The Canadian federal election produced the third straight Liberal minority government. The pre-election campaign incorporated sizable new fiscal measures. In this episode we unpack what it means for the economy, Bank of Canada policy, issuance, and the rates market.

Participants:

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

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

Jason Daw:

Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.

Now, the Liberal pre-election fiscal plan that's been sizable, 130 billion in new measures that will see a larger budget deficit than prior assumptions, and it was focused across the number of areas from direct tariff support, lower taxes in the lowest bracket, housing-related measures, military outlays, and a slew of measures for infrastructure and diversifying trade. So to kick off, the first question is going to be to Simon. I'm wondering what you think about the political strategy surrounding how this plan gets formulated into a budget. Will the Liberal fiscal plan go ahead in its current form or will there be negotiations? And from a timing perspective, when should we expect the budget?

Simon Deeley:

Key upcoming dates are May 12th, the swearing in of the cabinet, and May 27th when King Charles III opens parliaments with the throne speech. If the Liberals are able to get a deal on a broad budget plan, then we could see a budget as soon as June. If not, the Liberals may find it easier to pass more targeted legislation on areas of agreement or at least non disagreement with different parties. If Liberals go this route, then a budget may not be forthcoming for several months, but elements of the Liberal plan would come into place more piecemeal. Shifting to the macro side, Jason, what are the economic implications from the Liberal plans and can it offset the negative impact from tariffs and economic uncertainty?

Jason Daw:

Okay, so if the Liberal fiscal plan is largely adopted in the budget, it could provide a material boost to economic activity. Our estimates are that it could add maybe half a percentage point of GDP this fiscal year and around one percentage point to GDP each of the next two years. So there is a chance obviously, that the fiscal plan gets watered down or the policy mix changes in order to secure majority in parliament, but it's probably unlikely that the contribution to growth would be meaningfully diluted.

Now, to put the size of the fiscal initiatives into context, it would be enough to offset around a 10% direct tariff hit. Right now we estimate tariffs are only 3 to 4%, given that most of Canada's exports to the US are USMCA compliant. So a fiscal impulse consistent with the Liberal plan, that would go a long way to offset the second derivative impact from US tariff policy, namely slower global and US growth. Now, the uncertainty factor is the biggest unknown. It is clear that the delta on economic activity is going to be down, but the magnitude is very difficult to handicap at this point. The survey data has been very weak, similar to what we've seen in the US, but how much this translates to weaker business investment and consumer activity is the wild card. But it's probably unlikely that Canada experiences a deep or protracted downturn with the expected size of the upcoming fiscal boost.

Simon Deeley:

Following up with these deficits set to expand from fall economic statement levels, and given some provincial downgrades this year, is Canada's credit rating at risk at all?

Jason Daw:

Simon Deeley:

That's right, Jason, issuance was materially higher last year. The minority government could result in a slightly altered mix of fiscal measures rather than automatically leading to larger deficit spending. While we are focusing on new fiscal plans and possible fiscal slippage, the bulk of issuance, 90% plus, is actually from financial needs related to maturities and new requirements that were in the prior baseline assumptions in the fall economic statement. These total 313 billion for the current fiscal year, which started April 1st. Our base case for GOC net and gross bond issuance is about 327 billion, which would be about 35% higher than the previous high for net issuance last fiscal year.

Jason Daw:

When we look at the BOC's decisions, in hindsight the last couple of months, it does look like March was an insurance cut when the data may be justified a hold. And April was a hold when the data more clearly favored a cut compared to the prior meeting. Now, it potentially means that the bar for the Bank of Canada to resume cutting interest rates could be quite high. We think it probably takes an accumulation, which is multiple months, not just one month, of wheat growth and contained inflation for them to be comfortable doing more from here. The other point to make is that they were clear that monetary policy is not suited to manage tariffs, and with fiscal stimulus on the horizon, they'll probably be more cautious going forward than they would otherwise.

I do think that they probably want to avoid replicating the pandemic era mistakes of overstimulating the economy from the dual impact of monetary and fiscal policy creating future inflation problems. This is sensible given they've already cut a lot and core inflation has not yet normalized back to target. So there is a decent chance the easing cycle is over, with the risk slanted to one to two cuts being more likely, in our opinion, than four cuts from here. The market's pricing two cuts, and the risk, in our opinion, is that the BOC maybe meets those expectations or under delivers instead of over delivering. So Simon, rounding out the discussion, what do you think the implications are for yields or Canada US spreads or swap spreads?

Simon Deeley:

Thanks, Jason. Canadian yields trade quite closely with US treasuries of the same term. There are days of discrepancies depending on prevailing themes. Even in the de-dollarization sell off, GOC yields tended to move directionally with their treasury counterparts. Our bias going forward is for yields to be relatively neutral near term, but should drift higher as more and more issuance needs to be absorbed by the market. Alongside the risk that the bank may be finished with the easing cycle, and we think GOCs are likely to cheapen against treasury counterparts in the coming months, with the previously mentioned tenure sector, our preferred tenor where we could see GOC under performance. Another place where issuance can impact the market is swap spreads. The difference between swap rates and GOC bond yields of the same maturity. We expect candidates to cheapen in this space over the coming months and quarters from minus 29 basis points currently, we think minus 40 is a reasonable level.

Jason Daw:

Thank you for joining this episode of Macro Minutes. There are multiple dynamic factors influencing the Canadian Economy, bank of Canada decisions, and the interest rate market. As these evolve, the landscape could shift quickly, so please reach out to us directly or via your sales representative for ongoing insights. Thank you everyone for joining this episode. If you have further questions, you can reach out to us directly or via your sales coverage or visit rbcinsight to read our content.

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