The Bank of Canada has further rate announcements scheduled for April and June but the odds aren't looking good that there will be further rate cuts.Chris Wattie/Reuters
This was supposed to be the year of the rate cut. The only questions were how soon and by how much would central banks slash their policy rates to the delight of investors and debtors everywhere.
Well, you can forget about a rate cut in March – that’s almost certainly not happening. The odds aren’t looking good for April or June, either, when the Bank of Canada has further rate announcements scheduled.
The U.S. Federal Reserve, meanwhile, is seen to be on hold until at least July, and will be pressed to squeeze in just three or four rate cuts this year, judging by overnight index swaps, which serve as a proxy for rate expectations.
A few months ago, markets were expecting as much as eight Fed cuts this year, bringing its key rate down by two full percentage points.
Financial markets seem to finally be coming to the realization that central banks have zero urgency in easing back on interest rates. With the market’s probabilities for rate cuts falling so quickly, it raises the question, what if there are no rate cuts this year at all?
It’s a question with big implications for stocks, which have rallied furiously on the belief that the hour of the rate cut was approaching.
Financial markets globally hit a turning point last October, as faith in a soft landing grew. Inflation was suddenly fading and without the economy succumbing to the forces of recession.
Since that time, the S&P 500 Index has gained 23 per cent in just four months. The Nasdaq Composite index is up by 27 per cent, while the S&P/TSX Composite Index has gained 13 per cent.
Why the Canadian stock market is a dud on a global scale
The good vibes have extended to equities globally, all predicated on the notion that the fight against inflation was won and interest-rate relief was on the way.
“Those expected rate cuts were a huge part of that rally,” said Stephen Lingard, the head of investment research of CI Investments’ multi-asset team. “It was helpful in allowing the market to look through earnings weakness.”
Most of the rise in stock prices was driven by expanding market multiples rather than growing corporate profits. In other words, the improving mood of investors outweighed pressure on company fundamentals.
So what happens if you take rate cuts out of the equation? You remove a crucial stimulant at a time when stock markets might be particularly vulnerable to a mood swing.
You would be hard-pressed to find a credible forecast calling for this year to pass without rate cuts.
But it could hardly be considered a remote scenario when the economic data have largely defied the consensus for the last year or so.
Just look at the state of the U.S. economy, which was almost universally expected to fall into a recession last year. Not only did that not happen, U.S. GDP growth accelerated last year, at 2.5 per cent from 1.9 per cent in 2022.
“If that keeps up, how can the Fed cut, if inflation continues to be troublesome?” Mr. Lingard said.
The higher-for-longer mantra that investors largely abandoned last year has crept back into mainstream economic commentary.
But the stock market itself has yet to adjust to the potential for minimal rate cuts this year. That would almost certainly deliver a blow to investor sentiment, which at the moment seems steeped in artificial intelligence euphoria.
The Canadian stock market is especially vulnerable to high interest rates, given its heavy weightings in value stocks and dividend paying names. Most Canadian dividend-focused ETFs, for example, have delivered negative returns over the two years since the Bank of Canada started hiking interest rates.
This is a big reason the TSX has been a notable laggard in this era of high inflation and higher interest rates. But in that is the silver lining. So discounted are Canadian stock prices that they are probably less susceptible to an unwinding of rate-hike optimism.
Canadian stocks carry a valuation multiple of about 15 times next year’s earnings, compared with 22 for the U.S. market.
For the TSX, there is strength in weakness.
Tim Shufelt