Benjamin Tal
Managing Director and Deputy Chief Economist, CIBC

The current trade dispute between China and the U.S. is probably the most significant factor impacting markets at this point in time. This dispute is about much more than trade. It’s about an American attempt to keep China in a permanent state of technological inferiority. The American strategy here is clear: block China from becoming a dominant player in the technology space. If that’s the real agenda, then a simple trade agreement will not do. We might already be in the midst of a technology cold war. China’s control of information within its borders suggests that it is already operating in a separate digital dimension. By cutting off Huawei, the U.S. has taken a retaliatory step that is taking us closer to a complete tech-split. Accordingly, while we expect pragmatism to eventually take over, it probably will not happen any time soon and even then, the eventual agreement will be a “cold” one.   

At this point, the US Fed really doesn’t need more bad news to justify a cut as early as July. Markets are fully priced for at least two moves during the second half of the year, and for two more next year. Some observers are calling for much more than that, with tweets suggesting a Fed move of 50bps in July, receiving more and more “likes” lately.

We agree that 50bps in the second half of the year, starting in July, is a real possibility, but we also think that traders are getting a bit too excited. The reality is that markets tend to overshoot. The call for a 125bps hike as recently as November of last year was an overreaction, and today’s calls for anything more than 50bps of easing are also an overshoot. Remember, we are talking about pre-emptive cuts here, as opposed to easing aimed at lifting the economy from the ground up. For an insurance move, 50 bps is plenty.

If we are right, the long-end of the yield curve is not a friendly place at the moment. Not only is it pricing in unrealistic rate expectations, but it also embodies inflation expectations that, to us, don’t make much sense. Inflation expectations now stand at 1.6%—down from 1.9% earlier in the year. The recent softening in inflation expectations coincided with the decline in oil prices. In fact, since the financial crisis, oil prices and inflation expectations have been highly correlated. On average during that period, a 10% change in oil prices led to a 9bp change in expectations. Now, clearly this is pure correlation as opposed to causality, as inflation expectations fall for the same reason that oil prices fall—an anticipated softening in global growth. But, the 40bp decline in the breakeven rate in response to the near-20% decline in WTI since late 2018 is almost double the response seen in the past. That suggests that inflation expectations might be overshooting even more than usual on the downside.

And if that’s not enough, long-term interest rates are vulnerable to changes in short-term interest rates. That is, previous episodes of pre-emptive easing, such as in 1995 and 1999, have resulted in higher long-bond yields down the road. And the logic is clear: to the extent that the market views the pre-emptive strikes as successful in preventing or postponing a recession, that cannot be beneficial for long bonds.

So you are the Bank of Canada. You see the Fed easing and the U.S. curve steepening. What do you do? Can you divorce yourself from the Fed? In 2002, the Bank started to hike while the Fed was actually cutting. That courageous act of independence was short-lived, however, with the Bank undoing the hikes shortly thereafter. In 2010, the Bank tightened by 75 basis points while the Fed was in neutral.

The Bank of Canada is in no hurry to act. Its 1.75% overnight rate is below the Fed’s, its own core inflation measure is right at the 2% target, and it’s leery of restarting another wave of household borrowing if the economy doesn’t really need it. But it’s hoping that growth will instead pick up next year from exports and related capital spending, and standing pat on rates as the Fed trims 50 bps would likely send the Canadian dollar to firmer levels. That, and the downside risks to global growth from trade uncertainties, would be reason enough for the Bank of Canada to offer up a token 25 bp cut next year to trim the loonie’s sails.