Traders wary of July BoC key rate cut following unexpected surge in inflation report

Markets immediately responded to an unexpected acceleration in Canada’s inflation rate in May by sending the Canadian dollar higher, while domestic bond yields spiked as traders scaled back bets on the odds of another interest rate cut in July.

 

Canada’s annual inflation rate rose to 2.9% in May while key measures of core inflation edged up for the first time in five months in an unfavourable reading for July interest rate cut prospects.

 

According to LSEG data (formerly Eikon), swaps markets are putting 45 per cent odds now on a second rate cut by the Bank of Canada on July 24. They stood at 65 per cent prior to the 830 am ET inflation report. Some 50 basis points of additional easing is now priced into the market by the end of this year, which is modestly less than before this morning’s inflation data.

 

The loonie rose about two-tenths of a cent, to 73.29 cents US, while both the two year and five year bond yields jumped 10 basis points. While those are quite large daily moves in the bond market, they only bring those yields back to where they were earlier this month, with the five year now at 3.464 per cent.

This is a large enough move in bond yields to likely put pressure on interest rate sensitive stocks when equities open at 930 am ET in Canada.

 

Here’s how implied probabilities of future interest rate moves stand in swaps markets, according to data from LSEG as of 846 am ET. The Bank of Canada overnight rate is 4.75 per cent. While the bank moves in quarter point increments, credit market implied rates fluctuate more fluidly and are constantly changing. Columns to the right are percentage probabilities of future rate moves.

Here’s how economists and market strategists are reacting in written commentaries following the data:

 

Katherine Judge, senior economist with CIBC World Markets

Inflation moved in the wrong direction in May, with the CPI accelerating to 2.9% y/y, against expectations for an easing from 2.7% to 2.6%. The acceleration was led by cellular services, travel tours, rent and air transportation. The Bank of Canada’s preferred core measures also looked higher than expected, with CPI median rising by two ticks to a 2.8% y/y pace (vs. 2.6% expected), and CPI trim at 2.9% y/y (vs. 2.8% expected), with both increasing by 0.3% m/m in seasonally-adjusted terms. Overall, with the data showing much faster price pressures than expected, this casts a lot of doubt on the possibility of a July cut.

 

Olivia Cross, North America economist, Capital Economics

July cut on shaky ground …. The stronger monthly gains in the Bank of Canada’s preferred core price measures will give the Bank some cause for concern after starting its loosening cycle in June. However, with some of that strength due to factors that are likely to be one-offs, and given there is another CPI report before the late July meeting, for now we are sticking with our view that the Bank will cut again next month.

 

The larger-than-expected 0.3% m/m seasonally adjusted rise in the headline CPI brought the annual rate back up to 2.9%. There were upside surprises in a number of components, although some are unlikely to be repeated, such as the 2.4% jump in travel services, 0.5% rebound in food prices and the larger 0.9% m/m jump in rents. The good news was that, despite the latter, shelter prices rose by a softer 0.4% m/m, thanks to the softest gain in mortgage interest costs since the Bank’s earlier hiking cycle began. However, with the new CPI weights incorporated in this release increasing the importance of shelter prices, even that milder price overall gain still had an upward effect on the monthly increase in overall prices.

 

The bad news was that CPI-trim and CPI-median each rose by 0.3% m/m and the average monthly gain in April was revised up to 0.2%, a step up from the 0.1% gains seen over the first three months of the year. All that means the three-month annualised rate rose back up to 2.5%. That is a step backward and increases the chance of the Bank pausing at its July meeting, but there are several more key data releases before then that could sway the Bank’s thinking.

 

Jules Boudreau, senior economist, Mackenzie Investments

Today’s inflation data shows that Canada’s path to 2% will be a bumpy road, but doesn’t rule out multiple rate cuts in the rest of 2024. Canadian inflation exceeded the average economist’s forecast for the first time in 2024, interrupting a string of comforting CPI prints for the Bank of Canada. …

Prices accelerated across the board, with services prices contributing most to the uptick in inflation. Most notably, rents surged in May, rising 10% (annualized) from April 2024 to May 2024. While rents are hard to measure precisely from one month to the other, and one data point isn’t a trend, this uptick is a headache for the Bank of Canada. Rent is salient, politically sensitive, and has a massive weight in the consumer basket.

 

This CPI report is not a death knell for a July rate cut. The Bank will see one additional CPI report, and a pivotal jobs report before decision time comes. Over the course of 2024, the balance of risk has clearly turned from inflation to growth. Cutting rates at a steady pace is necessary to jumpstart an ailing Canadian economy that is underperforming all its global peers. Zooming out, a sustained bounce in inflation is very unlikely, given the sluggish state of the economy and the disinflationary trend around the world. The Bank of Canada won’t miss the forest for the trees. Multiple rate cuts are still on the table for the rest of 2024.

 

 

 

This article was first reported by The Globe and Mail