John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).
Spring is in the air, and you can feel the thaw in Canada’s real estate sector. Given widespread expectations that the Bank of Canada will soon begin cutting interest rates, thereby allowing some mortgage rates to fall, industry groups are forecasting the return of happy times, with the Canada Mortgage and Housing Corporation expecting new record highs in house prices before long.
But here’s a possibility that’s getting too little attention: What if interest rates don’t come down?
The narrative changed sharply on April 25 with the release of the latest U.S. GDP report. What it found was that while the economy was growing more slowly than expected, inflation was heating back up. The following day’s Personal Consumption Expenditure report seconded that finding. The prospect that the dreaded “stagflation,” which made life so miserable in the late 1970s and early 80s, might be returning to the United States sent a chill through stock and bond markets.
It also created a dilemma for the Federal Reserve. Either the U.S. central bank needs to cut interest rates to stimulate an economy that is sliding toward recession or it needs to keep them where they are, or possibly even raise them, to choke off a potential rebound in inflation.
Of the two options, the second is currently looking the more likely. A careful read of the GDP report reveals that the weakness in the economy may not last, since a higher-than-expected trade deficit and depleted inventories slowed growth. However, incomes remain sufficient to keep consumers buying, if more cautiously, which suggests inventories could rebuild.
But there’s little such silver lining to be found in the inflation readings. On the contrary, the evidence is building that not only is inflation not returning to the central bank’s 2-per-cent target, it may now be turning back up. As a result, traders in U.S. credit markets have now priced out all but one rate cut between now and the end of the year – and that, only at year’s end. Given the direction of travel, with the number of expected rate cuts continually being reduced, it is no longer outlandish to argue that American interest rates may even just stay where they are. Some analysts are even raising the possibility they could go even higher, although Jerome Powell showed little eagerness to do so when he spoke this week.
The divergence creates headaches for other central banks. The Bank of England, the European Central Bank and the Bank of Canada all want to cut interest rates soon, since they are overseeing economies that are considerably less robust than the American one. But if they do so, their currencies will weaken vis-à-vis the dollar. That could then raise inflation, since any goods traded in U.S. dollars – not just imports from the U.S., but commodities and other goods whose exchange on international markets is conducted in dollars – would get more expensive.
Opinion divides within central banks as to how to respond. At the ECB, some governing council members want to go slow and see how things pan out before cutting rates. A similar tone of caution is showing up at the Bank of England. Meanwhile the Bank of Japan, which is already pondering the possibility of rate rises, has to contend with a plunging yen, given the higher interest rates on offer in the U.S.
As a result, traders in future markets are now pricing in fewer rate cuts this year at the BOE and ECB. That will leave the Bank of Canada in a bind. Yields on U.S. government bonds are rising, dragging the rates on Canadian bonds up with them. The direction of travel in credit markets is thus toward higher rates. BoC Governor Tiff Macklem will have to decide if he wants to navigate a potentially lonely course against this current. As the big player in Canada’s credit markets, the central bank could ensure rates fall if it really wants to. But there would be a price to pay. In particular, the value of the loonie in relation to the greenback could fall, possibly a lot, and inflation could quickly rebound.
In short, there is a growing possibility that interest rates, if they do come down, will come down less than investors hope. Those hoping to be rescued by cheap money are likely to be disappointed.
A colleague of mine, a former adviser to Barack Obama who’s now at Stanford University, recently surveyed experiences of monetary tightening around the world to reach a jarring conclusion: There is no painless way to restore price stability. Investors have to accept that returning to low inflation can’t be done without asset prices taking a hit.
To date, Canada’s property sector has weathered the central bank’s tightening in fairly good shape. But this fight may not be over. Investors should brace for the possibility that before the good times return, they may first have to weather more pain.
John Rapley