canadian inflation (core CPI). Hence, real policy rates are essentially zero/negative.

The Federal Reserve in the U.S. has more room to ease by comparison (at least by this measure), but they appear to require more evidence that the strength of growth, the low U.S. unemployment rate, and the impacts of tariffs will not jeopardize the current more moderate rates of inflation ahead. As Fed Chair Jerome Powell has said recently, “If it turns out that inflation pressures do remain contained, then we will get to a place where we cut rates, sooner rather than later.” He elaborated, "In a situation like this where the process could go on for a long time, where the effects could be large or small, it's just something you want to approach carefully. If we make a mistake here, people will pay the cost for a long time."

It seems likely that the Fed will find enough comfort in the data in the coming months to reduce the policy rate to a level closer to the U.S. inflation rate. However, does that - or any action the Bank of Canada might also take - really matter all that much to borrowers?

New reality on “the curve” - Does policy even matter to borrowers?

The chart above is the differential between the yield on a 2-year U.S. government bond and that of one that matures in 30 years. As you can clearly see, that differential has been rising steadily more recently. In other words, the longer the term for which the money is being borrowed, the higher the yield now on a relative basis. Markets refer to that as “curve steepening.” 

There are two main drivers. The first is essentially the belief that underlying inflation will continue to be sticky relative to growth than it was previously. The second is the continued concern over the amount of government debt (especially in the U.S. but also in Canada) that needs to be issued to finance government policy. Both of these factors have two things in common:

• They both suggest that rates on longer term debt - such as mortgages and business loans - will be challenged to fall significantly (both absolutely and also relative to the policy setting);
• Neither are influenced by that central bank policy setting (at least quickly and directly).

So in short, while it is always wise to pay attention to what the central bank is doing with policy rates and saying about policy prospects ahead - it may not actually be that relevant to the true cost of borrowing in the coming months.

This article was originally published in The Twenty-Four.