The Canadian economy is at stall speed and the BoC is in a holding pattern. There has been no GDP growth and anemic employment gains over the last year – amid the dual forces of a population and trade shock. The consumer has actually been quite resilient in the face of these shocks. While the starting point should keep the BoC on hold for the rest of the year, better prospects for growth are ahead and this should see the BoC delivering hikes in 2027. Listen for more detailed views on the Canadian economy and fixed income markets in the coming quarters.

Participants:

• Jason Daw (Desk Strategy), Head of North America Rates Strategy
• Simon Deeley (Desk Strategy), Canadian Rates Strategist

* Research Analyst opinions are their published views, independent of those expressed by Desk Analysts

Speaker 1:

Simon: Okay, let's kick it off with a question back for you, Jason. What's happened in the economy last year? We know it was pretty volatile, had some questions around trade, USMCA growth was pretty low, some issues in the labor market. Can you give us some more detail on what you've seen?

Jason: Thanks, Simon. Yes, indeed. The best way to probably characterize what's happened in the economy over the past year is that it's been at stall speed. GDP growth has been zero, and that's been the result of two unprecedented shocks that have hit the economy. The first one and probably the most important has been population growth, which has effectively been zero. And then there has been trade uncertainty, which is probably a secondary consideration, but one that was still important as far as how the economy evolved. I would say that the one positive aspect of what happened was the consumer. The consumer did grow around 1.5% over the past year, and that is a really good outcome against a zero population growth world. So the question then really is, is 0% growth really all that bad? And I think when you calibrate that against population, which was effectively 0% growth and labor productivity, which was slightly negative over the past year, 0% is not all that bad and really just reflects the potential GDP for the economy.

Now that's what happened in the recent past, I guess, Simon, what is the outlook going forward? It seems like there's maybe some more bright spots. Stuff might be looking a little bit better over at least a 12-month horizon, and if not, maybe even in the second half of this year.

Simon: Yeah, absolutely. We do have growth picking up even starting in Q2. If you look at where growth is tracking so far, it's even above 2% early on judging by the monthly GDP indicators. But going further into the year, we do think growth is above potential for Q3 and Q4, unemployment rate ticking down. On the inflation side, it has come down a fair bit. So if you look at it from an underlying inflation or core inflation perspective, it's certainly come down to around 2%. We think it should remain around there, but the key aspect here on the growth side is when you have above potential growth, the output gap or the amount of slack in the economy is reducing. And when that happens, the Bank of Canada tends to pay a lot of attention to it. It's really a guidepost for how they conduct policy.

So that output gap closing what we expect to happen in the second half of the year or start to happen in the second half of the year is certainly a key indicator for the bank going forward. On the housing front, things have been relatively soft, nothing too terrible, but certainly moving in a softening direction. We don't really think there's a huge change there. And in terms of the growth drivers, other than that, the consumption side, as Jason mentioned, has been a good driver over the last year. We think that will continue. And then government spending, we're seeing announcements from the government, including on the defence side. Those end up being a pretty solid add to growth as well. But there are plenty of risks in the economy and we've seen some of that even this week on the flare-up with US and Iran and the move up in yields.

Jason, what do you think the risks to Canada are on the oil side?

Jason: Yeah, the oil side is quite interesting because up until a couple days ago, oil was going down and bond yields were not necessarily following suit. So the correlation between oil and rates like we saw in March, April, even through May, that correlation broke down. And then over the past couple of days, it started to reassert itself again when oil has started to rise. The question is why didn't bond yields adjust lower when oil was going down over the past couple of months? And there's probably a couple of reasons. Maybe there was still lingering concern that there would be a flare up in the Middle East and oil would rise again, but probably more importantly was the big narrative shift that happened with the Fed. If you recall, before the US-Iran conflict, the market was pricing rate cuts for the Fed. Now it's pricing rate hikes and that's affected global bond yields and Canada specifically.

As far as the economy's concerned, the Bank of Canada has cited it as a risk, but it would require inflation expectations rising quite significantly. We saw a little bit of that in the business outlook survey, but I think where we are with oil prices right now, let's say around $75 to 85 a barrel, it is a bit in the zone of irrelevance for the Bank of Canada and the economy overall.

Moving on to the other big risk out there, USMCA, obviously it was not renewed on July 1st. What do you think as far as the economic implications of that and the path going forward for USMCA and whether a new deal can be struck?

Simon: Yeah, USMCA has certainly been a key risk ever since Trump came in. The July 1st non-renewal was really the only likely outcome there given what the Trump administration has said, but it's not a sign that they don't want any agreement. It's just a sign that they didn't like the current agreement and that's certainly what they had voiced for some time now. So going forward, essentially we're in a point where if there's no new agreement struck, we're in an annual review period where the sides meet and discuss potential options for a new agreement or we end up with a new deal. And so at some point, if they do reach an agreement with changes and the most likely thing here is you have USMCA acting as kind of the center agreement and you have bilateral arrangements between the US and Mexico, US and Canada. If we end up at that point, then that removes any lingering uncertainty for certain businesses.

There's an uncertainty on how much that will really release investment. It probably helps at least a little, but I think firms are adjusting to the current environment and when they need to make decisions, they are making decisions. The rolling annual review periods is a possible outcome as well. If Canada and Mexico, for example, don't want to sign onto agreement, the Trump administration doesn't want to exit. And that is one of the key views that we have is that the Trump administration doesn't want to exit. The US in general doesn't want to exit USMCA. They just want to get some concessions. If the negotiations go that they can't reach an agreement, then you're just in annual review periods, they may want to just wait out until there's a new administration. But we think the most likely outcome is a new deal. One, we think Trump would want a new deal in order to show that he's made some improvements and praise what he's done. We think it's good for Canada and Mexico as well to reduce the uncertainty. So we do think that's the more likely of the two likely outcomes. And again, we do think a withdrawal is pretty low likelihood just because the US could have withdrawn at any time or triggered the process at any time and they haven't. And we think that's a sign they think it's at least too costly to do that and they want to move ahead with just extracting some concessions from Canada and Mexico.

So Jason, what do you think this all means for the Bank of Canada? Shouldn't they be cutting rates if growth has been so weak, if there's any concerns on the USMCA side?

So this year, Bank of Canada on hold, but there is a clear path to rate hikes in 2027, which we would characterize more as adjustment-style hikes from the bottom end of neutral to the top end around a hundred basis points. The timing of when those rate hikes could occur, it is still very uncertain. We've penciled in the first quarter. Could it be the second quarter? Yes. Could it even be a little bit earlier into the back part of this year? That is a possibility, but our base case is at least a Q1 starting point. For them to move over the next few months or even over the next couple of quarters, that would really require a tail risk scenario in either direction. So growth would have to be in recessionary type of territory. There would have to be job losses, which we haven't seen.

So moving on to the market side, Simon, what about bond yields in the curve? Is there any differentiation between what we're thinking short-term, let's say the next one to three months versus what we're thinking over the next three to 12 months?

Simon: Yeah, the market side's interesting. What we think short term, so over the summer, for example, we do think it's an environment where front end can perform. There is a decent amount still priced, pretty close to one full hike priced for the Bank of Canada by the end of the year. As Jason said, that we don't think that's warranted. So we think there is a timeline for some long front-end positions. We think those can pay off, especially given the move we've seen recently and what that recent move does underline as well is the risk to this. So the risk is that if there's a pop in oil prices because US-Iran flare up, which is what we've seen this week, then you see front-end yields move higher, risk of hikes increase, and that moves against the recommended position. It is one where if volatility's low, then being long the front end makes a lot of sense.

And so it is something that we favor right now, but it's not without risks given the US-Iran situation. Over time though, so say over the next six months to a year, we do think the stronger growth profile that we've mentioned and inflation kind of moving to around 2%, not below. And that reduction in the output gap means that the Bank of Canada should be looking at hiking. And what comes with that is a rise in front-end yields. So we do think, for example, by the end of the year, the two-year yield can move up to above 3% currently in the mid 280s. We think it can move above 3% by the end of the year as the market positions for Bank of Canada hikes early next year. And then also that for yields further out the curve, there's some potential for them rising. We think near term, they're probably more likely lower similar to the front end. But then over the longer term, we see it kind of flattening out for the 10-year part around 360. So that's the case for both late this year and also into the middle of next year. And so what that generally means is, and this is consistent with what you expect when a central bank is tightening rates, is that the curve is flattening led by the front end. So front-end yields moving higher, curve flattening in general.

What about you, Jason? Do you have any strong directional moves based on where the market is at the moment?

Jason: Yeah, I tend to agree that over the next one to three months, the play is for front-end yields to be a little bit lower in Canada, for the curve to be a little bit steeper. And you can even have a situation where a lot of the outperformance that we've seen in Canada versus the US continues. And I do think that will ultimately set the stage for a reversal where the opposite dynamics start to unfold sometime around the fall period. Some of the other interesting things that we cited in our mid-year outlook, Canada versus Europe, that seems relatively interesting. It's been a fairly stable cross-market spread over the past few months and has generally been moving lower rather than higher. And in a world where investors are still favoring carry, that does seem like something interesting for people to consider. The other interesting aspect between relative pricing Canada and the US in this case that looks quite disjointed is what the market's pricing for the BOC and Fed from a sequential policy standpoint over the next 18 months.

Thank you to all our listeners for tuning into this edition of Macro Minutes. The Canada situation is evolving rapidly. The economy's been weak over the past year, but there are bright spots as we go towards the end of 2026 and into 2027. Fiscal policy is possibly one of them. Population growth dynamics may change. The consumer could stay resilient. So we've been used to the central bank on hold. That may change as we go into 2027. So if you have any questions on Canada, feel free to reach out to your sales representative or us directly for further insights.

Speaker 3:

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